As Soon As I Get My Head Round You

All day long I’ve reading, researching, and thinking about Paulson’s No Banker Left Behind Plan and what is going to happen to the economy. This post isn’t about the guilty parties that got us into this bailout mess or why this plan is going to be a disaster. Instead, I want to try and guess how this all ends. As a student of economic history, I think we may be fast approaching a pivotal moment.

I see three possible outcomes:

  1. Paulson and Bernanke will succeed and the market and economy will be put right back on track.
  2. Deflation. (Cash is king, Debt is slavery)
  3. Hyper-Inflation. (Cash is trash, Debt becomes -relatively- cheaper)

Outcome one is a fairy tale. If you are long in equities now, you are betting against history.

Up until the bailout, I’ve been firmly in the deflation camp. Deflation is not declining prices, but a decline in the money supply caused by the destruction of credit. Loans go bad, banks collapse and lending tightens. This causes a restriction of the money supply and thus deflation. Despite Bernanke and Paulson’s tough inflation talk over the past year, it is now clear by their actions that they fear an all-out deflationary collapse.

Is the bailout going to be inflationary? Are they going to print their way out of this mess? Throw around enough cash to make devalued assets worth elevated prices by devaluing the currency. This option would punish those with savings to alleviate the pain felt by those with debt. I have a tough time believing bankers would shoot themselves, but anything is possible. Also, it may be easy to inflate asset prices such as homes, but in a global economy, how can one inflate all salaries to pay for those assets? I don’t think you can.

Maybe Thomas Jefferson’s banking warning holds the answer?

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered.

I’m still in the deflation camp but as someone with zero debt and savings that could be my wishful thinking and bias. I’m going to keep reading and thinking about this. A possible deflationary collapse mixed with a stock market that put in shorting bans is a volatile recipe for a stock market crash.



Add yours

  1. Welcome to the USSA! How is it that you and I saw this crisis coming a year or two ago, but the clowns in charge had no clue? But I digress!

    First, I’m not sure this plan works (unless the govt pays too much for the paper). Many financial institutions are technically solvent because they have not had to mark their debt to market. Once they do (when they sell to the govt), many balance sheets will be negative.

    Second, if it does work I think it makes the recession more shallow, but longer (like Japan). It will allow unsound financial institutions to limp along for a much longer period.

    Third, I don’t know the answer to your question (yet), but I don’t think anyone else does either. We are in uncharted territory. I agree that if left alone this would result in a huge deflationary death spiral. The impact of the $700B bank bailout (on top of the $100s of billions already pumped out there) must be inflationary, but is it inflationary enough to offset the deflationary effects? I’ve not read any analysis yet from a reputable person to know (and it’s beyond me).

    I do know this can’t be good for stocks over the long term though. Both high inflation and recession are bad for equities. I think we get a bounce out of this in the market, but spending more on the government credit card is only postponing the inevitable pain.

    Of course, if they are creative enough, maybe they can blow another bubble!

  2. Two more points occurred to me:

    1) I think the govt HAS to pay a premium …otherwise the banks would have already sold them right? This is like [moral hazard]^2.

    2) Many of these banks are technically insolvent, which means the only way they can escape the FDIC takeover is to make high risk bets with this money …or limp along like 90s Japan. We have essentially given an alcoholic a fifth of whiskey. I think the “Law of Unintended Consequences” is gonna be a bitch.

  3. Russ Winter had an interesting piece on how the Treasury might handle the bad debt.

  4. I completely agree with Russ Winter’s post. Always remember your investing 101: “buy low, sell high”. It’s that simple. Don’t over complicate it. Fortunes are being made right now and it’s only going to get better. Personally, I’m licking my chops and getting overwhelmed with the opportunities.

  5. The Winter article is a little too “conspiracy theory-ish” for me …but maybe he is right. Time will tell…

    I think Calculated Risk and Krugman are right on the mark though:

    To summarize, Treasury just pays a huge premium for the bad paper in an attempt to recapitalize the banks. Sure, there is probably favoritism, but that misses the point.

    Roubini further explains why the Paulson plan will fail (HOLC article on 9/19):

    He argues that to really get to the root of the problem the govt needs to buy the actual mortgages (anything else is a band-aid)). This has much less benefit for Wall Street though, so Paulson wants to skip directly to the bad paper.

    Matt – What specific opportunities are you considering? With 500 point up days and 500 point down days lately I thought day-traders are the only ones doing really well! 🙂

  6. Hey, Jim, I don’t day trade and don’t invest in the stock market traditionally. I mostly invest in residential and commercial real estate and, occasionally, companies I do some freelance work for in exchange for an equity stake in the company if I really like the company, the economics of the model, and (most important!) the leadership and management. I do this because I know what’s going on behind the scenes. Investing in companies any other way is just plain foolish (for me!) — I’d rather just play the lottery (same thing in my opinion).

    So, I’m a very boring investor. Conservative. Long term view, etc.

    Anyway, in terms of specific opportunities in commercial real estate, we’re seeing prices coming down and sellers being more willing to offer creative terms on the financing side (they need to if they really want to sell because bank financing is more of a pain in the ass to get right now – still there, but just a big pain – takes longer to close deals, more costly, etc). The real opportunities, as I see them, right now is in residential real estate, especially affordable housing. In fact, we made 3 offers last week on 4 star, over 55/senior living mobile home parks (oh, sorry: “Manufactured Home Communities”) in strong, growing markets with high demand but limited supply for this sort of asset. Let’s count the opportunities from one of these deals alone: cash flow/income from pad sites (we’re leasing dirt, not homes, so no running toilets to deal with), cash flow/income (and small pops from down payments – $10k here, $5k there) from the notes we hold on each home, appreciation of the park itself, and the most exciting upside is the long term land banking play where we could scrape the park all together and build a hotel, lease the land to a hospital, whatever use makes sense as the time … the point is that you’re buying in the path of progress and earning income while you wait all while holding an appreciating asset … who really cares what happens on wall street? It may limit the amount of money you can make and when, but buying this kind of asset in this kind of way, you have the luxury of waiting for the right time in the market — in the meantime, you’re making out okay believe me).

    So, having said all this, why day trade at all? Or invest any other way? You’d be better to passively invest in real estate deals with someone you know very well with the right experience matching the right security instruments for your risk tolerance for the right investment/asset: let them do all the hard work while you sit back and collect the checks (with a really large check a few years down the road).

    All of the daily changes going on the market/economy are just entertainment for people who don’t have anything better to do in my opinion.

    Again, bottom line: are you an investor or speculator? A creator or consumer? (rhetorical question to ask ourselves, not to you Jim). 😉


  7. Matt – Interesting post …I also plan to invest in real estate, but in a couple years when we hit bottom (as per Case-Shiller). I’m sure if that is what you do you can find great deals now though.

    I’ve thought about the investor versus speculator question for a while. Most people assume that it is related to the length of time you hold an investment, but I disagree. I think it is related to the amount of risk versus knowledge.

    My econ and MBA studies tell me the market is going much lower …so I happen to be short equities and in cash at the moment.

    I don’t day-trade, but do use technical analysis to pick entry and exit points.

    And I’m just short equities …too many variables with currencies and commodities right now to know if they will go up or down.

    Anyway, just my 2 cents…

  8. Jim, I completely agree with your definition of investor (has knowledge and knows personal risk spectrum) versus speculators.


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