Monday, September 29, 2008

Private Client Commentary - bailout

Dear Clients,

What interesting times we live in. As I write this, the politicians have yet to agree on the details of the "bail out" package they've been working on for the past week (but I suspect that by the time you read this, there will be a plan). They're simply doing what politicians do - desperately weighing the political ramifications of whatever deal they strike.

How is it that we find ourselves in these predicaments? I mean both the financial predicament that presumably calls for a bail out, and the political predicament that I feel exacerbates the emotions around the issue.

As for the financial predicament, in a nutshell; the trouble with the economy today is that it's suffering a hangover from the real estate party. And for many players in the financial industry (the big substance abusers) it's much worse than a hangover - in fact, they partied so hard that, if we don't pump their stomachs very soon, they're dead. The problem for the rest of us is that we rely heavily on these drunkards. And if Hank Paulsen and Ben Bernanke are right, if we let them die, the ramifications for the consumer and the economy as a whole are severe.

But what of the moral hazard of rescuing these addicts, aren't we just setting them up to do it all over again? And wouldn't such a bail out fly in the face of the basic tenets of capitalism? As for the "moral hazard", expect any deal from Washington to include major regulatory reform aimed at keeping this kind of thing from happening again anytime soon. As for, "does this fly in the face of capitalism" - that would be a big fat yes. But the seven hundred billion dollar question is - what happens if we don't do it?

According to Paulsen, Bernanke and Warren Buffet, to name a few, if we don't do this bail out, our financial system, as we know it today, will virtually collapse right before our eyes (I must add however that not all economists agree with this dire prediction). And the ultimate cost of a crashing economy, lost jobs, etc., will make this bail out look like peanuts. On the flipside, if what Paulsen, Bernanke and Buffet say is true, the deal not only bails out the banks and gets them back into the business of lending - it ultimately turns a profit for the taxpayer in the long-run.

They say the stuff we would pull from the stomachs of these banks would not be at all fatal if it were in a stronger stomach. So what they're proposing is a purchasing of the mortgage investments from the banks at a discount, then holding and managing them until such time that the market improves and they can be auctioned back into the private sector - for potentially more than what we paid for them. Last week Buffet went so far as to suggest that if he could, he would do the deal himself.

The bottom line seems to be, like it or not, that some sort of bail out package will be passed - and it may in fact prove to be a step in the right economic direction. Longer term however, it's the precedent we're setting that we need to be concerned with.

As for the political predicament, I honestly feel the consumer deserves some of the blame. Mr. Consumer says he wants the government to stay out of his business; he wants to be free to become the best he can be. He wants free markets where he can invest in the creativity and innovation that will make richer the world and his portfolio. He wants all the upside, but oh how he hates the downside.

Our politicians are scared senseless (literally). They're deathly afraid of the very capitalist system they've sworn to protect. Yes, they profess out loud their undying commitment to Mr. Consumer's freedom, to protect his right to work for the things he wants in life - because that's precisely what Mr. Consumer tells them he wants.

But what happens to that thinking during those inevitable times when the freedom of capitalism combined with previous government intervention (like the huge stimulus the Fed pumped into the banking system during the 2001 recession) allows a bubble to form, a bubble dangerously expanded by excess and greed? Suddenly the politicians, out of fear of the consequences of the bubble's inevitable bursting - out of the fear that Mr. Consumer will blame them for all of it - try desperately to patch it.

(In reality, what we have is a situation where previous government intervention may have over-stimulated capitalisms creative juices, and consequently, more government intervention may be needed to fix the resulting problem. It


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