While the government's plan lets Wall Street relax for the time being, huge questions about potential side effects of the strategy remain
Capping possibly the wildest week in U.S. financial history, the markets breathed a sigh of relief on Friday, Sept. 19, at the U.S. government's multipronged plan to fight the financial crisis (BusinessWeek.com, 9/19/08), including a bailout fund par excellence to be created by the Treasury Dept. that will buy up bad debt and cleanse financial institutions' balance sheets of the toxic credit derivative products they have been holding. The details of the fund—how much bad stuff it will be authorized to buy and how those assets will be valued, to take two examples—are still to be worked out, and therein lies a host of questions about what negative side effects there potentially will be as a result.
In addition to the bailout fund, which could cost taxpayers up to half a trillion dollars, the government's overhauled playbook includes the Federal Reserve's unprecedented $85 billion bailout of privately owned insurance giant American International Group (AIG), Treasury's $2 trillion backstop of U.S. money market funds, and the U.S. Securities & Exchange Commission's temporary ban on short-selling on nearly 800 U.S. financial stocks.
To borrow the medical metaphor that's been cited all week, with priority given to restarting the patient's heart, less attention has been paid to the possible collateral damage the stress may cause his other vital functions. While survival of the financial system has been at the forefront of people's mind, there are a host of questions that remain to be answered in the weeks and months ahead, from details about how some of the government programs will work to possible unintended effects the cure may have on the way the markets function and how the economy performs over the longer term. BusinessWeek takes a look at some of the potential aftershocks.
Foremost will be how actually to value the assets to be bought by the superfund, a task likely to be neither simple nor quick, given the difficulty the market has had up until now in valuing them amid widespread unwillingness to buy them, says Hank Herrmann, chief executive of Waddell & Reed (WDR) in Overland Park, Kan. "A great deal of consideration has been given to how to value [collateralized debt obligations]" to no avail, he says. "And who's going to value them? Outside professionals?"
Worth the Negatives?
Herrmann also wonders what impact those valuations will have on homeowners across the country when their neighbors' foreclosed houses start being appraised differently and how fair that is to people who have kept up with their mortgage payments. "It's a lot better than the vicious cycle of spiraling down we've been having, so I think you're going to have to put up with some of this stuff," he concludes.
A related question is who exactly will U.S. taxpayers be bailing out? Should the commercial banks struggling with mortgage loans that have gone into default be treated the same way as the broker-dealers who are responsible for helping to create the crisis in the first place, asks David Joy, chief market strategist at RiverSource Investments in Minneapolis.
"It's the banking system you want to help out here. You want to free up credit so lending takes place. I'm not sure that's helped by including the [large financial] institutions in this," says Joy.
Another matter to be clarified: Will the government be buying bad mortgage-backed securities bought by foreign central banks and other overseas investors?
Although the credit crisis has been addressed, the reality of how all these extraordinary measures taken by the government over the past two weeks will play out in the economy is still very fuzzy, says Herrmann at Waddell. A major uncertainty is what impact it will have on the creditworthiness of the U.S. government itself and whether or not that is reflected in the value of the dollar, he says. That's hard to gauge since the number of other countries with possibly more complicated problems may leave foreign investors no better alternative for where to stow their money, he adds.
An Iffy Supply Increase
With the national deficit expected to double next year to $800 billion as a result of the bailouts, a hike in inflation is very likely, say investment strategists. The extent to which the money supply expands will depend on how much money the Fed decides to create, vs. swaps and transfers says Herrmann. If the Fed decides to sell more Treasury bonds to help finance the programs, and the public gives cash to the Fed in exchange, does that really increase the money supply? he wonders. And how might the bond market react to a big expansion in Treasury debt? Treasury yields plunged this week in reaction to an enormous flight to quality into government bonds.
"The Fed can attempt to sterilize some of this by selling Treasuries and taking some money out of the system, but I'm not sure they have the latitude to do that," says Joy at RiverSource. The central bank's balance sheet has gone from 80% Treasuries to 50% since the crisis began, he says.
Herrmann also allows for the possibility of deflation as a result if the government moves lead to more risk-averse behavior from the banks and credit remains hard to come by. That would translate to less economic expansion and probably reduced concerns about inflation, he says.
The SEC's sudden ban on short-selling on 799 financial stocks—perhaps the most controversial move—has already had an unintended disruptive impact on the options market, where market makers rely on being able to short underlying stocks in order to hedge their risk.
By implementing the new rule on options expiration Friday, the busiest day of the month for the options market, without consulting the exchanges or firms that make a market in options, the SEC caused liquidity to freeze up and the bid-ask spread on options to widen on Sept. 19, says Joe Kusick, senior market analyst at OptionsXpress (OXPS) in Chicago.
"Depending on what the SEC does right now, we have an extreme problem on our hands come Monday [the day the ban takes effect]. The exemption has not been made for market makers," he says. "This is adding another potential crisis. The options exchanges with the short-stop rule cannot provide the liquidity necessary to stay open."
He says the SEC needs to make a definitive statement about the impact that the rule, which lasts until Oct. 2 but could be extended for up to 30 days, will have not only on retail customers but on the exchanges and how they provide that liquidity.
As for whether the government's new rule book has overturned long-standing assumptions of how free markets are supposed to operate, Alec Young, equity strategist at Standard & Poor's Equity Research, thinks it's too soon to tell. "It's dangerous to make heavy-duty judgments when you're still sort of in the eye of the storm," he says. "This has been a fairly run-of-the-mill bear market if you see the percent decline. It will reinforce the fact that equities tend to outperform other assets like Treasuries over time because you take on more risk."
He doubts that many investors will turn away from stocks in the long run because of the extra volatility. Most people, he believes, own stocks for retirement purposes in tax-deferred accounts and don't rely on them for short-term gains.
Joseph Biondo Sr., senior portfolio manager at Biondo Investment Advisors in Milford, Pa., says he's not worried about a challenge to the free market philosophy but warns that the regulation likely to be imposed could become too confining.
Ironically, the comprehensive bailout plan could turn out to be the ultimate moral hazard, encouraging more reckless risk-taking behavior in the future. There's certainly potential that by providing a backstop for money market funds, the government might exacerbate the temptation of overly reckless behavior, unless it puts regulations in place to prevent inappropriate practices, says Herrmann. Those regulations would add an extra layer of expense on those running the money funds, however, he adds.