Tuesday, October 07, 2008

The Bailout and the Markets

Well, another fun day in the markets on Monday. I just have to point out again, those people in Congress must be eating their hearts out after bending capitalism over and cramming it in the ass by voting in favor of the $700 billion bailout plan on Friday, and then nonetheless watching the market lose 5% of its value across the board in two days, and really closer to 8% from where it was at the moment Friday's voting for the bailout began. If only all those who voted in favor could lose their jobs as well this coming November, then the cycle would be complete and I would be a happy man. For me, it's not in the least about politics; it's about accurately representing the interests of the people who voted you into office to enact their will. You don't do that, and I want you out on your Constitution-defying ass.

Anyways there are a lot of incredibly interesting things going on in the market right now. Today I thought I would take a minute and respond in a little more detail to a good question I was asked by dubspoke in the comments to yesterday's post. Basically, dubs wanted to know what I think should have been done if I don't like this whole bailout idea.

Now, this is obviously not an easy question to answer, but I'm going to give a relatively simple answer anyways. The most important point to note, however, is what I've said here previously, which is that I don't purport to be someone who has all the answers for this crisis. I just know that the one they've come up with -- simply coming up with $700 billion dollars and directly buying up all the bad mortgages and other crappy assets the financial institutions in this country have put on their books over the past several years -- is not the right one, which it seems the market agrees with after all despite a couple of head-fakes to the upside during the past couple of weeks prior to the passage of this bill. As I've said here recently, I'm not an economist, I'm not a banker and I know very little about complex mortgages. So I'm really not the right guy come up with "the" answer to the very real financial crisis in this country right now.

And before I forget, let me be clear again that there are many people in America right now who simply say Eff the Banks, let them die out and fall on their own sword for the bad decisions they have made. This also is not me. As much as I would love to give the big middle finger to the banks and tell them just that (believe me, I would love it), that response will for sure have drastic financial consequences for everyone in the country. We can all see at this point how many major, real banks and other financial institutions are failing, and if we do absolutely nothing for them, all the big banks will die out, people's money will disappear, and we will very quickly be faced a banking crisis the likes of which no one who's ever lived in this world has seen. At this point, we really do have no choice but to do something quick and something big to help get the banks back on their feet, stable and lending again, doing what they do that helps serve as the backbone of the American (and global) economy, to use dubspoke's phrase. Doing nothing, frustratingly, is just not an option right now, as much as I would love to stick it to these banks who got rich by being jackasses over the past decade.

No, we have to do something big and something fast to help save the entire banking system in the U.S. But I never for one second thought this particular bailout plan was the right one, right from its very essence as a means to simply free the banks of all their bad assets, and put them on the government's books instead. That my friends is a ghey idea and we will be paying for it for a long, long time (literally). So while I don't try to pretend that I have all the answers here, dubs was asking me what I would have done instead, and in a nutshell, here it is. I know I'm not knowledgeable enough to answer that question. But I can look to someone who clearly is: billionaire investor Warren Buffett. Put simply, I would do what Warren Buffett has done over the past couple of weeks with his multibillion dollar investments in Goldman Sachs and GE. If there is really $700 billion available to play with here, I would not be spending it buying up all the bad assets purchased by these banks over the past decade. I would be buying preferred stock in these companies instead.

There are several problems with the current bailout approach, all stemming from the fact that I have hammered home again and again here over the past couple of weeks that the whole essence of the Paulson plan is to bail out the bankers, not anyone else and not the economy at large. First, buying up these bad assets puts the government in the crappy situation of having to own all these bad assets, which of course is itself a bad thing and is made even worse by the fact that it's our money -- yours and mine -- which is being used to make these purchases. I don't want to own a portfolio of mortgages that is worth 20% of what the banks claim it's worth and that is going to see thousands of defaults over the next several years. Why would I? Of course, the banks would do anything not to own those piles of shit either, which is why they hatched this entire idea with their banker buddy Hank Paulson, and why he readily agreed.

Secondly, buying the mortgages from these banks directly does not enable the purchasers -- the government, but really you and me -- to participate nearly as much as I would like on the upside from profits resulting from these purchases. Paulson has been adamant from the moment he unveiled this bankers' bailout plan that he does not intend to buy these crap debt assets from the banks at the "firesale" prices that the loans are currently being bought and sold at in the marketplace. He wants to pay more than that. Why, nobody has yet to put forth a single argument that even passes the giggle test. Because the real reason Paulson wants to overpay for these loans is that it will help the banks if he does, and will hurt the banks if he pays fair market value for them. Period. That's it. That's why Paulson wants to pay these banks two to three times the current market value of these bad assets he's going to buy up with our money, because these banks want Paulson to give them more money in addition to taking the troubled assets off of their books. And because he is a banker just like them, he is all too happy to do it. With other people's money (just like the bankers over the past decade).

Lastly, and this stems from the above two ideas, but the biggest problem I think with this whole asset bailout plan for the banks is the disincentives it creates. What this plan will do is give more money and buying more troubled assets from the very banks who acted the worst during the past decade or so. For the Citigroups and the Countrywides and the Fannies and Freddies and WaMus and Wachovias and the like, who have the most billions of dollars of horrifically distressed loan portfolios on their books because they were the most reckless of all during the deregulation period of the past 10 to 15 years, those banks will get the most relief now from this plan, being overpaid the most for the largest amount of debts being taken off their books. It's sad really, and anyone who doesn't think that this will simply incentivize more bad action, less prudence and more recklessness from the nation's financial institutions in the future, you're nuts. Of course it will. It sends the wrong message, it rewards the wrong people unfairly, and it will lead to the wrong response from banks and other investment houses in the future in this country.

Instead of the above, I would take this $700 billion and buy preferred stock in all of these hard-hit financial institutions. This way, we are infusing them with billions and billions of dollars -- literally -- of fresh capital, which by definition will itself re-invigorate lending from these banks. Banks don't make money by sitting on billions of dollars of cash and just hoarding it. Their whole existence is based on lending and investing their cash, and making more money putting their piles of cash to work than they have to pay out in interest to investors who keep their money on hand at the banks as deposits and the like. That's the whole way it works. So while giving cash money to these banks by directly buying all these horrible investments off of the banks' books is also likely to re-stimulate the lending that has been slowing to a trickle over the past month or two in this country, simply purchasing preferred stock in them a la Warren Buffett would have the exact same effect, pretty much by definition. But just look at how much better the side effects of a preferred stock investment plan are than a loan purchasing plan.

First, we're not actually buying the bad loans that these banks have sitting on their books. We don't have to worry about getting a bad price for them, because we're not going to buy them at all. We don't have to worry about how we're ever going to make a profit or even get rid of these bad loans in the future at all, because we're not buying them in the first place. We would be infusing these banks with cold hard cash that they will have no choice but to lend and invest and do their banky thing with, but we would not be taking on the responsibility and the problems of dealing with all those messy mortgages and other debts that the banks irresponsibly purchased over the past decade with no one in Congress watching over their shoulders in the least.

Secondly, even though we won't have to worry about how to make a profit from reselling the bad loans we purchase through the current bailout plan because my suggestion would be not to purchase them at all, we still have a tremendous opportunity to profit from the preferred stock investments we are making under the idea I am proposing here. Look again at the deal Warren Buffett recently got with both Goldman and GE. Basically, he gets preferred stock, which is called "preferred" because #1 it gets preference over regular common stock in the case of a buyout, bankruptcy, etc. and #2, it also pays an extra dividend, which in Buffett's case I believe is 10% per year with both the GS and the GE investments. So the government (i.e., you and me) could be purchasing preferred stock in every bank we choose to help under the current plan, making 10% per year as a dividend on this investment, plus getting to participate directly in 100% of the upside in these companies' stocks after they start lending again with our huge cash infusions. Let me give an example to make this a bit more clear:

So, let's take Citigroup. C shares are currently trading around $17.50 a share, giving the company a market value of around $95 billion. So if we determine that Citi needs $20 billion of fresh capital in order to effectively support the company and re-stimulate its lending practices, then we purchase $20 billion worth of C shares at a price of let's just say $17.50, even though in reality we should be getting a Warren Buffett-type price of more like $15 for that size investment. But let's just say it is at the current market value of $17.50. So we, the taxpayers, now would own approximately 16% of Citigroup, and Citigroup would have $20 billion of fresh capital to do its banky thing with. So the lending and the investment by Citi gets kick-started again, and let's say in two years things have recovered somewhat thanks in no small part to these huge cash infusions, and now Citi shares have recovered up to $40 a share. A level not in any way silly since Citi shares never once traded below $40 a share since 2003 until less than a year ago when the whole credit crunch really started to be felt and bank shares started getting pounded. So in two years we, the taxpayers, could sell our $20 billion investment in Citi preferred shares -- which btw have already paid us $2 billion in interest in the first year and another $3 billion in the second year assuming a linear return over the two years in Citi shares -- for nearly $46 billion. So we bought in today for $20 billion, and in two years we sell out for $46 billion, plus we made $5 billion in interest over that two year period. Now that's what I'm talkin about. That's how a smart bailout plan would work. Which is why the smartest, best investor in the world is doing just that right now, putting his money to work by investing not in the shit on these companies' books that no one in their right mind wants to buy, and not by overpaying for the shit at that, but rather in preferred stock in the companies themselves.

And the best part about this entire new plan as opposed to the current bailout plan is that it still leaves the bad shit on these companies' books, so that they, and not we, have to deal with it. So those banks that made the biggest investments in the worst piles of crap out there don't get bought out the most and rewarded the most for their recklessness. Sure we might have to make a larger preferred stock investment in the hardest-hit banks to enable them to overcome those horrid loan portfolios, and we could do that, but those banks would pay a huge price for their reckless investment decisions as well they should. So say Wachovia, trading last week at $16 a share for a market value of $40 billion, actually needs the same $20 billion cash infusion to shore up its capitalization because it made way more redonkulous investments in bad loans than Citigroup. That's ok, because we can use our $700 billion to buy $20 billion of preferred stock in Wachovia, only in this case, we would be owners of 33% of the shares after this purchase, instead of 16% as was the case with the Citi example above. So Wachovia gets the money they need to re-stimulate their own lending and investment practices, and once again we get to participate on the upside as owners of a third of the entire company. So I'm ok with the incentives that this creates, because instead of just buying up the most assets from the worst-behaving banks of the past decade, we give them the cash infusions they need but we take a much larger ownership stake in the companies when we do it. So they do feel the pain of having acted so recklessly in the recent past under this proposal, which is to me one of the most important aspects of any bailout plan we can come up with.

And sure, I hate the idea of any government ownership of the private companies in this country. I hate it with a passion. But at this point, with the banking system in the pickle it is in at this point in America, the sad truth is that we have no choice but to do something drastic. Desperate times call for desperate measures, and believe me, if you're not enough on the inside to realize or understand it that is ok, but these are the most desperate times for every bank out there since the Great Depression without a doubt. And given the choice between the preferred stock investment plan I have outlined above, and the troubled asset buyout plan currently being pursued by Hank Paulson and pushed so hard by our trusted and beloved President, I choose the former eight days a week. And my suspicion is that most of the public would choose it as well. And don't get me wrong, I'm not trying to take one lick of credit for coming up with this idea. It's not my idea. You can thank Warren Buffett for the idea, if he was even the first to come up with it. It's just smart investing when it comes right down to it, something which Treasury Secretary Paulson sadly is not remotely interested in promoting with his plan.

Anyways, two other good stories I wanted to link quickly today. One comes out of Lehman chairman Dick Fuld's testimony yesterday before Congress, and it is of course a story I absolutely love. How do you not love someone just hauling off and knocking the CEO the fuck out right in Lehman's own gym the day after Lehman Brothers declared bankruptcy thanks in no small part to Fuld's unbelievable hubris and shortsightedness. I wish I knew who it was who did that, so I could go walk right across the street over there and shake his hand in person. Oh and about Fuld's testimony, the first highlight for me was Fuld disputing that he had made $400 billion in compensation over the past several years as Lehman's CEO, insisting instead that it had only been closer to $310 million. Ooooooooooohhhhhhh, wow were we wrong about that to think that he had made too much money relative to his performance in his time as the head of Lehman Brothers. Only $310 million, what were we thinking, that sounds totally fair.

I also loved this part of the testimony, which I am copying direct from this Yahoo! News link:

Waxman released e-mail correspondence from June 2008 in which Fuld dismissed the suggestion from executives at a Lehman subsidiary that the company's top people forgo bonuses to "send a strong message to both employees and investors that management is not shirking accountability for recent performance."

Fuld wrote, "Don't worry — they are only people who think about their own pockets."

The suggestion came from executives at Lehman's money management subsidiary, Neuberger Berman, who also were recommending that Lehman spin off its business to insulate its employees — and their bonuses — from Lehman's sagging stock price and from "management mistakes."

George H. Walker, President Bush's cousin and a member of Lehman's executive committee, breezily shot down the ideas, according to the e-mails.

"Sorry team. I am not sure what's in the water at" Neuberger Berman, Walker wrote to the rest of the executive committee. "I'm embarrassed and I apologize."

Yes, President Bush's cousin, there must be "something in the water" for anyone to actually suggest that top Lehman executives give up their fucking bonus after what they did to this company during 2008. Uh huh. Good stuff right there, and a great look into everything that was wrong with Lehman and the whole executive compensation scheme at the i-banks over the past several years on Wall Street.

Lastly, for those of you seriously concerned about your investment portfolios -- regardless of the absolute size of them -- after this recent market turmoil, there is one genuinely good sign: Jim Cramer said Monday morning on the Today show that he would not buy U.S. stocks for the next five years. Now, despite Cramer's status as probably the most famous and recognizable television personality in the investing world, this guy has been so dead wrong so much more than he's been right, he is almost a reliable contra-indicator a la Waffles betting on football games. I mean, Cramer was out there on March 11 of this year telling people on his CNBC tv show that Bear Stearns was fine at $60 a share just two business days before the company was sold to JP Morgan for $2 a share. Cramer also called the bottom of the markets this past August, actually saying that the July 2008 bottom was the lowest the market would get (this was about 12% above Monday's closing price and more above Monday's intraday low). And that's just two examples of a million where this guy simply has not a clue in the world about what is going on. He is wrong a good 90% of the time in what he says, so the fact that he now suddenly at this point announces he would not buy U.S. stocks for five years means we could very well be nearing a short-term bottom. Just one bright spot on an otherwise very murky horizon for investors today.

Labels: , ,


Blogger Riggstad said...

Good for you Hoy for calling out Cramer.

There was/ is a lot of buzz on philly talk radio the last two days about him being accountable for yesterdays huge loss in the market.

I couldn't get on the show fast enough. Unfortuntely, I couldn't get on at all.

1:26 AM  
Blogger Hammer Player a.k.a Hoyazo said...

Yeah I don't really blame him so much for yesterday's huge loss. Any more than I credit him for any rally that happened on a day when he "called the bottom", which has happened about 30 times in the past year, wrong every single time of course. But it definitely contributed to some degree, especially being that he said it on the Today show and not just TheStreet.com or on his ghey show on CNBC, that is a much wider audience and much more susceptible to fear and to believing anything that some supposed pundit says.

All I know is, Cramer is an entertainment guy and not a market pundit anymore. He is wrong *far* more often that he is right these days, by a multiple of 4 or 5 it seems. He just says a bunch of stuff every day and sees what sticks, and then acts like he never said the other stuff at all.

1:58 AM  
Blogger DubsPoke said...

The smart people don't listen to Cramer, but, as we all know, the world is full of idiots.

Anyways- thanks for the reponse to my question. I'm a fan of the oracle of omaha myself. I just don't know if the government could pull off what he is doing.

There was another article, I'll try to find the link to it, that refers to infusion by raising huge amounts of capital through bond offerings or something along those lines. I'll try to find it and post/send it to you later.

Thanks for the reponse. Wish I had a more intelligent reponse but I'm too busy fielding questions from pissy financial advisors atm. I'll try to get back later.

Thanks again.

2:13 AM  
Blogger Astin said...

I can't speak with certainty about US preferreds, but in Canada, they don't work that way.

Prefs trade much like bonds, and, in fact, are more closely tied to bond movement than stock prices. They start at a par of $25 with an interest paid, and from there you're calculating yield.

What Buffett did was buy Prefs with their wonderful interest-paying aspect, and warrants to buy the stock at a fixed price that are good for the next 5 years! He did something only someone like Buffett can do. The government could potentially swing just as sweet a deal on volume alone, but they honestly don't hold the sway Warren does.

Also, preferred stock doesn't count against the market cap/float of the common equity shares.

Which is a perfectly viable solution that is preferable to the bailout they're going through. Buying prefs with warrants (essentially call options) would have a huge upside potential for taxpayers. The trick with the government doing this is that they'd have to be sure they were warrants for NON-VOTING shares, so that they'd have ZERO control over the direction of the companies if they exercised said warrants. This lets them infuse capital, take part in the upside, but NOT socialize the banks.

Personally, I think they should change numerous laws and rules for the PUBLIC that would encourage people to invest in long-term interest investments in order to provide capital, along with various other tax changes that encourage increased investment and capitalization. By changing these rules, you can encourage far more than $700 billion in investments from the ultra-rich, hedge funds, institutional investors, pension funds, and the general public.

Cramer's a moron, but a damned entertaining one. Market's not done yet, as shown by the 500+ point drop today, but if you have the balls, it's not a bad time to start looking for buys.

1:04 PM  

Post a Comment

<< Home