Tuesday, October 7, 2008

I Don't Mean to Brag, but...

Since September 23, the S&P 500 Index has dropped over 11%. What’s interesting about September 23rd? Nothing, except that was the day that I decided to sell half of my stocks (which are almost entirely in S&P 500 index funds) and move the money into an interest bearing account. My strategy until that date was buy and hold. I have never tried to time the market, so why would I start on September 23rd? My faith in the free market led me to fear that the single largest intervention in the history of the American economy could only lead to stagnation in the stock market.

Let me explain in a little more detail, however, why I did not and do not like the bailout. The bailout, eh hem, excuse me, the “rescue plan” is specifically designed to attract capital away from successful uses and put it back into failing financial services firms. This misallocation of capital will slow the economy’s recovery.

The theory for the bailout says that panic set into the first circle of financial services firms and spread to other institutions. The panic would continue to spiral in a vicious circle until all commerce stopped and no credit would be offered anywhere. Those on the Left allege that this cycle of greed and bust is an endemic problem of an unbridled free market and could become permanent, holding the economy back for years and years. Washington, being beset by that other human frailty, panic, simply had to pass the bailout. Investors, seeing the brilliance of Congress, proceeded to pull money out of the market in droves, dropping the Dow Jones Industrial Average down 1,200 points in the next 8 hours of trading.

The problem that I have with the bailout thinking is three fold. To have a “credit freeze”, enormous amounts of capital must be withdrawn and hoarded metaphorically if not literally under the mattress. Eventually, people are going to use that capital again. People won’t forget how to make medicine, drill for oil, or program computers. The incentive to exchange what I can produce, but don't need today, for what you can produce and I do need today will still be there. The economy will go on.

Second, as the panic pushes prices down the opportunity to make a killing gets bigger. I suspect that if the Porsche dealer in town were panic selling Carreras at 20 cents on the dollar, I would not be the only person in line. Many of the “toxic” mortgage backed securities already offer fantastic rates of return with little risk if you hold them to maturity. Now the government plans to borrow $700 Billion from the public. To get us to lend them the money they have to convince us, with higher interest rates, that loaning them money is better than loaning money to other businesses. This moves capital away from companies with sound business models and moves it to those without sound business models. This decision to move capital away from good companies will slow economic growth and the rate of return available in the market.

Lastly, banks are not necessarily the best arrangement to help capital find its most productive use. With the advent of the internet, we have seen the demise of many a middleman. The music industry is in shambles because entertainers no longer need the lumbering distribution companies thanks to iTunes. Venture capital funds capitalize the tech industry in Silicon Valley, not banks. The next Google does not dress up and go down to First National of San Jose to get a small business loan. Even the news industry is dying because bloggers connect average people with news and ideas that need no filtration and distribution. If someone in Minnesota wants to find out about a news conference at a NASA, they don’t have to read a reporter’s opinion, they can watch it on YouTube. Innovation should not be stifled by helping the old guys stay in business.

Banks are inherently unstable by design. They guarantee a rate of return to depositors and then loan out the money to someone else. A bank invests on the margin, also known as leverage. Banks have a nasty habit of getting over leveraged leading even small panics to become meltdowns. Maybe banks should be allowed to fail because they are simply risky relics that have passed their prime.

You might ask, “How will companies who need loans get money? Where would I put my savings?” Just look at mutual funds. A mutual fund company doesn’t borrow and lend, it only recommends to average people where to put their savings (i.e. their capital) and then charges a fee for the advice and administration. There are hedge funds that allow individuals to lend mortgages directly to other individuals, skipping the whole mortgage bank model. Maybe financial experts should be giving advice instead of taking risks. If we allowed banks to fail the financial services industry might be forced to evolve to a more stable system. What have we chosen to do instead? We have decided to bailout the banks so we can keep doing things the way they have always been done. The bailout keeps the big banks big and status quo humming.

To help you wrap your head around this, let me use a metaphor from nature. When someone yells “Help, help there's a fire!” it's likely to send a chill down the neck of the steeliest men. For years, the forest service instinctively reacted this way trying to douse every fire. They finally realized, however, that nature needs those fires to clear out the dead wood, prevent disease, and allow the forest to bloom in new splendor. This bailout, like all meddling, keeps us loaded down with dead wood. It slows growth and reduces opportunities in the economy and the stock market.

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