There are elements of the $700B bailout that no one is talking about and I’m not sure why.  First, this bailout is not a classic bailout because the “bad debt” is actually backed by assets with real value, namely, real estate.  The government is not pouring money into a black hole, like they’ve done in the past.  They’re taking this debt (and asset) off the books of banks who cannot properly value these assets. 

When the real estate market recovers the government could sell the assets and put the revenue back into Treasury.  In a best case scenario the government could actually EARN revenue because they are essentially buying these assets low and could potentially sell them for a higher price later on.

This historic bailout will do two things:

• It will take bad dept off the books of banks which will free up money for new mortgages
• It will stop the flow of bank owned properties into the marketplace, which is eroding home prices

In other words, this bailout will bring new buyers into the marketplace and potentially put a bottom on the home price erosion, which I believe is one of the most significant threats to the US. 

It’s hard to understand why this bailout is being characterized so negatively.  The government is acting more like a Venture Capitalist, coming in at the last minute to purchase assets at a low price who then holds them until the market turns around.  The fact is, these assets could actually increase in value over the next 7 to 10 years and be sold off at a higher price to help solve issues like Social Security, Medicare, or an overtaxed military. 

Let’s say a bank took over a $200,000 mortgage in foreclosure and the property is valued at $150,000.  If the bank had several hundred of these “bad” loans the write offs would be significant and would cripple it’s ability to generate more mortgages for new people.  These properties would be pushed into the marketplace at a low price in order to get them off the books, but at the same time banks cannot create new mortgages so the prices drop even more.

The bailout plan would allow the government to take these bad loans (and the asset) off the banks’ books.  In the example above, the bailout would be applied to the $200K mortgage, but the government would also own the asset.  Instead of dumping the property into a competitive marketplace, the government could hold the asset for a few years until home prices recover to some degree.  In 5 years from now, they could sell this same asset for $220K and actually earn revenue.   

The unfortunate part of this is the government rarely manages anything properly.  So, there could potentially be millions of government owned properties floating around in the next 7 to 10 years not being kept up.  This could also undermine home prices and erode a potential Return on Investment.   

If this bailout is done right, it could have a significant long term positive impact on the economy and even help remove part of our deficit.  If, on the other hand, it is not managed correctly, the consequences could be negative.  However, not acting at this stage would mean significant erosion of home values which could have a cataclysmic effect on our economy and the world economy.  Banks will continue to fail, home values will continue to fall, more people will owe more than what their house is worth, which will result in even more foreclosures, which will lead to more bank failures, etc.  The downward spiral must be stopped and there are not many institutions that have the ability to invest such large amounts of capital.

My concern at this point is this process will become politicized, the bailout will stall, more banks will fail, and the window of opportunity will close.  If more large banks fail, which they will as home prices drop, a bailout will not be possible.  It will be too late. 

I wonder if it’s possible for our government to put political views aside and act on behalf of it’s citizens?  It will be interesting to see how all of this unfolds this week.  My guess is the next two weeks will be one of the most historic times in US history from a financial perspective.  We’re at a crossroads and it could go either way.  Here’s to holding my breath and hoping for the best!!      

One last point that has not been discussed.  Let’s say the government takes over these assets and banks write off the debt.  If this happens, I believe those who went into foreclosure could have a significant tax burden, which could also pull a great deal of money out of the economy due to the sheer magnitude of the problem and it all happening at the same time. 

In the example above the the individual would owe $200K, but the asset would only be valued at $150K.  The amount ”forgiven” would be $50K ($200K – $150K), which would show up as “income” on this years taxes.  This would amount to a tax bill of $10K to $15K, which could push many into bankruptcy (or at least seriously curb spending), which would also put a burden on our banking system. 

There are many facets to this bailout and due diligence is needed, but if honest dialog turns into “analysis paralysis” then the country is doomed and so is the world economy.  I’m not a big fan of how the Republicans are pushing this through, and I’m also not comfortable with the Democrats adding pieces to the bill that are politically charged. 

But then again, who the heck am I??! 

Last week the SEC banned short selling for financial services stocks.  It was an unprecedented move.  Some have come out to denounce it, but I think this action was positive and should be made permanent, rather than having the ban lifted in early October. 

Short selling is used when an investor believes a security (stock) will go down.  Here’s a description of a short sale from wikipedia:

“Short selling or “shorting” is the practice of selling things the seller does not own, (often financial instruments), in the hope of repurchasing them later at a lower price. Often the sold item is ‘borrowed’ or ‘rented’ for the period of sale and re-purchase.  Short-sellers attempt to profit from an expected decline in price (in contrast to the ordinary investment practice, where an investor “goes long,” purchasing a security in the hope the price will rise).”

The reason short selling is fundamentally flawed is it turns the stock market into the largest casino on the planet.  Look closely at how this quote from Wikipedia is worded.  It’s implies “betting” on which way someone thinks a stock will behave – it says nothing about owning something of substance.  This implies gambling, and it’s one of the reasons our financial system is struggling – it represents a fundamental flaw.  In fact, much of our financial infrastructure is becoming more casino-like and looks less like what it was originally intended to do.

The original intent of the stock market was to invest (not gamble).  It was designed to provide capital to entrepreneurs who had a good idea and a strong business model.  If the company performed well the stock would pay a dividend to those who owned it.  It was a way for a wide variety of people to participate in our free market economy who may not otherwise be able to do so.  It was a way to develop this country from the ground up, in a grass roots way.  It’s a brilliant model in which citizens can take ownership and have a vested interest in success. 

Like any successful model, the negative parts of human nature will try to undermine it.   

In recent years, the stock market has evolved into a casino.  It’s become a way for those addicted to gambling to ”justify” their vice.  The stock market has become a way for people to “make money” first, and invest in good ideas second.  That was not the original intent.  Originally, people ”made money” in the stock market via dividends, and increases in the value of the stock was secondary.  Now, this concept has been flipped: 

• People who participate in “shorting” care little about dividend payments and good ideas and more about “making money”
• People “bet” on which way the stock market will move, rather than investing in good ideas and business models
• People buy “options” which have no intrinsic value, and it’s sole purpose is to “bet” on the value of a stock – this is pure gambling

Short selling has nothing to do with investing in good ideas and good people.  It has nothing to do with finding unique business models or healthy entrepreneurial endeavor.  It has little in common with finding CEO’s that can make valuable ideas a reality.  Short selling is wrong on every level and should be banned forever.  This is also true with “options” and other financial instrument that have no actual value like ETF’s. 

Options and short selling are supposedly used as a form of ”insurance” to protect an investor from downturns in the market.  This “insurance” argument is used to justify high-stakes, wall street gambling and nothing else.  A stock should go up or down based on dividends, or potential of dividends, as well as the business model and management team.  Short selling and Options put false pressure on stock prices because people are not selling stocks based on a desire not to own them, but rather because they believe the price will go down.  While this distinction may seem insignificant, it’s absolutely essential to understand the subtle difference – on one side is healthy ownership on the other side is gambling and chance.

The added pressure these misguided financial instruments put on the real price of stocks is a fundamental flaw which will continue to plague our financial system.  Of course, those who create the tools that allow gamblers to feel better about their vice and undermine a great institution make billions of dollars.  It will be unlikely these practices will stop until we experience the downside that comes from swimming against the current of morality. 

Gambling is wrong and will undermine the original rightness of the financial system as long as it is allowed to persist.  I understand the seeming value of “insurance,” but in the case of short selling and Options this “duck” walks and talks like ”gambling and chance” rather than investing in good ideas.  Let’s call a spade a spade and ditch short selling and options forever.  

Who’s with me??!!