Stock Market Bolstered By Bailouts

In the past week, we have venerable investment banks Lehman Brothers folding and Merrill Lynch merging with Bank of America, leaving Goldman Sachs and Morgan Stanley as the remaining bastions of independents on Wall Street.

Next, the Federal Reserve announced a $85 billion loan to insurance giant, AIG, allowing them breathing space to liquidate assets in an orderly manner. Just when you thought “madness of crowds” has been curbed, Morgan Stanley set off another round of sell-offs by seeking merger partners. All in, these brutal events are not for the faint-hearted, especially when you are investing in stocks with money you cannot afford to lose.

Nevertheless, a silver lining awaits investors who are patient. The message from Morgan Stanley was a wake-up call and turning point. Traditionally, Morgan Stanley has operated in a conservative manner with better management and ethics as compared to their counterparts on Wall Street.

At last count, their balance sheet was much stronger than Lehman Brothers, but even then, they could cave in under the savage attacks from short-sellers. Danger is clear and present: financial institutions are scrambling to raise capital but are unsuccessful as banks hoard cash and refuse to lend, unless at exorbitant rates. That signifies extraordinary circumstances which calls for a decisive intervention.

Bush and Paulson bailouts

On Friday, President Bush and Treasury Secretary Henry Paulson announced a series of rescue plans which should spark a massive upswing in stock markets around the world next week. These measures, aimed at preventing a disastrous financial melt down arising from a loss of confidence in the banking system, will not come cheaply – possibly hundreds of billions of dollars.

Bush said at a White House press conference:

“We must act now to protect our nation’s economic health from serious risk. There will be ample opportunity to discuss the origins of this problems. Now is the time to solve it. This is no time for partisanship. We need to move urgently needed legislation as quickly as possible without adding controversial provisions that could delay action.”

This will be one of the few times I agree with George Bush in principle. Sitting on the fence and watching the credit dry up for American businesses and consumers will be devastating to the economy. As to why the US government and taxpayers have to placed in such a compromising position, payback will come later when the situation has stabilized.

A witchhunt on the raiders, mismanagement and flagrant misrepresentation will be conducted while tighter regulations and accountability have to be enforced. This is where the next US President has to show his leadership and resolve in implementing financial reforms, lest America repeats the debilitating fallout from the Japanese property bubble of the 90s. However, now is the time to extinguish bush fires and save the forest.

Of course, it is also expedient for Bush to have stepped down by then and left a platter full of bad debts and illiquid assets for his successor and American taxpayers (and their children).

Earlier, Paulson highlighted an asset relief program to remove mortgage-related “illiquid assets” from the finance industry. He wants it big enough to have “maximum effects” and boy, is it a dizzying blank check. The exact details will be tabled in the coming weeks between Paulson, lawmakers and Bush administrators.

In addition, the Treasury said it would insure up to $50 billion in money-market fund investments at financial companies that pay a fee to participate in the program. The initiative, which lasts for a year, will guarantee that the funds’ value does not fall below the standard $1 a share.

Redemptions have severely strained the $3.3 trillion U.S. money-market fund industry over the last week. Investors who placed money in such funds expect their holdings to be as good as cash, thus if they are deemed less than safe, the domino effect spreading across the global financial system is unimaginable.

The Securities and Exchange Commission also chipped in with an “emergency action” to ban investors from short-selling 799 financial companies. An immediate difference in the stock market took was felt as short sellers have to cover their positions heavily and quickly before they get hauled up for unlawful actions.

Since the Great Depression of the 1930s, this is the federal government’s most extensive intervention in the financial markets. A national deficit swelling to $1 trillion annually notwithstanding,  I have to credit the Federal Reserve and Treasury for going on the offensive. Instead of plugging holes in a battered system as and when they appear, they bite the bullet and decide to overhaul the entire system.

This is a double-edged sword though as they have played out their hand and if it is not enough to stabilize the stock market, short sellers will come back with a vengeance and pummel financial stocks lower. By then, Paulson and Bernanke may have exhausted their tricks in the bag and a financial calamity is inevitable.

However, let’s assume that the situation is brought under control. After all, investors need a bit of optimism now and nobody wants to think about the downside. This intervention will have served its purpose if stringent supervision over the excesses of mega corporations can be implemented. People have short memories when it comes to the pain of recession and the laws are there to protect against irrational behavior and greed.

Consolidation must continue in the financial sector, with or without bailouts, because too much lending capacity flows from weak hands. Failure to weed out weaker parties such that the fittest survive will only drag down the entire system and delay the onset of a sustainable economic recovery.

It is easy to understand that saving all parties will only result in an even bigger mess in future. But a selective bailout policy sends out the wrong signals too. Currently, it seems that prudent management is not appreciated, unhealthy status quo must be maintained, and good luck if you fail to attain the “too-big-to-fail” status. I have a feeling this is a perception which will be carried over into the next speculative bubble.

Meanwhile, investors cheered the measures as the Dow Jones soared 400 points on Friday, after having surged 410 points on Thursday. This included meteoric rises for battered finance firms like Morgan Stanley, Goldman Sachs and Washington Mutual.

Should we invest heavily again now that a rally is forming? I can only say, enjoy the rally while it last. I believe there is a bit more upside given that we are just starting on the confidence building phase of a bear rally. After the Presidential election, we shall see.

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Filed under Banking, Business, Economy, Stocks

4 Responses to Stock Market Bolstered By Bailouts

  1. Bailing out these companies is a must. Left to their own devices they will fail. That wouldn’t be a bad thing until you look at the assets they do have and will leverage to stay afloat as long as possible. They will raise the rates on every adjustable rate product they have just as quickly as they can, including the ones issued to good paying middle income people.

    More is at stake than a couple of big corporations and poor people who can’t afford to keep their homes.

    brad harts last blog post..Bush Wants Bailout McCain Says Screw Them

  2. I see another Enron incident going to happen. Misrepresentation and creative cash flow practice had been on the horizon for quit some time. I think those practice more conspicuous than creative accounting reporting since investor heavily depend on cashflow performance.

    Obvious reason for consolidation would always be synergy. Malaysia had gone through a couple of this in the past starting with bank merger. Now we looking forward to consolidation of insurance company a brokerage firm.

  3. Goldman Sachs and Morgan Stanley have also got their status changed in order to generate more money.

    Why does the US spend so hugely on its war machine instead of spending it on the uplift of its own people?

    Nasir Jamals last blog post..Bomb blast at Marriott Hotel Islamabad

  4. Great blog, found you through MyBlog I will add to my list to follow. Keep it up.

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