Saving the TARP Bad Asset Buyout

Turning Bad Assets Good

The heart of the response to the U.S. financial crisis last fall was the $700 billion TARP program. The on again, off again program was to buy bad assets from banks and free them up to lend again and reinvigorate the economy.

A few weeks after arguing that this program was essential to saving the world economy, the Treasury and Federal Reserve backpedaled and decided to use the money to inject equity directly into the banks.

While that was a worthy objective and essential to enabling the banks to resume lending, it left the financial markets puzzled. What was the Treasury really thinking and did they know what they were doing? If the bill was named the Troubled Assets Relief Program, why wasn't it dealing with troubled assets?

Dealing with an unprecedented crisis strains, the financial markets were panicking and the critical thing in shortest supply was confidence. Treasury's flip flopping and floundering squandered whatever confidence was left.

In reversing its decision to purchase bad assets, the Treasury cited as their biggest obstacle figuring out how to price assets. That's a question that Treasury and the Fed had danced around during Congressional testimony in September and later.

The problem in a nutshell is this. Because no one wants to hold illiquid assets now, prices have plunged. In a few years, when institutions are more willing to assume normal risks, these assets may rebound significantly if their intrinsic value remains the same. The Federal government can add these assets to its balance sheet now and wait a few years for the increase in price and an expanded number of buyers.

But which price should the Government pay? The current low market price, the expected higher future price or something in between?

The answer is critical because the idea is to help these financial companies recover so they can provide the wherewithal to get the economy moving again. If the Government pays too little, it won't help the banks. If it pays too much, it will feel like a chump and taxpayers will be taken for a ride.

The real answer may be that the Government should inject money now and worry about the price later.

Here's how that would work. Think options. The Government would pick an arbitrary middle price and pay the banks that money now. That would help the banks get back to work, lending money to sound borrowers. The Government would sell the assets it is acquiring over a period of years. If the Government got good prices, it would split the upside with the banks. If it realized lower prices, it would collect some of the difference from the banks.

This would accomplish three major things. It would help repair the balance sheets of the banks now and restore confidence. We would avoid the thorny problem of pricing for now but a market-based mechanism would be used in the future. This would avoid the problems and possible corruption of arbitrarily setting prices. Finally, this would bring transparency to the process and boost investor confidence which is a critical step toward recovery.

Stock Market Suffering a "Lost Decade"

Once in a Lifetime Financial Crisis

Most people now agree that the current financial crisis is a once in a lifetime collapse of the world economy. While we don't yet having any way of knowing the ultimate depth of the contraction, the threat to the world economic system has been the greatest since the Great Depression of the 1930s.

In a single week in mid-September, the last of the major Wall Street investment banks failed or became commercial banks, the largest U.S. commercial insurance company had to be bailed out with more than $125 billion, money market funds began to fail and needed to be guaranteed to prevent a run and Congress debated a bailout of the commercial banking system. In short, in one week, under a conservative Republican laissez faire administration, the U.S. went from a regulated but free market financial system to a heavily government run network of financial intermediaries. And everyone could only hope for the best.

That week turned out to be the worst in stock market history with a decline of about 18 percent in the broad averages. As one commentator put it a few months earlier, "If you think you understand what's happening, you aren't paying attention."

To put stock market performance in perspective, the stock market is flirting with declines that challenge the worst performance since we began keeping good records in 1926. That includes the current record-holding period of the 1930s, when the brunt of the Great Depression hit. Depending on which of the broad averages one uses, last year's decline was about one-third, which was the worst calendar year performance since 1931 or 1937 (the S&P 500 and Dow Jones Industrial Average respectively). All told, about $7 trillion of stockholders' wealth vanished in the U.S. (wiping out the gains of the last 6 years) and approximately $26 trillion disappeared worldwide.

By some measures the market could still decline further based on estimates of market declines during past financial crises. A study by economists Carmen Reinhart and  Kenneth Rogoff of past financial crises, http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf, would indicate a further ten percent decline is possible.

Using another measure, however, this is already one for the record books. Over time the stock market has trended upward at a pace of about 10 to 11 percent per year. That trendline is consistent over long periods. Individual years differ widely with gains as high as 54 percent (S&P 500 in 1933) to a decline of 43 percent (S&P 500 in 1931).  Over longer periods, the market, which reflects economic activity, is much more consistent. Good decades make up for bad decades and the returns catch up with the long-term trends.

Prior to the current decade, the worst decade, not surprisingly was the 1930s, with an annualized return of -0.1 percent per year, or nearly flat. In the 1940s, spurred by a post-war boom, the annualized return was +9.2 percent, followed by an ebullient market in the 1950s, returning +19.4 percent per year. The first half of the 1960s was relatively strong followed by weakness later in the decade as inflation hurt the economy. For the decade, the annualized return was +7.8 percent. In the 1970s, which had two big recessions and rampant inflation and a big bear market mid-decade, the return for the whole decade was still a positive +4.6 percent. In the 1980s, a two-year recession gave way to a long-term recovery and bull market and a +16.1 percent annualized return. The 1990s followed a similar pattern with an early recession giving way to a record peace-time expansion and an annualized return of +17.9 percent.

Now we are nearing the end of what may turn out to be the "lost decade." The Dow, the most popular market barometer, breached 10,000 in 1998. It now hovers around 8,000 or a decline of 20 percent. For the decade of the 2000's, the annualized return to date of the S&P 500 is -6.8 percent. Using the S&P 500, the broadest major indicator, and calculating by decade, this will be the worst decade in the 80 years of modern record keeping unless the market returns to near record levels and rallies by close to 75 percent this year. While possible, it certainly doesn't seem likely and this period is likely to go into the record books as the worst decade for the market in the modern era.

The silver lining in this debacle is that the market tends to revert to the trendline over time. That means good periods eventually follow bad ones. Great bull markets are borne in the ashes of terrible bear markets. While the sunshine won't necessarily break through soon, eventually the storm will depart.

Super Bowl Indicator Bodes Well for Stock Market

Steelers, Cardinals Provide Grounds for Optimism

The Pittsburgh Steelers should bring back cheer to Wall Street. For many years investors have tracked the outcome of the Super Bowl as a strong indication of whether the market would go up or down for the year. Despite the silliness of the linkage, it has proven a more reliable indicator than most expert predictors. Over the years, the indicator works about 80 percent of the time. Chance alone would mean it should work only half of the time.

The indicator holds that when a team from the National Conference or an original NFL team is the winner, the market will go up. If an old AFL team wins, the market will go down. Views differ on how to treat expansion teams that have joined the league since the AFL and NFL merged in 1970.

Both the Arizona Cardinals and the Pittsburgh Steelers should lead the market up this year and we certainly could use that after the worst calendar decline in more than 70 years. The Steelers seventh appearance in the big game augurs even better. After their six previous appearances, the Dow has always risen.

This is the first appearance in the Super Bowl for the Cardinals so they are an unknown for the stock market. However, their status as the NFC representative is a good omen.

The Steelers have won five previous Super Bowls tying them with the San Francisco 49ers and the Dallas Cowboys for the most championships in modern football history. If the Steelers win this Super Bowl -- and they are favored -- they would stand alone as the most successful NFL franchise.

Along with that record of on field performance, they have a chance to be the best talisman for the stock market. In five appearances in the Super Bowl, the 49ers were victors each time and the Dow rose an average of 20.7 percent but there was one losing year for the market, 1990. The Cowboys have made a record eight appearances in the game and the Dow has risen 10.2 percent per year, slightly below the long-term average, and there was also a losing market year in 1978.

The Steelers alone have never ushered in a losing year in the Dow and their long-term average return is 19.6 percent. If the market rises 27 percent this year they will eclipse the 49ers in every market related way. While that would require a big rally, last year's 34 percent drop was one of the biggest in market history. A 27 percent rally would only bring the Dow to 11,146, the closing level in mid-September 2008.

New York Giant fans may be disappointed that they did not repeat their trip to the Super Bowl but market participants should be relieved. Their victory last year should have led to an up year and instead the big drop was one of the biggest dents so far in the indicator. In four trips to the Super Bowl, the Giants have left behind disappoint markets, averaging a drop of nearly five percent.

While all of this may seem overly whimsical in the midst of a serious financial crisis, most American market participants do take their pro football seriously. And while there is no reason to assign any cause and effect to the Super Bowl Indicator, people move billions of dollars every day on flimsier evidence than this. In any case, all investors would be well served by joining the legions of Steeler fans around the country in a hearty chorus of Go Steelers.

Overcoming Fear

Learning the Wrong Lessons from the Stock Market Crash

Investors always gravitate between fear and greed. The pendulum had swung too far toward greed in recent times. Now investors have been traumatized and the danger is that they will stay fearful and lose opportunities.

Both extremes are bad. Being too fearful is less destructive than taking too much risk but it is still a huge problem. Whether someone is saving for their first house, to send children to college or to have a secure retirement they must invest prudently. But to do that, they must accept prudent risk. Every investment carries some risk whether an investor identifies that risk or not.

A measure of the level of panic is the investment posture of major institutions. Short-term treasury bills are being issued at close to zero percent interest. What that means is that major market players are willing to hand over their money to the biggest borrower in the world in return for -- nothing. There are trillions of dollars under the government's mattress and major institutions are asking for nothing in return except for a piece of paper that says the U.S. government will give the money back, with no interest, at a specific time.

So if the big institutions panic, should individuals panic too? While panic was certainly justified for several months in the fall -- just because I'm paranoid doesn't mean someone isn't out to get me -- one should examine the current environment in weighing investment decisions.

It's highly likely that the world economy will go through a brutal slump for most of 2009 and recovery for late 2009 or even 2010 is problematic. While there are some grounds for being more optimistic, it's not necessary to rely on that to chart an investment course.

Going back as far as we have good records, to 1926, the broad stock market has increased on average by more than 10 percent per year. That takes into account the 85 percent drop during the Great Depression, the dark days early in World War II when the Germans and Japanese raced toward victory, the brink of nuclear war in the Cuban missile crisis, the ravages of inflation and the prolonged economic slump of the U.S. in the 70s and early 80s and the tech stock collapse at the dawn of the millenium. Through all that, the stock market has recovered and grown in line with the economy.

On average through all those bleak periods and boom periods, the stock market has doubled every 7 years and quadrupled every 14 years. It's never smooth and never guaranteed but it has worked for a long time. While there were periods this fall when it looked like the world economy could completely derail, the greatest danger seems past. Now it is a matter of being patient and enduring pain but the outcome should be similiar to that of all the many times over the last century.

Most investors do not have access to anything that can equal the returns of stocks over the long term. Investing in a broadly diversified representation of the stock market makes it possible to realize those returns with the least risk. Investors should not abandon that avenue as part of their investment arsenal just because of some recent trauma -- the second worst year of the last century. This too shall pass. From past experience we also know that whenever the market does recover, it is likely to be suddenly and with big moves. A big part of the gains will be concentrated in a short period and few people will realize what has happened until after it is over.