The Fake Math and Unquestioned Assumptions of Bailing Out Banksters.

So far the US government has spent about $2 trillion bailing out Goldman Sachs, AIG, General Motors  and  other politically well-connected businesses and banks. 

We’ve been told that these businesses are TBTF (too big to fail).  If one these did fail then it would destroy the rest of the economy.  OK, I’ll buy that it would be catastrophic to their employees and their shareholders, but it’s not at all certain that all the rest of the US would share their fate.   Even if we do accept that their TBTF status makes them able to hold the rest of the entire US hostage, then our federal regulators have been criminally negligent in not breaking them up into smaller, competing pieces.

What should we make of the recent well-publicized payback from GM to the US treasury for the bailout?  We’ve seen the ads on TV where the head of GM was crowing that the taxpayers were paid back PLUS INTEREST for their loan.  The simple explanation is that it’s flatly a lie that all of the money was paid back.  Only a tiny part was paid back, and the interest for that part came from the rest of the bailout, not from some miraculous turnaround of a bloated and inefficient company.  

Consider this analogy:  I ask you to loan me $100, but we’re going to chop it up into 10 different IOU’s of $10 each.  Then I quickly pay you back $11 for one of the IOU’s, then I go on TV saying how I paid back every penny plus interest (neglecting to mention the other 9 IOU’s).   I still have $89 of yours in my pocket, and maybe I’ll get around to paying that back some day, if everything works out well in my favor, but don’t hold your breath.   Yeah, that’s exactly how the GM bailout worked.  The taxpayers are still waiting and they’ll continue to wait a very long time, but by then people will have forgotten about this fraud. 

Another bogus part of the accounting is that our masters in Washington are only counting the benefits (saved jobs and saved shareholders) of their brazen and unprecedented transfer of wealth from the treasury to banks and large corporations.  They’re not counting all of the lost jobs because private people don’t have that $2 trillion to spend and buy things from other, more competitive businesses. 

 Of course supporters and apologists of the bailouts will say that the $2 trillion wasn’t taken from anyone, that it was borrowed money or  “created”  by the US Federal Reserve via quantitative easing.  Thinking about it a little while reveals that borrowing merely transfers this loss of buying power from the present to the future, plus interest.  If a counterfeiter creates new money and passes it around, it’s widely accepted that he’s stealing small amounts from everyone else because he has diluted the value of the currency.  The FED is doing exactly the same thing by creating electronic records of money.   Either borrowing or creating money has the same effect of destroying jobs, but this is lost in the calculus used to justify the transfer of money to banksters.   

Moral Hazard - Why Bailing Out the PIIGS Could Backfire

Sovereign Debt

For the past year and a half many of us have been watching the news come out of Europe about some of the smaller states inching closer to insolvency (bond default) and getting bailed out by the stronger states (Germany and France mostly).   The weakest of the states have been summed up as the PIIGS which stands for (Portugal Ireland Italy Greece and Spain).  It’s natural to wonder if these bailouts are important and speculate on how they might affect us and our investments.  

Bond Crisis - Starting Small

As a start, only Greece, Ireland and Portugal have actually been in talks with the IMF, ECB and others about possible bailouts.   Many people have said that these economies are so tiny that they don’t matter so we shouldn’t be concerned about the bailouts, and they have a good point.  Look at these GDP numbers as a percentage of the US GDP:

Greece:   2.0%

Ireland:  1.2%

Portugal:  1.5%

You can see that these economies are indeed tiny so if the problem should be confined to those, now and in the future, then it really should be no problem just to bail them out.   Many people have said that bailing them out will help investors feel better about the sovereign debt bond markets and therefore stop the spread.  Will it?

Moral Hazard

The problem with bailing out these small states is what Alan Greenspan called the “moral hazard”.  He was referring to the US bailing out banksters, which is the topic of a future blog, but the problem is the same.   Such handouts might lead other governments to seek the same easy way out rather than make the tough choice between lower government spending or higher taxes (both of which cost politicians votes).   Both Spain and Italy have large budget deficits and may soon seek bailouts as well.  Here are the approximate GDP’s of those countries relative to the US:

Spain:  10%

Italy: 14%

It’s apparent that it would be much harder for Germany and France to carry Spain and Italy for very long, considering the sizes of those 2 down-and-out economies.  Worse,  a handout today does not correct the structural flaws (e.g. overly-generous pensions and early retirements) inherent in those weak economies, so they’re likely to come back again tomorrow seeking more handouts. 

State Debt - It can't happen here?

The problem of independent states being close to default and seeking relief from the larger union is not confined to the Eurozone.  In the US several states have large budget shortfalls and some people have been talking about bailouts or “loan guarantees”.  Here are 4 US states that are dangerously close to default and their GDP relative to the US:

CA:  14%

NY:  8%

MI:   3%

IL:  4%

It’s apparent from the above figures that the relative size of the top 4 potential state bailouts in the US is about the size of the European bailouts in terms of GDP.  

Investing in Municipal Bonds - The danger of contagion

Since politicians are unlikely to want to give up votes by raising taxes or cutting spending, there’s a strong incentive for these states to seek a bailout or loan guarantee (in effect a bailout light, or future bailout).  And once a few states get bailouts it would be almost impossible for Obama and the Congress to refuse other states bailouts, under charges of favoritism, so a bailout for one quickly becomes a bailout for all 50 states.  Instead of the contagion being contained there are real reasons to believe that the contagion would spread.  Even fiscally more-responsible states like TX would likely line up for a piece of the federal pie.  After all, bringing those goodies home would garner a lot of votes and allow taxes to be cut and “much needed”: programs to be funded.  

Value Investing - 5 Basic Principles

Return on Investment - Equalized Across All Options

Return on investment is almost the same everywhere AFTER accounting for risk.  This idea goes by many different names such as the "invisible hand", the "efficient  market principle" or "competition drives out profits".

For example, while US treasury bonds currently pay about 3% and Greek debt pays 13%, they're really the same!  The market is currently guessing that the Greeks have about a 10%chance of defaulting within one year. When you calculate your expected value from both of these investments it works out the same. If one investment pays a whole lot more than others, after adjusting for risk, then many investors would flock to that investment, driving up its price and driving down its risk-adjusted yield  (i.e. competition driving out profits).

Capital Preservation

Many gambling schemes (e.g. Martingale betting) ignore the very real possibility of the gambler being wiped out and not being able to bet any more.  To avoid this people generally diversify and only invest a small amount of their not worth in highly risky things.  You'll sleep better if you can't be wiped out by one unlucky event.

Price Earnings Ratio - The value of growth

The P/E or price earnings ratio is a simple way to measure what the return is this year for a given company.  A P/E of 20 means that it earns 1/20th of what it costs to buy a share.  Note that 1/20th is a return of 5% which is a decent return in this market.  Of course you need to consider also the risk that this company will go bankrupt as well as the possibility that they will grow a lot.  So start-up companies can justify a P/E or 100 if you think that their earnings will double every year for the next 3 years because they have an awesome market-displacing product or process.

Avoid Debt

Debt is risk.  If a company has a lot of debt on a per-share basis then they have to take a big chunk of their revenue to service that debt.  Currently interest rates are near record lows, so there is some risk that rates could rise significantly.  Just ask those people who bought houses with ARM's (adjustable-rate-mortgages) about that risk.

If a debt-ridden company currently has a P/E of 20 and interest rates double then the P/E could quickly go to 50 or 100, which would in turn drive down the stock price (the P part) until the P/E becomes something more reasonable.  Another problem with debt is that it reduces a company's agility.  If a company has high debt and unexpectedly needs to raise capital for some reason, then it will pay a high interest rate to compensate investors for the risk.  Similarly if there's a great opportunity to buy a competitor who's going out of business, the company with high debt will be at a big disadvantage in a bidding war with a low-debt rival.

Contrarian Investing - Avoid the popular, consider pariahs.  

OK, generally I believe in the efficient market principle, at least as a very good first approximation.  This means that investments are usually fairly-well priced to balance the risk and reward, considering all of the available information.  However bubbles do form, such as housing prices in 2005 or the internet stocks in 1999.  If everyone thinks that this investment "can't lose!" maybe you should consider other less-trendy alternatives.

Welcome to Financial Ripples.

This first blog on my site will serve as an introduction.  I'll tell you what sort of things that we'll talk about, what you and I can gain here, and some simple rules of conduct.

I intend for this blog to be generally about the economy and investing as well as whatever topics are tangentially related to the broader economy such as politics, law and societal trends.  I chose the name Financial Ripples because I view the economy as being the sum of effects (many of them nonlinear) of many different competing forces. If you want to talk about monster trucks please try to help the rest us understand just how this societal trend can affect the economy and why it is newsworthy.

My own rule of thumb on on whether or not something is newsworthy is "will this matter 10 years from now?".  So an NFL coach getting fired really won't matter to most people in 10 years,  but vast changes to the healthcare laws or Google dominating yet another aspect of the online universe will have significant effects on our lives.

I hope that this blog can serve as a place to exchange ideas.  I'll share my ideas as a starting point.  If you think that there's some point that I've missed please add to it.  Even if I disagree with you I'll be glad that you contributed to the conversation.  It probably helps my brain grow stronger if I have to go through a reasoned counterexample to your arguments, rather than reading a post that says little more than "True dat!".

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