Assessing the Bailout and Your Investments

By JOHN PETRICK Special to the Palisadian-Post With the financial and housing sectors near meltdown, the U.S. government has been taking steps not seen since the savings and loan crisis in the late 1980s. What started as a fairly simple three-page proposal from the Bush administration effectively giving the Treasury unconstrained power to coordinate a bailout of the country’s financial system ended on Monday. As the vote by House members was shown on TV, stocks plunged and investors fled to the safety of the credit markets, worrying that the financial system would now keep sinking under the weight of failed mortgage debt.   Lawmakers voted down a plan that was different from what the Bush administration had originally proposed. The Treasury would have been permitted to spend $250 billion to buy banks’ risky assets, giving them a much-needed cash infusion. There also would be another $100 billion for use at the president’s discretion and a final $350 billion if Congress approved. In response, the markets turned highly volatile as it became clear the measure wouldn’t find the necessary support. At its low, the Dow Jones Industrial average broke its previous record for an intraday drop set during the first trading day after the September 11, 2001 terrorist attacks. Still, in percentage terms, the seven-percent decline remained well below the more than 20 percent drops seen in October 1987 and October 1929. Originally deemed a Troubled Asset Relief Program (TARP) by Treasury Secretary Henry Paulson, the now Emergency Economic Stabilization Act of 2008 (EESA) was created to essentially empower the Treasury to purchase distressed mortgage debt. Similar to what we saw during the S&L crisis, the Treasury had planned to set up a holding company to house these mortgages akin to the Resolution Trust Corporation (RTC) that was created in 1989. The RTC took into receivership financial institutions that had shifted away from traditional home mortgage financing and had overextended themselves by getting into new, high-risk investment activities. It pooled all of the bad loans, separated them based on quality and sold them off in ‘slices’ by auction. From start to finish the procedure took six years, but by taking control of the assets and controlling the sales of the assets the government was able to contain the costs to taxpayers by preventing a fire sale via a distressed liquidation process. The U.S. General Accounting Office estimated the final cost of the crisis to be around $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government, or in other words, the U.S. taxpayer, either directly or through charges on their savings and loan accounts. Did it work? The outcome was highly debatable. Some claim that since the RTC eventually needed much more money than initially projected, this led to big costs to the U.S. taxpayer and contributed significantly to the budget deficits in the early 1990s. However, the RTC was responsible for closing 747 thrifts with assets totaling $394 billion, and this accomplished its overriding goal: end the crisis, which like today, was threatening a massive drain not only in the U.S. but throughout the global economy. In the early to mid-1990s, lower interest rates and a slightly improving economy eventually eased the chokehold on the thrifts and we began to get out of the woods. Had it passed, could the EESA do the same?   Clearly, economic growth has slowed, but it has yet to contract meaningfully as it is likely to do if acute steps to avert a deepening of the financial crisis are not taken. However, there are clear differences between then and now. Primarily, the underlying assets of the brick-and-mortar S&L’s were reasonably easy to price and sell. On the other hand, the values of numerous, confusing, complex financial instruments today are far more difficult to assess. The RTC took over hard assets by taking control of the failing banks, whereas the actions today consist of taking over the banks’ failing assets. Is $700 billion big enough? Will breaking up the $700 billion into numerous smaller ‘slices’ abate the impact of the plan? Under the agreement, the government would have only been responsible for buying mortgages originated on or before March 14, 2008. Had the EESA passed, its success would have contingent on whether or not the capital infusion was large enough to have had the capability to buy an enormous amount of ‘bad debt.’ It wouldn’t have necessarily had to buy all of the ‘bad debt,’ but it would have had to clearly show that it is capable of doing so. The current market pressures have forced selling on these mortgage securities and has quite possibly pushed their price below their true fundamental values. Similar to the steps taken in the RTC, some sort of government action is needed, and the government must acquire these assets to alleviate the fire sale. However, it must purchase them above current values to entice the brokers to sell them, yet the purchase price must still be below the fundamental value in order to avoid overburdening taxpayers. Accomplishing the aforementioned steps should have effectively stabilized the financial markets and stopped the free-fall in these mortgage-backed securities. The hope would have been that passing such a bill would ultimately alleviate the pressure banks have been feeling amidst the credit crunch and begin to create additional liquidity in the markets. Why it didn’t pass? Over the weekend there had been much debate over executive pay, government oversight, taxpayer protection and assistance for troubled homeowners. It seemed that by Monday morning most of the above had been agreed upon, excluding an effort to give judges the power to modify mortgage terms for people who had filed for bankruptcy. Warnings from the President, the Secretary of the Treasury and the Chairman of the Federal Reserve that the approval of the plan was essential to the future of the economy were dismissed, and so was the EESA. Some major concerns were that this program, much like the RTC, was a bailout and would have ultimately fallen in the lap of taxpayers. In an effort to alleviate the long-term burden, taxpayers would have been given an ownership stake in companies whose bad assets were purchased. That in itself proved to be a major issue amongst voters who felt it was a big step away from the basis of American capitalism and a step closer to socialism and could set a scary precedent for the future. The government had already moved in and taken Fannie Mae and Freddie Mac into conservatorship, a step that many had viewed as a step towards nationalization. Another concern was one purely political in nature. With the elections looking and the constant talk of ‘Wall Street vs. Main Street,’ many elected officials felt the bill was viewed negatively by the majority of their ‘Main Street’ constituents and a vote for the bill could mean a vote against their future employment. This egocentric view may have easily swayed some from their true beliefs and led them to vote differently from what got them elected in the first place. Monday’s setback may ultimately prove to be a positive. Many felt that the original bill, even after modifications, was thrown together hastily and hadn’t been thoroughly thought through, based on the short time horizon everybody had been given. This week’s delay should provide more time for lawmakers to brainstorm and put together a deal that, if passed, can ultimately prove more effective in the long run. What now? As we look to coming days, weeks and months ahead, the EESA will likely be revisited and reconstructed from the ground up with Monday’s market failure in mind. It can be assumed that many in the House needed to see the violent upheaval the markets showed to have a better understanding about just how important some sort of plan is. Once there is an agreement and a plan is passed, it should prove to be positive as the uncertainty surrounding the financial markets will be alleviated. In the meantime, declining property values and worries surrounding the credit crunch coupled with a global economic slowdown will most likely lead us into a recession (if we aren’t there already) by year’s end and likely through much if not all of 2009. It is important to remember that financial markets are forecasting instruments, and that the stock market historically bottoms well ahead of the end of recessions. Typically, markets tend to gain 25 percent off their lows before a recession is over. A good example would be to study what happened during the creation of the RTC. The S&P 500 bottomed in October 1990 following the creation of the RTC in 1989. The U.S. economy went on to experience a recession in the second half of 1990 through early 1991. That’s the good news. The bad news is that this isn’t 1989 and this isn’t the S&L crisis. Today’s plan will likely be much grander in scale. The original estimates on the failed EESA were over four times bigger than the RTC. Currently, Wall Street analysts’ consensus expectations are for the S&P 500’s corporate operating earnings per share to grow at a pace between 20 to 25 percent. But with economic growth slowing and likely to remain below average, this seems to be exceedingly optimistic. What should this mean for you? Recently, panic has set in and almost everyone wants out. One benefit the stock market provides that real estate doesn’t is liquidity. Selling your house can be a time-consuming process, sometimes taking months before you’ve closed escrow and received your check. With the stock market you can have your cash in a matter of seconds. With emotions running high, this can quickly lead to panic and panic can lead to ill-advised decisions. The S&P 500 index has been used as a broad-based benchmark of U.S. stocks since 1926. On average, annual returns over this period were around 10 percent a year. But in most years they were anything but ‘average.’ In actuality, only four times annually did the market fall within the range of 8 to 12 percent. That being said, the market as a whole moves in bursts, both to the upside and to the downside. These rapid swings to the downside trigger fear selling and many times cause people to miss some of the biggest up days that tend to follow. To put this in perspective, an investment in the S&P 500 Index from the end of 1987 through the end of 2007 (approximately 5,000 trading days) would have returned 11.82 percent (excluding the effect of dividends). But missing just the best 10 days in this 20-year period would have reduced that average annual return to 9.35 percent. Moreover, if you had missed the top 100 days in this period, your return would be negative. A key element to surviving a down market is staying committed to a intelligent plan ‘ one that makes sense given your investment goals, time horizon and risk tolerance. With the recent volatile gyrations in the market, many investors have fallen prey to emotions and have let their long-term plans fall by the wayside. It is essential to stick to your plan and not allow your emotions to control your decision-making. No one ever made money panicking; cooler heads will prevail. (John Petrick, a native of Pacific Palisades, is a Registered Representative with and Securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 310-445-2504 or e-mailed at john.petrick@lpl.com. All performance referenced is historical and is no guarantee of future results. Please consult your financial advisor prior to investing.)