Although the Bailout Bill Was Rejected, It’s No Time to Panic
By Martin Hutchinson
Contributing Editor
Money Morning
Unless you’re the chairman of the George W. Bush Presidential Library hoping for one last truly memorable economic achievement that would guarantee some big donations – as well as eventual visitors – the failure of the $700 billion bailout yesterday (Monday) was no time to panic.
Of course, the stock market did panic, with the Dow Jones Industrial Average plunging more than 777 points in its worst-ever single-day point loss (although the 6.98% decline in percentage terms is much less severe than the 20% nosedives of 1987 and 1929). At this stage, however, it’s apparent that the U.S. stock market is actually catching up to a new – and more-sobering – reality that’s been apparent ever since The Bear Stearns Cos. Inc. collapse back in March: For the U.S. economy as a whole, the failure is actually good news over the long haul; it paves the way for the re-emergence of American economic might on a basis that’s far sounder than has existed since the middle 1990s.
The bailout plan was unworkable. It basically called for the U.S. taxpayer to buy “toxic waste” debt from banks that knew far more about what that debt was worth than the ultimate buyer ever would. The plan made rosy and unrealistic promises about the eventual cost to the taxpayer being zero. There were no limitations on what prices could be paid for the debt, and U.S. Treasury Secretary Henry M. “Hank” Paulson and U.S. Federal Reserve Chairman Ben S. Bernanke so committed to the scheme that the taxpayer would not have been present at the negotiating table – hence Bernanke’s outrageous comment last week that taxpayers could pay well above market prices for this rubbish was only too likely to be realized.
Participating banks were to suffer tax penalties on the remuneration of their five top officers, and would be forced to grant indeterminate amounts of warrants to the Treasury, and Congress would have the right at the end of five years to recoup the cost of the bailout from the financial-services industry. The effect of these provisions would be to remove the bailout’s activities from the normal market for these rubbish assets, preventing the alleged central objective of the plan from being realized.
The outcome would almost certainly be a more or less total loss of the $700 billion by taxpayers, while the prices of certain assets on bank balance sheets would remain completely undetermined, since there would be no proper market for them, but only a bunch of politicians playing with funny money. That reality – plus the obligation to pay back the government’s outlay for a giant mess in five years’ time – would leave huge investing risks present in all banks up to, and including, JPMorgan Chase & Co. (JPM).
The bottom line is that the U.S. government would have controlled the entire U.S. financial sector.
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At this point, it sure looks as if we can thank the good sense of the U.S. House of Representatives, and hope against hope that it will adjourn for electioneering without passing this legislation – or anything else that’s anything like it.
Back in December 1929, then-U.S. Treasury Secretary Andrew W. Mellon – one of the greatest to serve in that role, and the only treasury secretary to serve under three U.S. presidents – announced that the problem of the Wall Street crash could be met by liquidation: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… purge the rottenness out of the system.”
The opposite path was taken by President Herbert Hoover with his Reconstruction Finance Corp. (RFC) – to a notably more unhappy result – just as the opposite path was chosen by Paulson and his acolytes. Borrowing $700 billion to invest in mortgage paper that has shown itself to be virtually worthless; it just reinforces failure and starves success of the capital it needs, which is the exact opposite of the recipe for success in a free market system. The great Austrian economist Joseph Schumpeter said that capitalism was a process of “creative destruction.” You cannot have the one without the other, so pouring money down a rat-hole to prevent further destruction will kill creativity and turn the economy into a Soviet-style mess.
As for the stock market, it is becoming increasingly clear that it has been suspended for the last decade at an artificially high level by the immense bubble of cheap money created by Federal Reserve chairmen Alan Greenspan and Bernanke since 1995. U.S. stocks, therefore, were poised for a drop, to an equilibrium level that could be as low as 7,500 on the Dow (I arrived at that potential nadir by measuring from early 1995, and calculating based upon a belief that stock prices should increase approximately in line with gross domestic product, or GDP), or even 5,000, should the market’s “animal spirits” find themselves to be exceptionally depressed.
Yesterday’s sharp drop could mark the beginnings of a realization by the market that the world has changed since 2006, that the subprime mortgages and securitized assets it thought so solid in 2006 were speculative toys, or outright junk, and that a world of lower asset prices can still be a world of increasing incomes and economic growth.
Once stock prices are so low that stocks yielding 6% can be found everywhere, the U.S. middle classes will once again begin saving and investing in stocks. Only then will the U.S. payments deficit disappear (because imports will no longer be artificially inflated) and the funding problems of government will become manageable.
This will bring about other benefits. New-growth businesses in the U.S. economy will find funding from domestic savings, something that’s non-existent right now. Emerging markets will have higher costs of capital than the United States, because of their smaller capital bases in a world of scarcer money, so that outsourcing jobs and investments to them will take place only when there is a true comparative advantage in the poorer country, including proper recognition of the higher costs of capital there.
As I discussed last week, the optimal current investment strategy is a defensive one, with inverse Treasury bond funds (such as the Rydex Juno Inverse Government Long Bond Fund (RYJCX)), some gold, and maybe some other carefully chosen counter-market plays. However, the failure of the bailout package, if it persists without a “rescue,” has made the moment when optimism returns considerably closer. For that we can be thankful.
[Editor’s Note: Money Morning Contributing Editor and credit expert Shah Gilani has outlined an alternative bailout plan that is designed to ease the banking crisis at a minimum cost for U.S. taxpayers. It’s a complicated issue, no doubt. But we urge you to take a look at the "Money Morning Plan." If you believe that some (or all) of these points make sense, we urge you to pass them along to the congressional representatives and governors of your respective states – especially now that debate has taken on an emergency status and that time is of the essence. We’ve even provided a listing of each state’s representatives.]
News and Related Story Links:
- Money Morning Alternate Banking Bailout Plan:
Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers. - Money Morning News Analysis:
Dodge the Pitfalls and Uncover the Profits From the $700 Billion Banking System Bailout. - Wikipedia:
Collateralized Debt Obligations. - Wikipedia:
Andrew W. Mellon. - Wikipedia:
Reconstruction Finance Corp. - Money Morning Special Investigative Report:
Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
Pingback by Money, Stock and Finance » Blog Archive » Although the Bailout Bill Was Rejected , it’S No Time To Panic on 30 September 2008:
[...] By Martin Hutchinson Contributing Editor Money Morning Unless you’re the chairman of the George W. Bush Presidential Library hoping for one last truly memorable economic achievement… Money Morning is here to help investors profit …[Continue Reading] [...]
Comment by Mary Diane Dolan on 30 September 2008:
According to the picture painted for us, the desperate, desperate former investment banks, at the edge of oblivion, cry out piteously for even a drop of “liquididty.” –And Paulson repeatedly expresses uncertainty that they’ll AGREE TO PARTICIPATE in a process of getting it to them!!!??? Can someone please explain? (I certainly do agree with Mr. Hutchison’s article; Paulson’s dealmaking attempts are more preciselly described as “hustling”).
Comment by Rick R. Pelley on 30 September 2008:
So the larger of the two Chambers rejected the bailout fiasco. However, prevailing “good sense” now, is too little, too late.
A complement measure of good sense must now come from weighty sectors abroad in order to “validate” what has occurred at home. Such will not happen, sufficiently.
This is because, over time, the greatest of all good sense, “trust” has been fatally breached. Not just at home, but everywhere else, too.
Comment by Ed on 30 September 2008:
I have mixed opinions on this. On the one hand i want our government to stay out of the economy but on the other hand they caused this mess and should have to fix it. Yesterday the market dropped in value over 1 trillion dollars. As an investment advisor that directly affects the people i serve. I have retired people now more concerned than ever as this affects their money directly. The $700 billion dollar infusion doesn’t afect them directly now and while i do not pretend to undestand how it will pan out i do know that my retired clients cannot take the market going down to 7500 or 5000 as Martin envisions is necessary to correct this. If the markets did this then we would have another problem…an abundance of poor retired people and a bunch of disenchanted people with a lot at stake in their 401k or pension. So certainty overrides uncertanty for me and i think a bail out is the lesser of two evils. I liken it to having a house party and inviting all the neighborhood children. After awhile we notice juice being spilled on the rugs and furniture. That is not the time to debate which children made the mess and how do we hold them accountable. Clean up the mess first (the party was your idea) and then deal with regulating it.
Pingback by Bail-out failure no reason to panick on 30 September 2008:
[...] Although the Bailout Bill Was Rejected, It’s No Time to Panic By Martin Hutchinson Contributing Editor Money Morning [...]
Comment by joe ross on 30 September 2008:
What are your thoughts on THE FIX?
Comment by Dan Sampey on 1 October 2008:
Instead of trying to reward failure, why doesn’t Congress reward the good banks with the needed funds to keep the economy rolling. Of course with regulation and accountability so there is not a repeat. Let those in Congress and Wall Street pay for their mistakes. The financial institutions that made the CEO’s rich, have them sue the CEO’s for all their worth to get the money back. I am sure there are several billion dollars in assets that can be recouped. Since the blind can see that this bailout will not work, let the markets, that they SO believe in, take care of them. The government has gone too long rewarding stupidity and crapping on the the good ones.
Comment by Valued Customer on 1 October 2008:
Ed, I hate to say this, but before you can clean up the mess, you have to end the party. It’s too bad you aren’t preparing your clients for that, because that’s what’s happening now.
I only hope Congress continues to be incapable of selling us out for the forseeable future, because that is the only thing that can weed out the overleveraged, the fraudulent, and the incompetent from this extortionate market.
Ed, you can take heart tho, shovels are easy to master, and a long, hard day using one provides a deeply satisfying nights rest!
I can only hope that the combination of Putin not seizing the Georgian oil pipeline, and Congress’ incompetence at defrauding the American people have sufficiently weakened the banksters that they will be joining the unskilled labor force within the month – at least the ones that avoid prison.
Comment by Rick R. Pelley on 2 October 2008:
To Valued Customer:
Your comment reply to Ed yesterday was very well said.
Rightly, the party must end, but not by way of “reward” money for “extortion”. The larger chamber of Congress should reveal an outcome today.
By the way, is not the Secretary Treasurer, Henry (Hank) M. Paulson, a former Goldman Sachs chief bankster? Ever heard the old adage: “Birds of a feather, flock together”?
Best wishes.