Friday, October 3, 2008

Bailout 1.1 passes! Will we need 2.0?

So the bailout bill finally passed. No doubt all those amendments helped convince Congress to give the nod to the legislation. While others get all excited over such proposal like the one to suspend mark to market accounting, my favorite amendment is:
For investors the key question is whether the authorities will have to come back to the well again later. To evaluate any solution, here are the issues to consider:
  • Does it give the system solvency? or just liquidity?
  • Who finances the rescue?
  • How does it affect the US consumer?

Does it make the system solvent?
I have written before about the solvency and liquidity. The scale of the Fed’s liquidity injections into the financial systems has been off the charts. The latest report states:

Banks' discount window borrowings averaged $367.80 billion per day in the week ended October 1, nearly double the previous record daily average of $187.75 billion last week, Federal Reserve data released on Thursday showed.

Liquidity isn’t the problem. Solvency is. What price does the Treasury pay for these toxic assets and will it make the system solvent? I keep repeating Brad Setser’s comments but it’s worthwhile to keep them in mind:

If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

If the bailout doesn’t create sufficient solvency in the system, then we may need another bailout. Jonathan Weil has suggested direct equity injections [read: nationalization] into the banks would be a lot more efficient way of spending $700 billion.

Who finances the bailout?
The question of who finances the bailout has profound investment implications. If it’s financed by the printing press it will be highly inflationary. On the other hand, if the majority of the burden is borne by foreigners (China, Japan, Middle East states, etc.) then the results are likely to be deflationary.

If foreigners have to finance the bailout, then what do they want? Over in his blog, Fabius Maximus proposed a Brady bond like solution for the US:

The Master Settlement of 2009

I. The US receives $1.5 trillion in new lending in 2009 and 2010, with smaller loans in the following five years. New lending under this agreement ends in 2015.

II. Existing US government and agency bonds held by foreign central banks are rescheduled. Principal or interest payments begin in 2016, amortized over the following 30 years at low fixed interest rates.

III. The bonds are denominated in an index of currencies, weighted by the debt held by each nation. We lose the ability to inflate the debt away by printing money.

IV. The US dollar is immediately devalued by some fixed amount (perhaps 20%). The lower dollar will reduce our imports, as they become more expensive. Our exports again become competitive on world markets, so we can earn the money to pay our debts.

V. Our creditors will demand (and receive) consensions [sic]. We can only guess what those might be. China will certainly ask for a sphere of influence that includes Taiwan.

How does this affect the US public?
Lastly, the reaction of the US public may be as relevant as Argentineans demonstrating in the streets in the last crisis in Argentina. Nevertheless, Macro Man was right when he noted that Americans are at serious risk of class warfare:

[The chart] shows a surge in corporate profits (at the apparent expense of wages) as a share of national income. It is the divergent fortunes of these two series that has fueled Main Street anger and turned "no" voting Congressmen into class warriors.

Stories of giant CEO severance packages also didn’t help matters.

Inflation or deflation?
For investors, we come back to the key question of inflation or deflation.

How does the solution, however it is implemented, affect the balance sheet and spending power of the US consumer? What happens ultimately affects earnings and growth, which is what the equity markets are all about.

Given all the turmoil, it may be wise to sit out October and wait for the dust to settle.

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