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The Consequences of Bailouts


Looking deeper into the ripple effects of Fannie, Freddie, AIG.


Over the last 2 and a half years I've been writing about the sheer insanity behind the mortgage market's imaginative yet devastating loan creations (sub-prime, stated-income, option-ARMs, interest-only and -- who can forget the granddaddy of them all? -- the negative amortization). I've also pontificated on its relationship to the disastrous credit cycle: over-leveraged American consumers and the massive amount of debt being accumulated by institutions alike. But yet, it was business as usual – or was it?

This piece is not intended to banter about what has already happened and join the ever-growing bandwagon of "I told you so." It's designed to point out that I believe there are some very dangerous precedents being set which could potentially create further disruptions.

It began earlier this year with the "stimulus cash" being sent out, to the tune of $100 billion dollars. Whether you received $600, $1,200 or another amount, this money was meant to stimulate the economy. Every time I discuss this it disturbs me to no extent.

I can't count the number of times I've penned articles mentioning how the American consumer is spending more than they make and it's only the second time this has happened since, yes, the Great Depression.

In my opinion, the US government, in its ultimate wisdom, decided that if consumers could not pull any more money out of their homes to spend on frivolous unnecessary items, then it'll send them some. How will this will be good for the economy?

Ask yourself one question: "Would you give more money to a child that not only spend his allowance, but ran up your credit card and couldn't pay?"

However, this isn't my biggest concern. In the last few months we've witnessed the Bear Stearns bailout, the Fannie (FNM) and Freddie (FRE) bailout, the Lehman Brothers (LEH) failure, The Bank of America (BAC) purchase of Merrill Lynch (MER) and now the American International Group (AIG) bailout. The buzz phrase on the street is "privatizing profits and socializing losses."

Is there another Lehman Brothers out there?
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Again, this article is not intended to debate the merits of these decisions, but more to discuss the consequences of these actions. Understanding the sheer importance of these bailouts, the global ramifications, we must look ahead and comprehend what may transpire when the next axe falls.

If and/or when another firm is to go down, whether due to investor confidence (declining share price), inability to finance, illiquid balance sheet or an assemblage of all of these issues, one only has to look at the last few months to see what may happen. For example, let's say "Firm ZYX" is the next on the chopping block. It has some illiquidity on the balance sheet, confidence abates and the stock begins trading below book value so it cannot secure financing to sustain itself. Selling begets selling and Humpty Dumpty can't be put back together again.

Let's assume good ol' Dad (the government), borrowing from our earlier question, is going to come to the rescue of this particular child. ZYX is still, for all intents and purposes, going to trade to zero (Fannie and Freddie).

Hence, ZYX's smart thing to do is begin shopping itself to other, more capitalized, firms (Lehman - Barclays (BCS)). But if I were the purchaser, why would I buy ZYX knowing that if I wait it out the stock will continue to fall (or plunge), and I can get it substantially cheaper through bankruptcy and only purchase the assets I want?

The current term used is "vulture": Pick over the dead carcass instead of spending all the money on bringing the person to the hospital.

Either way, they're still dead. The markets are teetering on a very dangerous level right now and if any more confidence – the glue that holds our financial system together – is destroyed (individual or institutional), let's just say this: "It won't be pretty for anyone!"

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No positions in stocks mentioned.

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