Bailout Defeated, What Now?

The shocking news from yesterday was the defeat of the $700 billion bailout bill that was supposedly going to save the known world from financial ruin. On news of the failed bill, the markets responded with panic and dropped by almost 800 points, marking the largest one-day point drop in the market's history. Now it seems everyone is panicking and not sure what to expect. Bush and Paulson are threatening a long-lasting and painful financial meltdown if nothing is done, but can we believe them?

First off, I want to say that there was no guarantee that this bailout was going to save the financial system in the first place--no one knows for sure--although one can predict that it would at least provide a short-term boon to the financial industry. If nothing else, the bailout would have met expectations of the market and helped calmed some fears. In my view, this bailout would have just been a short-term fix and would not meet the expectations that were being set by Bush and Paulson. $700 billion is a big price tag for a short-term fix in my book.

The bottom line is that the market needs to correct itself. Right now, asset values are retreating to where they should have been in the first place. For a long time the government has been using tactics aimed at boosting the market, and as a result, asset values rose to heights they should never have seen. The government, of course, is trying to continue to support these higher prices, but is now finding some resistance. In the short term, they can probably keep the gravy train rolling, but at some point someone is going to have to pay for these policies. It seems that Americans have finally decided to speak up and be heard, as evidenced by the numerous politicians who said they didn’t vote for the bill because they feared for their jobs. Unfortunately, one way or another, the bailout is probably going to happen.

Even though this $700 billion bailout bill was shot down, that doesn’t mean that another version can’t and won’t pass. More likely, though, is that the Fed will end up having to bail out the industry one company at a time. The purpose of the $700 billion bill was to address the problem at the source (the valuation of toxic mortgage assets), thus helping all companies in the industry; that way, they wouldn’t have to worry about bailing out individual companies.

Naturally, I’m not really for bailing out anyone, but I think I would rather see a major overhaul/bailout package than to see us try to fix this thing piecemeal. Unfortunately, the Fed has a lot of power when it comes to bailing out institutions and they don’t really have to ask taxpayers for permission. There will come a point where the Fed would conceivably need to get more money from Congress, and then taxpayers could have a say in a roundabout way, but if that time comes, who is going to argue against saving the Fed? It is much easier to let these companies go under than it would be to let a staple of the U.S. government do the same.

Which Cities Will Suffer The Most From The Financial Crisis?

With Wall Street in tatters and financial institutions going under or merging left and right, real estate investors would be wise to take a closer look at the cities which are going to be hit hardest by the aftermath of the financial crisis. Which cities are most reliant on the financial industries? Knowing this can give you a great insight into how the local real estate market may react. BusinessWeek compiled a list of the top towns which are likely to be hit hardest by the financial crisis. According to BusinessWeek, the cities are ranked by percentage of people employed in finance, insurance, real estate and leasing in 2007, as estimated by Claritas (these numbers are represented below in parentheses). All cities have a population of at least 20,000 people.

1. Darien, Conn. – (27.23)
2. Bloomington, Ill. – (26.31)
3. Hoboken, N.J. - (23.33)
4. West Des Moines, Io. - (22.15)
5. Garden City, N.Y. – (20.22)
6. Summit, N.J. – (19.74)
7. Westport, Conn. – (19.39)
8. University Park, Tex. – (18.83)
9. Wethersfield, Conn. – (18.73)
10. Mountain Brook, Ala. – (18.66)
11. Lake Forest, Ill. – (18.60)
12. Urbandale, Io. – (18.52)
13. Normal, Ill. – (17.28)
14. West Hartford, Conn. – (16.67)
15. Newport Beach, Calif. – (16.56)
16. Westchase, Fla. – (16.45)
17. Rockville Centre, N.Y. – (16.29)
18. Naples, Fla. – (16.10)
19. Ridgewood, N.J. – (15.94)

I don’t think it should be a surprise to anyone to see a heavy dose of east coast cities on this list, especially ones that were commuter cities for Wall Street people heading into Manhattan. The author of the BusinessWeek story made the case that while Manhattan is home to Wall Street, the real estate market there won’t be hurt nearly as bad as these bedroom communities. There is just not enough supply in Manhattan itself to justify such a drop, and the market is also grounded by incredible foreign interest.

Another city that investors should keep an eye on is Charlotte, N.C. The city has become one of the biggest centers of finance in the country and while it might not be struggling right now, it is certainly a possibility as we move forward. Charlotte has become something of an investor darling in the past couple years. With its reasonable prices, job growth, appreciation and stability throughout the housing downtown, many investors have entered the Charlotte market. While I’m not suggesting you necessarily jump ship, necessarily, if you own investment property there, you want to fully understand the risks. The same goes for just about every other place out there. As an investor, take some extra time and consider the job market in your area. Where do the people in your community work? Are these institutions at risk?

If layoffs start happening in bunches, as they certainly could soon, you can bet certain communities are going to be devastated. Communities that are over-reliant on shaky financial companies should be avoided. If these companies go under, or merge and relocate operations, it will lead to a drop in real estate prices and likely a substantially depleted tenant base as well.

Bailout Plan Stalled; Is There Hope?

In a surprising turn of events, the bailout plan that seemed so certain to get bipartisan approval yesterday was held up during negotiations. Republicans suddenly decided to take a stand against the bill and are trying to push for alternative measures that involve less taxpayer money. The main idea on the table right now is for the government to insure these toxic mortgages rather than to buy them outright. It seems that these politicians must have received a heavy dose of taxpayer complaints over the last couple days in order to make such a drastic shift.

The other big news from yesterday, of course, was seizure of Washington Mutual, which earned the distinction of becoming the largest bank ever to fail. But you can rest assured that if some sort of major bailout plan is not agreed upon, Washington Mutual probably won’t keep that title for long. The state of the financial industry is so bad right now that there will surely be many more bank failures to come if the government doesn’t intervene.

I should add that I’m not advocating for government intervention; I’m actually overjoyed that the current bailout plan is being held up. Buying up $700 billion of toxic assets with taxpayer money doesn’t sound like a good idea to me. You might be able to sell me on the importance of saving the financial industry and all that jazz, but you’re not going to convince me that the only way to do this is by taking all this bad debt off the books of failed companies and adding it to the government's books. Personally, the insurance idea sounds much more reasonable to me, but I would want to know a little more about the proposal before I gave it my support.

I was reading a New York Times piece this morning about the bailout’s stall, and I found it humorous--and suspicious at the same time--that at one point during negotiations, Treasury Secretary Henry Paulson got down on his knees and begged House Speaker Nancy Pelosi to support the bill. It made me think, what would make Paulson feel so strongly about the bill that he would stoop to such levels? Either he truly feels like this bill is the only thing that can save the country he loves so dearly, or he wants the bill to pass so badly because he has a huge financial stake in the outcome. I don’t have the information on all of Paulson’s holdings, but since he was the former CEO of Goldman Sachs, I would venture to say that he probably still holds a substantial amount of his wealth in that stock. If this is the case, it would certainly make one wonder about his motivations.

It will be interesting to see how things end up shaking out. How are the markets going to perform if the bailout talks continue to drag out? How many more banks will fail? I’m still not sold on any sort of bailout, but I’m adamantly opposed to the one that was on the table. I also hope that the politicians opposing the bill are doing so because they recognize the flaws in the bill rather than just using it as a political ploy for John McCain, as some Democrats are suggesting.

Who’s Going To Buy American Debt Now?

Yesterday I read an interesting piece from Money Week by Richard Benson; the title of the article was “Who will pay for America’s Bailout?” As my regular readers know, this has been a huge question on my mind. We certainly know that Americans aren’t going to buy up all the U.S. debt, because we don’t have the money to do so. Sure, Americans will buy up some of it, but our debt is increasingly being purchased by foreign countries. Naturally, we would have to assume that they will also be relied on to help finance our new trillion-dollar bailout. Benson points out in his article, though, that there might be a problem with that thinking.

Benson explains that one reason why foreign countries buy up U.S. debt is because American consumers are buying their products. As we buy low-cost goods from China and oil from the Middle East, we give those countries dollars in exchange for their goods. With those dollars, they then turn around and buy U.S. treasuries and other U.S. financial assets. But that series of events could be in jeopardy.

Benson theorizes that, as the U.S. trade deficit narrows and economic hardship further expands into American households, we are going to be sending fewer and fewer of our dollars abroad. With fewer dollars coming in, Benson foresees less interest from foreign countries in buying U.S. debt. The following is from Benson’s article:

“The financial markets are going to slowly realize that the only reason foreign central banks bought Treasuries is because the US bought their goods first! China, as one example, realizes our money is not that good and will take an interest in holding dollars only because we are buying goods and services from them. Foreign countries have no reason to buy massive amounts of Treasury debt unless we buy something from them first.”

Since the U.S. economy cannot function without borrowing obscene amounts of money, we will be left with two options. We can either pay more for the debt, and hope that increases interest to the necessary level, or we can print the money we need. There is, of course, an option three of defaulting on our debt and declaring a nation bankruptcy of sorts, but in reality that is unlikely to ever happen, considering we have the power to print our own money.

Since we can ill afford to pay ever-higher interest rates on our debt for long we would end up looking at option number two at some point. Where does printing more money lead us? You guessed it: Inflation. Benson ends his article with this investment advice:

“My investment plan remains the same. I expect real assets will greatly out-perform financial assets. First, I want to buy gold and silver in physical form whenever I can. In the world of inflation, while cash is king, gold is the emperor! Second, I look to accumulate real assets if they are quality assets and the prices have crashed down. So, I do believe that in a few years even real estate will again be a great inflation hedge!”

The Global Property Bust

Most of the focus in relation to the popping of the real estate bubble is centered on the U.S., but the U.S. is far from the only country in the world experiencing a property bust. Global Property Guide recently published a list of housing price changes across the world for quarter two of this year, and a vast majority of these countries experienced a fall. The U.S. had one of the worst price drops, with a drop of 18.93 percent; if you think that is bad, compare it to Latvia, which saw a fall of 33.08 percent. Overall, 21 of the 33 markets tracked saw a drop last quarter, but those numbers are likely underestimating the problem, according to the report.

Not only are some of the official statistics understating the problem, but these numbers don’t take into account the severe drop in transaction volume that is occurring in some places. For example, the country which saw the biggest gain in quarter two was China, yet the report states that “transaction volumes [in China] have fallen sharply, suggesting that buyers are now nervous.” Falling transaction volume is a precursor to falling property prices, so it looks like things are going to be getting worse even in the best of markets.

One thing to note, which really isn’t discussed in the report, is the relationship between mortgage availability and property prices. Markets which saw high leverage use, such as the U.S., are more vulnerable to severe price drops. This is especially true if extremely high-risk or subprime loans were used. Markets which stuck with traditional lending practices likely won’t experience as severe a drop, and likely did not see as high a price climb, either.

A lot of the run-up in prices in these emerging markets was caused by speculation, and while lending wasn’t really a huge concern in these markets, you need to pay attention to end use. If there is no immediate use for the property, it is likely that you are going to see the value drop now that investors aren’t willing to throw money around on a whim. Speculative investors are the ones being hurt the most right now; you can bet that they are going to be in need of cash soon, if they aren’t already, and willing to drop prices substantially. When buying property in an emerging market, pay attention to who the buyers are. If investors are buying from investors, that is not a good sign. At some point an actual end user needs to be the one buying, or else it is unsustainable.

Smart investors are going to remember this pattern--and it is a pattern rather than a new phenomemon--next time around. The boom and bust cycle will be back in the future--you can bet on that--so next time make sure you are prepared and watching for the signs.

Model For U.S. Bailout: One Good, One Bad

Believe it or not, this is not the first major financial bailout in recent history. There have been previous bailouts, and there will be future ones as well, thanks to the nature of boom and bust cycles. So the U.S. has a couple different models to look at when considering how to approach its own bailout; one in particular was substantially more effective than others have been. Probably the two closest comparisons to the current U.S. financial predicament are Sweden and Japan. Sweden faced a near financial collapse in the early 1990s, and Japan experienced the lost decade lasting the entire 1990s.

The difference between these two examples is that Sweden’s economic struggles only lasted a couple years, while Japan’s kept going and going. To this day they have yet to fully recover. Carter Dougherty, a writer for the International Herald Tribune thinks the U.S. could look at how Sweden orchestrated their bailout and learn from it. One of the biggest things that Sweden did in their bailout was to make sure to drain every penny from shareholders before offering any money. In addition, they also took major stakes in these institutions. This not only allowed the government to recapture some of their investment, but it also made the plan acceptable in the eyes of the public. The current U.S. bailout plan is a hard pill to swallow for U.S. taxpayers because it doesn’t do enough to penalize the people who got us into the mess in the first place.

Over in Japan during the '90s there were a whole bunch of policy blunders that are almost legendary now, as is the result: more than a decade of zero growth. The U.S. surely doesn’t want to replicate what happened in Japan, which is one of the reasons the Fed has been proactive in response to the current crisis. It is hard to compare our two different economies, but you can rest assured that U.S. policy makers looked closely at what happened in Japan when they were deciding on the best course of action.

Again, it is hard to compare the U.S. economy to any other economy in the world--if for no other reason than its sheer size--but at the same time it should be helpful to look at what has worked and what hasn’t worked in the past to help formulate the solution to secure our future. I’ve repeatedly said on this blog that I’m not a fan of bailouts, and that will always be the case. My ideology is that we should address the problem at its source and create a system that will prevent--or at least limit--the problem from happening again in the future. Bailing out the institutions that caused the problem is certainly not going to accomplish that result. I also acknowledge that because of the current state of affairs, we are left with little other choice, but we can make sure that we do this thing the right way. I like how Sweden did their bailout because it inflicted pain on the companies and their shareholders. This at least will make companies think twice in the future about taking on undue risk.

The Big Bailout Comes With A $700 Billion Price Tag

Going into the weekend there was a lot of talk about Paulson’s bailout plan and just how much it would end up costing. Well, now we have a number: $700 billion. The bill is just waiting to be signed into law now, although Democrats are trying to add some provisions to the bill which would provide more assistance to troubled homeowners, as well as some taxpayer protections. One of the biggest debates is on whether or not the government should be able to limit the amount of executive compensation, and specifically their severance packages. Democratic leaders make a great point that if the bill stands as is, it could lead to many executives jumping ship and taking a nice little bonus with them, courtesy of taxpayers. Republicans, of course, oppose that measure and for the most part want to see the bill pass as is.

Beyond the $700 billion cost of this whole thing, there are certainly some things for taxpayers to be scared about in regard to the bill. One big one is the amount of power that would be given to one man, Treasury Secretary Henry Paulson. The following is an excerpt from a Washington Post article about the bailout:

“The administration's proposal would give the Treasury secretary sweeping authority to purchase assets from any financial institution, whether headquartered in the United States or abroad, over the next two years. It would place no limit on when the assets could be sold. And it would allow the Treasury secretary to spend up to $700 billion without oversight or review by other federal agencies or the courts.”

I don’t know about you, but that scares me a lot, especially considering that Paulson is a Wall Street guy himself. He seems to be a nice enough guy and everything, but I still don’t feel good about giving him a $700 billion blank check. I think it would be a bad idea to pass this bill without proper oversight into his activities. This is just too much power to place in one man’s hands.

There was a lot of press, obviously, about the bailout plan this weekend, and the response from the public has generally not been warm. Most people are flat-out ticked off about this bill, and rightfully so. Basically, taxpayers are picking up the tab for these short-sighted loans made by Wall Street bankers who have made millions from them. Now that the assets are worthless and they are preparing to pay for their mistakes, the government is going to step in and buy all those assets, essentially saving them. Many people already feel like they were taken advantage of by being put in these risky loans, and now the originators of the loans get to walk away scot free. This series of events does not sit well with the public, and it shouldn’t. By bailing out these institutions, we are encouraging them to go out and do the same thing next time around. Why wouldn’t they? They get to make millions, and if anything goes wrong, the government will step in to save them.

Personally, I’m not a big fan of bailouts in general, but I also know that this one is sure to pass, so there is not much sense about complaining now. I just hope that it goes smoothly, and that somehow the government is able to get the message through to Wall Street that this can’t happen again. I’m doubtful that this will happen, but for my daughter’s sake I sure hope they figure it out. I know that I’m going to be adding a little extra gold exposure to her investment portfolio just in case. For some reason my faith in the U.S. government isn’t all that high right now.

Wall Street Bailouts: Government Keeps ‘Em Coming

In case we needed further proof that the government will do whatever is necessary to bailout Wall Street, they just gave it to us with the measures imposed early this morning, along with the additional ones they likely will impose. The first measure taken was the temporary banning of short selling on financial stocks. This was aimed at calming the markets and preventing the runs on stock that we saw with Lehman and AIG. The next move they made was to insure money market holdings. Several major money market funds had already broken the dollar threshold, and others were getting dangerously close. Naturally, this created fear among investors and the government wanted to ease those fears. The biggest measure, though, is one that has not been finalized, but they are working diligently on that. This measure would involve the purchasing of the toxic debt held by financial institutions.

For a country that says we believe in free markets, we sure aren’t showing it with all the recent moves being made by the government. While the short sale banning doesn’t really cost taxpayers anything, it does represent manipulation of the markets, because they are not being allowed to run their natural course. I love this line by SEC Chairman Christopher Cox, which was reported by the Associated Press (AP): “The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets." This statement was in response to the short sale ban. Don’t you like how he says they are committed to using every weapon to combat against market manipulation that threatens investors and capital markets? How are they going to do that? By manipulating the markets, of course. I’m not sure how they classify short selling as market manipulation, but apparently being smart and trying to make money off this financial disaster we call an economy isn’t allowed anymore.

The money market guarantee is going to be capitalized with up to $50 billion according to the AP, and will act similarly to the FDIC. Many of these money market funds held debt from Lehman, AIG and other financial firms, from which the problems are originating. We’ll have to wait and see how this plays out, but at this point it can only cost us $50 billion.

The big one we have to watch out for is this new idea that we should buy up the toxic debt held by financial institutions. Call me crazy, but why should taxpayers take on this liability when it is exactly what is destroying all these institutions in the first place? "This is a detox for banks, and will help cleanse themselves of the bad mortgage securities, loans and everything else that has hurt them,” said Anthony Sabino, professor of law and business at St. John's University in an AP article. Why do we want to cleanse these banks at the expense of taxpayers? Paulson (the brainchild behind this idea) even goes so far as to say that it is in the best interest of taxpayers. I don’t know about you, but I’m getting awfully tired of hearing that as our nation goes deeper and deeper into debt and our future financial picture looks grimmer every day. Paulson was quoted by AP as saying, in regards to the cost of his plan, "We're talking hundreds of billions."

Now that we have nationalized Freddie and Fannie, taken stakes in the largest financial insurer, bailed out some other financial institutions and will possibly be buying up hundreds of billions in toxic mortgage debt, I think it is safe to assume that we are taking on too much risk. If this mortgage paper continues its death march against those holding it, if the real estate market continues to decline, where does that leave us? In complete and utter financial ruin, that’s where.

U.S. Credit Rating Could Be In Jeopardy

The U.S. enjoys the highest credit rating possible, AAA, but that could be in jeopardy and the ramifications of that would be disastrous. The U.S. depends on its ability to borrow money and borrow it cheaply. If our credit rating were downgraded, the cost of borrowing money would go up and it would likely become more difficult to find people to by U.S. debt. The U.S. already has to borrow enormous sums of money just to make the payments on its current debt; an inability to borrow more could lead to default or severe inflation, as the Treasury might be forced to print money.

“By keeping its stake in AIG below 80 per cent, as it did when it nationalized mortgage giants Fannie Mae and Freddie Mac 10 days earlier, the US government will be able to keep the company's finances off its accounts. But pressure is building on the pristine triple-A credit rating of the US government, the chairman of Standard & Poor's sovereign ratings committee said. The bail-out ‘has weakened the fiscal profile of the United States’, John Chambers said. ‘There's no God-given gift of a triple-A rating, and the US has to earn it like everyone else,’” according to The Independent.

This news should be concerning for not only Americans but for the entire world. The U.S. is still by far the biggest player in the global economy, and every country would be impacted if the U.S. credit rating were to drop. Now, what are the chances of this actually happening?

Personally, I think there is a pretty slim chance of the U.S. credit rating getting cut. I'm not saying that we deserve the AAA rating, just that I don’t see them actually cutting it. I don’t think we should have a AAA rating right now, to be honest, but because they haven’t cut it by now, it is going to take an incredible event for them actually to do it.

We have to understand that, for the most part, no one in the world wants to see the U.S. credit rating cut; you can bet that the rating agencies know this and are taking it into consideration. Sure, they can say that the U.S. has to earn it, but we really know that they just don’t want to be the ones responsible for what would happen if the rating was cut. These ratings agencies are the same ones responsible for assigning the high rating to subprime mortgage securities, and we all know how that turned out. Only when defaults started happening en masse did they figure out that maybe they were rating this debt a little too high. We shouldn’t expect anything less when it comes to the U.S. rating, and you have to expect that they are going to be even more careful about messing with this one.

Treasury Sells More Debt: The Consequence Of Bailouts

All the news is awash this morning talking about the AIG bailout while an equally important story is seemingly being overlooked. Reuters published a story this morning called, “Treasury Selling debt to help Fed.”

“Treasury said it is selling $40 billion of cash management bills -- essentially a fresh batch of debt -- on Wednesday at the U.S. central bank's request as part of what a Treasury official called an attempt to ‘help them better manage their balance sheet,’" according to the article.

Unfortunately, it seems that people are forgetting that someone has to pay for these bailouts. This $85 billion to rescue AIG has to come from somewhere, and it appears that it will come in the form of more debt for the U.S. government. Combine this with Freddie and Fannie, and we are looking at a lot of new debt, in addition to the already swelling deficit. “Between the $29 billion the Fed pledged to swing the Bear Stearns sale to JPMorgan in March, $100 billion apiece to rescue mortgage finance firms Fannie Mae and Freddie Mac, up to $300 billion for the Federal Housing Authority, Tuesday's $85 billion loan to insurer AIG and various other rescue deals and loans, taxpayers are potentially on the hook for more than $900 billion,” according to Reuters. I don’t know who in their right mind would want to lend money to the U.S. right now, but thankfully there are people and governments out there doing just that. How much longer they will be willing to do so remains to be seen, but each new bailout and each new economic problem has to be getting us closer to that time when no one will lend to us.

Each time the government bails out a company, they say it’s the last one. It happened with Bear Sterns, then with Freddie and Fannie, and now with AIG. Somehow I don’t think this will be the end of it, and hopefully you aren’t buying it either. “’We're essentially continuing a system where profits are privatized and...losses socialized,’ Nouriel Roubini, a professor at New York University's Stern School of Business said, adding that auto makers, airlines and other struggling businesses would no doubt be asking for government help too,” according to Reuters.

“But Michael Feroli, an economist with JPMorgan in New York said the Fed could have chosen to let AIG fail, just as it had done with Lehman. ‘We don't know if the disease would have been worse than the medicine,’ he said. ‘We'll never know. But we know we lived through Lehman,’” according to Reuters. We lived through Lehman, and we would live through AIG. It would hurt, but we would live. Once we got through the short term turmoil we would also be in a much better position for the long term. Sometimes you have to make decisions that are going to be tough in the short term for the sake of the future; someday I hope our politicians realize this.

The Financial Crisis Expands: Where Should You Invest Now?

Lehman Brothers is bankrupt, Merrill Lynch has been sold off and now AIG, the largest insurer in the country, is on the ropes. Lehman’s bankruptcy was the largest in history and its ramifications will be hard felt in the financial world, but an AIG failure will be even worse. If you read the headlines this morning, it is amusing to see every Wall Street person say AIG is “too big to fail.” Of course they don’t want it to fail because it is going to have a huge impact on the market. AIG insures financial products, and “'I don't know of a major bank that doesn't have some significant exposure to AIG,’'' said Kenneth Lewis, chief executive officer of Bank of America, in a CNBC interview,” as Bloomberg reported.

Yesterday in the blog, I applauded the government for letting Lehman fail, and I hope they are willing to do the same with AIG. Sure, it will be tough, and in the short term things will get worse, but over the long haul, we will be glad we did it. Lessons have to be learned these organizations have to make fundamental changes to the way they are doing business.

Bloomberg reported this morning that, “Republican presidential nominee John McCain told CNBC today that there is a ‘moral hazard’ in forcing taxpayers to be responsible for the poor performance of companies. Asked whether regulators should allow AIG to fail, McCain said, ‘I think you have to.’'' I want to applaud McCain on this statement, and I sincerely hope that the rest of the government feels the same way.

For investors, times like this are extremely confusing and dangerous. The stock market has already taken a huge hit, and it is likely to drop even further. Even bank deposits are in question with many financial institutions on the rocks and the FDIC seemingly underfunded at the moment. You could look to other countries for safety, but it doesn’t appear that you will find any solace there, either, in this truly global financial crisis. Gold has been extremely volatile of late and many investors are wary of investing in it as prices have plunged. Real estate continues to fall, not really offering any comfort either. So again, where should people be investing?

I’m curious to hear what all of you have to say on the subject, so I would encourage you to let us know what you think the best investment is right now and why.

Lehman Brothers Declares Bankruptcy: Taxpayers Spared

Is it possible that the government has finally learned their lesson? After Lehman Brothers spent a weekend trying to find a buyer, the interested parties withdrew when the government said they would not offer any financial support to a potential buyer (as they did with Bear Stearns). That left Lehman Brothers with little choice but to file for chapter 11 bankruptcy protection this morning. This bankruptcy becomes of the largest in history, with $613 billion in debts, according to the Wall Street Journal. While a bankruptcy of this magnitude is certainly not a good thing, the fact that the government allowed it to happen should be looked at as a breath of fresh air by taxpayers.

There was a lot of speculation heading into the weekend that the government would do what they have been doing all along through this financial crisis and step in to save the day when push came to shove. Surprisingly, though, the government held its ground after attempting to help piece together a deal between Lehman and Barclays; when the government refused to provide additional backing, Barclays backed out. Since the government was more than willing to step in and provide assistance for J.P. Morgan to purchase Bear Sterns, this news definitely came as a shock to me. I can say that I’m glad the government finally took a stand, and if nothing else we will get a chance to see what life looks like after a major investment bank failure.

With Lehman and Bear Sterns gone, and Merrill Lynch agreeing to be sold to Bank of America, the only major investment banks left are Goldman Sachs and Morgan Stanley. Who knows whether or not these two companies will be able to make it through the financial crisis intact, but I feel much better that a new precedent has been set that we will allow the markets to take their due course with them. If the government had chosen to bail out Lehman, after doing so for Bear Sterns, then the other two brokerages would all but expect the same to be done for them if needed. Lehman’s bankruptcy will show them that this is not the case, and that they need to take matters into their own hands.

Sure, this is going to be painful in the short term; the markets are going to tank. Over the long haul, though, by taking a stand, the government is telling Wall Street that they can’t assume a government bailout. This will lead to better business decisions and risk management by these financial institutions, a more stable U.S. economy and less of a burden for taxpayers.

No More Bailouts: Let Lehman Brothers Fail

I just read an opinion piece by James Conrad on Seeking Alpha that made some great points about the government bailouts that have already happened (i.e., Freddie, Fannie and Bear Sterns) as well as one that may happen with Lehman Brothers. His point is that we shouldn’t be bailing out any of these companies, and the notion that the economy will tank if we don't is unfounded. He believes that we should let these companies take due course toward chapter 11 bankruptcy and fulfill their self-made destinies.

The following are some excerpts from the article:

"There is nothing that differentiates Lehman Brothers from any other big company except the fact that its debt, including a lot of counter party debt arising out of various derivatives, is held, mostly, by other Wall Street players."

"There is always systemic risk whenever a large company fails. There were also systemic risks to the energy markets when Enron, a huge energy trader, went bankrupt, but we got through that. That is what Chapter 11 bankruptcy exists to do."

"They do not have the best interest of the nation at heart. There is no reason why a company, like Lehman, cannot unwind properly, using the bankruptcy tools available, rather than being placed upon the backs of innocent taxpayers. Hank Paulson’s company, Goldman Sachs (GS), stands to lose billions on a Lehman collapse."

"Seeking to abuse the public coffers, in support of private interest, is not unique. PIMCO, one of the biggest bondholding institutions in the world, stood to lose tens billions of dollars on Fannie/Freddie bonds if the two GSEs collapsed without a bailout. So, Bill Gross, its Chairman, wrote, again and again, on the need to have those two institutions bailed out by the federal government, and lobbied to make it happen."

"Lehman Brothers is a private company. It is not a charitable institution, or a government agency. Its purpose is to make money, like its counter parties. In its day, it earned huge profits, and a very large percentage was paid out to its top management, in the form of salary and yearly bonuses. That top management is still in power."

Conrad goes on to bring up several other points as well, which lead one to question the logic behind using taxpayer funds to rescue these companies. I'm not a big fan of bailouts myself, so I tend to agree with many of Conrad’s points. I understand why the Freddie and Fannie bailout happened (even though I didn't really support the original debt guarantee), but I question the idea that Lehman Brothers is "too big to fail." I really hope the government sees the light on this one and lets Lehman Brothers fall to its own fate. If nothing else, an example needs to be set for these Wall Street investment firms that they need to do a better job of risk management, or else they will pay the price.

Mortgage Rates Are Falling! Will It Be Enough To Save The Market?

As most people know by now, the government has seized control of Fannie Mae and Freddie Mac. While seizing any company comes as a bit of a shocker, in this instance it was not completely without warrant. One of the nice ramifications of the government seizure for homebuyers is that interest rates have fallen substantially, down around 0.5 percent so far. This translates into almost $100 a month in savings on a $300,000 loan. Savings like this could have an obvious impact on the real estate market.

The fact that people can now buy more house for the same monthly payment is definitely helpful for the market. As we learned in the housing boom, people don’t pay attention to the price they are paying for the house, but rather their monthly payment. This dynamic has likely changed some as people have become more cognizant of the fact that housing prices don’t always go up, but I would still venture to say that the monthly payment is still the primary focus for most residential home buyers.

The tricky thing with this new lower conforming rate is that a good portion of the population isn’t going to qualify. The new lending environment has changed greatly from a few years ago. It used to be that practically anyone could get a mortgage, but that just isn’t the case anymore. Credit score requirements are higher and income qualifications tighter. The net effect in all this is that fewer people can buy homes. Let’s now take into account the record levels of debt and late payments; one could venture to say that credit scores across the population are not as good as they could be. Again, this is a bad sign and it appears to only be getting worse.

The government appears to be pulling out all the stops to fix this housing problem. The new Housing Bill initiatives will become effective October 1, and they include several measures which should provide assistance to the market. Will lower mortgage rates and the Housing Bill be enough to right this failing market? Will job losses continue to increase and economic hardships make matters worse?

I don’t have the answers, and I don’t think anyone truthfully does. There are so many variables at play here that the best predictions are sure to be wrong. We will have to wait and see how this all plays out. As an investor, my advice to you is to stay diversified and keep a good portion of your funds in cash equivalents. This will allow you the flexibility to pounce on great opportunities when they present themselves.

America’s Huge Debt To Foreign Countries Leaves It Vulnerable

We talk a lot about how huge America’s debt is (about $9.7 trillion), but what doesn’t often get addressed is the ramifications of holding this debt. Rather than focus on the obvious ones, like enormous debt service payments, and the impact on the dollar, I am going to talk a little bit about the foreign dependence side of things. Americans as a whole don’t save much, if anything. In fact, recently we actually dipped into a negative savings rate as populace, spending more than we earned. Since Americans have been saving less and less, this means that we are leaning more and more on foreign countries to fund our expenditures.

More than 25 percent of the national debt is held by foreigners, according to the U.S. Treasury website. It is not outlandish to think that this could potentially pose a serious political problem. If, say China or Japan--the top two holders of U.S. debt--were to attack an ally country of ours, even though we would want to step in we might instead do nothing for fear that the attacker might take actions to damage our currency or economy. Think of it as a card that these countries have in their hats which they could play whenever it benefits them.

Another potential problem that arises out of this is our dependence on foreign countries. We need them in order to function as a country right now. If, for whatever reason, foreign governments decided tomorrow that they were going to stop buying U.S. debt, we would be in a world of hurt. While it is unlikely that this would happen overnight, as our debt load increases and more alternative options become available elsewhere, it is not outlandish to think that slowly but surely, foreign governments will start moving away from U.S. treasuries. This is already happening to some extent as more and more foreign governments are diversifying into Euros and other higher-performing assets via sovereign funds.

America’s dependence on foreign countries to fund our debt is concerning without a doubt, but at least in the immediate future it is not an insurmountable problem. We as a country need to acknowledge that there is a problem and take steps to correct it. To slow down the increases of foreign debt we need to start cutting back on imports and increase our exports. Obviously this is easier said than done, considering how we have become addicted to low cost imports, but it is necessary in order to balance the equation out.

Protection Against Falling Home Prices

The Wall Street Journal just published an article titled, “Don’t Bet Against Your House.” The article talked about how the problem with real estate is that diversification is impossible, and while there are ways to hedge losses, they are only realistic for big players. I wanted to correct them on these statements and open some eyes to a few products on the market right now that can help homeowners defer some of this risk.

First off, there is a reason why these products are in existence: the owners and investors of these companies believe that the chances of home values crashing further is less than the chances of home prices regaining their historic levels. While purchasing one of these products can potentially limit your losses, it is essentially a bet against these companies.

The first product is offered from EquityLock Financial. This company provides homeowners with a hedge against falling home prices through use of price protection contracts. Basically, they use a housing index for a given area and if the index has dropped when you sell, then EquityLock Financial pays out that difference. If the index fell 10 percent between the beginning of the contract and the time of sale, assuming a home price of $200,000, you would get a $20,000 check from EquityLock. Since this is tied to an area index, and therefore is not neighborhood specific, it is also possible to sell for a gain and still get paid out, or sell for a loss and get nothing. For more information check out our article: EquityLock Financial Allows Homeowners to Hedge Their Home Equity.

Another creative product that allows homeowners some level of protection is the debt-free home equity plan, also known as the REX Agreement. What this does is allow homeowners to get a lump sum payment upfront (up to 13 percent) in exchange for giving up a portion of the home’s future appreciation. It is not a loan, so there are no payments. When you sell your home, a portion of the proceeds, above and beyond the initial contract valuation of your home, goes to the company as payment. If your home loses value, they get nothing and you get to keep your lump payment. They only get paid if your home appreciates. This option gives homeowners an opportunity to diversify a bit. They can take this money and invest it elsewhere, thereby spreading risk around. The downside to this plan is that if home prices start seeing improvement, you will be giving up a sizeable amount of that gain. In addition, there are certain rules that must be followed. For example, the home must remain a primary residence and must be properly maintained. This agreement also includes a clause that requires you to stay in the home for a minimum of five years before selling. If you sell prior to that time, you have to pay an early exit fee. For the right person in the right situation, this tool could offer a great opportunity to spread risks without immediate cost.

I want to stress again that these programs are not for everyone, but for the right person in the right situation, they might make sense. I wanted to show that there are creative solutions out there for people who are scared about declining home values. If you fall into that category, it might make sense to look at them a little closer, but know that it is possible to hedge and diversify out of real estate without being one of the “big players.”

Fannie Mae And Freddie Mac Seized

Probably the biggest news this weekend--alongside Tom Brady’s injury, if you are a football fan--was the report that the U.S. government is seizing control of Fannie Mae and Freddie Mac. There has been a lot of talk about this possibility over the past couple months, but I think the move was still a little shocking to most people. When we think of the U.S., we think free markets, and the seizure of companies definitely goes against that principle. While this might have come as a surprise to some, considering the bind we put ourselves in, this was the right move.

Typically I would be the last one to support the seizure of a company, but in this instance things are a little different. Obviously, the biggest difference is that in the case of Fannie and Freddie, taxpayers are potentially on the hook for trillions of dollars, with or without a government seizure. With this in mind, we needed to better align the goals of the company with the goals of the taxpayers. Since the taxpayers had little to gain from company profits, their only goal was that the companies don’t cost them any money. For too long, these companies had been profiting from an implicit guarantee from the government, allowing them to take on excessive risk.

How the current deal is set up with the companies is that the government has been issued preferred shares that are senior to all existing shares. This means that, in the event of liquidation, the government gets paid first. In addition, these shares pay out a 10 percent dividend yield, while at the same time the government cut the dividends for most other shareholders. This initial move did not require an injection of capital from the government, but the government has pledged to provide as much as $200 billion to the companies, according to the Wall Street Journal. The government also has acquired warrants which would allow then to acquire 79.9 percent of the companies for a nominal sum, according to the Wall Street Journal. Obviously, if the government were to exercise their warrants, the remaining shares would be so diluted that they practically worthless. The government has also ousted the companies’ leadership and placed the responsibility on the companies’ regulatory commission, the Federal Housing Finance Agency.

While my personal preference would have been to not offer the implied guarantee, followed by the actual guarantee in the first place, given our current circumstances, this move was in the best interest of taxpayers. Sure, it is going to cost us several billion dollars when all is said and done; whatever the number ends up being, though, it is likely to be less than we would have paid if we didn’t take over the company. At least in this scenario the government has some potential reward rather than only shouldered risk. The government hasn’t really put together a plan for how to deal with these companies over the long term, but I’d imagine it would involve some serious restructuring, which is definitely a good thing. Stay tuned for more information as things develop.

Is Another Economic Stimulus Package Imminent?

Now that the effects of the first economic stimulus package are wearing off and consumer spending is dropping like an anvil, taking America’s economic prospects with it, how long will it be before we see the next brilliant economic stimulus package? The government seems intent on avoiding a recession at all costs, so it seems almost inevitable that a second stimulus package will be unleashed, especially if Obama takes office.

Democrats in House are pushing for more economic aid to be sent out, but in this version they want to see money sent to local governments along with infrastructure improvements and assistance to certain families and workers in need, according to the Economist. Their proposal totals around $50 billion. So far President Bush seems intent to avoid another stimulus package, but who knows if he will change his mind or not. In all likelihood, though, nothing would happen until early next year, under the new President’s leadership. Since Obama has been pushing for a second stimulus package, it seems that if he is elected we can pretty much expect to see one next year, unless the economy makes a miraculous recovery in the second half of 2008 (not likely). McCain, on the other hand, seems opposed to one for the most part, but with Democrats expected to rule in both chambers, according to the Economist, he might be easily swayed if elected.

If I had to guess, I would say chances are more likely than not that we will see another stimulus package. The question that always comes up in my mind though is, “Who’s going to pay for it?” It seems rather silly to tax people in order to give them money back via an economic stimulus, which means we are going to rack up some more IOUs. What’s another $50 billion when you are already $9.9 trillion in the hole, right?

One Part Shelter + One Part Investment = Crash

So what do you get when you start adding to, and then increasing, an investment component in houses? A recipe for a real estate crash, according to well-known investor Peter Schiff. In an article this week, Schiff talked about how during the housing run up people paid increasing prices for homes not because of the shelter piece that they offered, but rather for investment purposes. He offered a rough estimate that during the peak, a $500,000 house might have offered a $250,000 shelter component and a $250,000 investment component. According to Schiff, the shelter portion represented the utility and desirability of the house and the investment side represented the future appreciation. Needless to say, the investment portion is in serious question right now, and since houses still offer the same utility, the investment side is the one that is losing value.

Without the prospects of enormous appreciation like we saw during the bubble expansion, home values still have a ways to fall. If we figure that Schiff’s estimates are accurate, and that at the height of the bubble half the value was shelter and half was investment, then prices could fall as much as 50 percent. Right now they have fallen around 20 percent, which would mean we could be facing up to another 30 percent in declines. Granted, I seriously doubt we will remove the investment piece entirely, so at least in my mind, another 30 percent in declines is probably unrealistic; another 15 to 20 percent, though, wouldn’t be out of the question.

If you want get the full scoop on the other reasons why Schiff says real estate is still not ready to recover, read his article: It’s Time to Get Real about Real Estate. But I do want to point out one other point he makes at the end of the article. Many people think that this housing correction is just one big doom and gloom scenario, and that the people writing about it are simply pessimists. In reality, however, this news isn’t bad for everyone. The fact that housing is becoming more affordable is great news for the millions of people who were stuck renting because they didn’t want to take on an outrageous mortgage payment. It is also great news for all the young people out there who are trying to buy their first homes. If this correction did not happen, it would be nearly impossible for many of these people to ever buy a home, so the fact that homeownership is now a possibility for them has to feel good. Sure, for existing homeowners who are seeing their values decline this news is hard to swallow, especially considering that most of them mortgaged their properties to the hilt, but it most certainly is not bad news for everyone.

Should Fannie Mae And Freddie Mac Merge?

New York Times columnist Andrew Ross Sorkin proposed that Fannie Mae and Freddie Mac should merge in an article titled, "And They Could Call it Frannie." He stated that by merging, the new company could save billions each year on overhead, among other advantages. The article started by saying this is a “bold” idea, and I would certainly agree with that statement. I for one am certainly not a proponent of a Fannie and Freddie merger, but let’s take a little closer look at Sorkin’s arguments.

Sorkin estimated that “Frannie,” as he calls it, could save around $1.2 billion annually on overhead costs. That savings, in turn, would add about $18 to $19 billion in market cap to the new company overnight. The next savings opportunity comes with foreclosure servicing, where Sorkin estimated that the company could save an additional $300 million annually thanks to economies of scale. Of course, as Sorkin pointed out, one of the results of a merger would be the loss of hundreds--if not thousands--of jobs, but he also claimed that these job cuts are coming one way or another, as Fannie and Freddie look to cut expenses. The biggest benefit, in Sorkin’s mind, is that this merger would lower the likelihood of a government bailout and would cost taxpayers nothing.

Now here is the problem with Sorkin’s plan as I see it: Current circumstances have already shown us that these companies are too big and too powerful. The government has no choice but to back their debt; if they don’t, they know that the mortgage market will collapse, taking the real estate market and economy with it. Fannie and Freddie have repeatedly demonstrated that they operate knowing this government guarantee is there, which leads them to take excessive risks. In addition, both companies have suffered from leadership issues over the years. By combining these companies into one giant company, some risks would be increased. If the two companies individually already had too much power, how much power will they as a merged company have? How much increased leverage will this mega company have over the government of our country? The leader of this new company would instantly become one of the most powerful people in America. What happens if this leader turns out to be bad? If this company failed, it would most likely be a death blow to the economy and would pose a serious threat to our political stability.

We don’t need one mega company; instead we need to split these companies up. Just as it is good to diversify investments in order to spread risks, we need to think in the same way about these companies. We need to make it so that if any one of the companies fails, it doesn’t have as much impact on the country as a whole. We need to spread out our risk. Sure, this plan would likely lead to increased mortgage rates, as the smaller companies would lose the government guarantee, leading investors to demand somewhat of a premium on the debt, but the government shouldn’t be guaranteeing this debt anyway. In the short term this plan would require some adjustments, but considering the long term, it is the best solution.

History Sides With Barack Obama’s Tax Plan, But What About The Future?

The New York Times published a compelling opinion piece this weekend written by Alan Blinder, an economics professor at Princeton and Democratic advisor, titled, “Is History Siding with Obama’s Tax Plan?” In his article Blinder uses historical figures to make the statement that Obama’s tax policy will be better than McCain’s. On the other end of the spectrum, the Wall Street Journal published an opinion piece this morning by Martin Feldstein and John Taylor, economic professors at Harvard and Stanford and advisors to McCain, titled, “John McCain Has a Tax Plan to Create Jobs.” Both articles make great points, but the authors are obviously biased. So who are we to believe? Which Presidential nominee ultimately has a better tax plan?

Of course, what candidates say in a campaign and what they do in office can be completely different, but even if we assume that the winner will follow through on his tax promises, we can only make an educated guess. McCain plans to keep the existing Bush tax cuts in place, which will help wealthy Americans and investors who pay capital gains taxes. McCain also wants to cut business taxes among other things, which Feldstein and Taylor believe will create jobs, spur growth and benefit virtually everyone. That certainly sounds lovely, but Blinder makes some great points that seem to counter such praise of McCain’s plans.

Blinder makes the case in his article that Democratic Presidents have greatly outperformed Republican Presidents while in office, economically speaking. From 1948 to 2007 the U.S. economy has grown 1.64 percent per year under Republican Presidents and 2.78 per year under Democratic ones. Blinder estimates that this difference in growth over an 8 year period would mean an additional 9.33 percent of additional income for every American. Blinder then goes on to point out that income inequality widens when Republicans are in office and shrinks when Democrats are in office. This point of course is fairly obvious given the policy of Republicans and Democrats, but worth noting nonetheless.

So where exactly does this leave us? One article focuses on the future, while the other focuses on the past. Can one really look at the past as an accurate predictor the future? The past certainly does not guarantee future results, but by what other means can we make projections?

Blinder’s article had the bigger impact on me because he actually supports his points with statistical facts. Whether or not they accurately represent what the future holds for Obama or McCain, they do give us a basis for conjecture. Feldstein and Taylor claim that jobs will be created, but they don’t support this claim with anything. Though the logical side of my brain tells me that tax cuts for businesses will lead to job creation, where is the proof? After reading Blinder’s article one is certainly left to wonder.

Another interesting piece of information I learned watching I.O.U.S.A. was that the national debt has tended to increase at a much faster pace when Republicans were in office. This coincides well with the GDP growth mentioned in Blinder’s article, but also, as pointed out in the movie, is a result of tax cuts. This again leaves one to wonder and even rethink one’s perceptions about the validity of certain tax policy reforms, though one must still question whether the past performances of a few Presidents can accurately predict future results.

Are McCain and Obama likely to follow in the footsteps of past Republican and Democratic economic performance, or are their plans different? Voters must decide for themselves, and I urge anyone who hasn’t yet read these two articles to do so, as they might encourage readers to think more seriously about this issue.