Dead Man Blogging …

Ok, so I’ve admitted that the government probably had to do something to stem the financial crisis.

Now I’m going to talk about all the ways this bailout could – and probably will – go wrong (with the caveat that all the details still haven’t been worked out).

• Everyone talks about how this plan will be reminiscent of the government’s ultimately successful strategy to create the Resolution Trust Corp. (RTC) in 1989 to help resolve the Savings & Loan banking crisis.  Numerous difficulties arose during that bailout as more than 2900 institutions and $900 billion in assets ultimately had to be rescued, and yet the cost and complexity of this current crisis will easily dwarf anything seen in the S&L crisis. The bad loans in question are larger in scope, broader in reach, and more intricate in design. Deciding which assets to buy, how much to pay for those assets, and how to get rid of them will be extremely delicate matters, and if we have learned anything about government, mistakes will be made in the process.
• The plan will certainly cost U.S. taxpayers a lot of money. Some optimists are talking about how the government could end up making money from this deal if they’re able to pick up these assets at very distressed levels and then sell them back at higher prices once things settle down. Such a scenario is possible but highly doubtful. What is much more likely is that the U.S. balance sheet, already drowning in foreign debt and facing enormous future liabilities caused by a troubling demographic shift (e.g. Social Security), will continue to deteriorate. This will lead to higher inflation, a higher deficit, higher taxes, a weaker dollar and ultimately, a large transfer of wealth to other nations.
• This bailout, even if successful and profitable, will once again institutionalize the concept of moral hazard into our economy. This is something I’ve talked about before in this blog, but economic moral hazard basically means that people will take on too many risks if they believe they will be bailed out if things go bad. There are folks, including me, who feel that the S&L bailout is one reason why the financial system got so quickly back into trouble. The Glass-Steagall deregulation of the industry didn’t help, either. I hear a lot of people say our current predicament is too critical and dire to spend time philosophizing about moral hazard, but that’s a circular argument which will never lead to addressing the issue.
• That’s why it’s so critical the government makes sure all institutions that need help suffer some kind of repercussion as it designs and implements its plan. And when the dust settles, government should begin modest re-regulation of the financial industry to try and ensure this level of risk-taking doesn’t happen again. Finally, the government should go hard after people who committed crimes during this period, and take back some of the billions in ill-gotten gains from those bad apples. No need to play the blame game immediately, and you’re never going to get back all that money (thinking about the multimillion-dollar bonuses many of these guys got over the past several years is a bit sickening), but people as well as institutions need to realize that overly risky behavior could lead to punishment down the road.
• The one thing we do know about the current plan is that the SEC has declared all-out war on short sellers (investors who sell borrowed shares in hopes of buying the stock back at lower prices and pocketing the difference). The agency has banned short selling on 800 financial-related stocks and forced large short sellers to disclose their positions. I hate this. It frankly disgusts me. It’s something a country like China would do (and has done). I’m a long-only investor, but short sellers are an easy scapegoat – they provide liquidity in the market and often correctly point out flaws in companies and business models. However, I do understand that confidence can make or break our financial system, and plummeting stock prices caused by unchecked short selling certainly threatened to exacerbate the crisis. So, while this ban sets a very bad precedent, I suppose I can live with it as long as it is a very temporary measure. In the end, the ban will only work if time and some breathing room was the only thing the market needed to stabilize. If this bailout isn’t sufficient and we have even more serious systemic issues, then this market rally will be only a temporary reprieve – stocks will fall again and the problems will begin anew as soon as the ban is lifted.