Bailouts Are a Mixed Bag – Even When They Work

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Although the ongoing financial crisis has introduced a new word – bailout – into the lexicon of most investors, a quick tour of history shows us that these big-ticket financial rescue plans are actually nothing new.

And that raises the question: Do they work?

A look back at history shows us that – like most government initiatives – the answer is “it depends.” While some investors might find that reassuring, history also suggests that the final tab for a financial-crisis bailout will be well in excess of what it should cost to fix the problems the crisis actually caused.

A Look Back at Bailouts

Take for instance the very first banking bailout in “modern” history, when Alexander Hamilton, the first U.S. Treasury secretary, told banks to accept bonds as collateral for loans that were then underwritten by the fledgling US government. At that time, a man named William Duer tried – and failed – to corner the market in government bonds, leading to the historically famous “Panic of 1792.” Faced with the potential for an almost-total complete collapse, Hamilton then borrowed money from banks and used it to purchase government bonds. Everybody survived (except for Duer, a one-time member of the Continental Congress, who went bankrupt in the panic and spent the rest of his life in debtor’s prison).

Forty-five years later in 1837, U.S. President Martin van Buren took the opposite approach and refused to involve the U.S. government when it came time to bail out the Second Bank of the United States. Organized under Federal Charter, the bank entered into speculative loans around the country, but was forced to suspend operations and went into liquidation in 1841.

Creditors received payment, and in an eerily similar outcome to today’s bank failures, stockholders received nothing. The depression that followed has been characterized as comparable to the Great Depression. Again, everybody survived, but in a foreboding manner, the damage spread throughout the U.S. economy.

In 1897, faced with a potential collapse of the U.S. Treasury (which was running out of gold to back its currency and its obligations), J. P. Morgan personally created a private syndicate on Wall Street to supply the Treasury Department with $65 million in gold and to float a bond issue that restored the U.S. government’s coffers to $100 million. He survived – as did the U.S. government, but many banks didn’t.

Only a few years later, in 1907, Morgan again rode to the rescue and – in one of the most fabled stories on Wall Street – locked banking executives in his personal library on East 36th St. until 5 a.m., which was when they finally gave in and agreed to backstop yet another financial crisis. This time the damage spread wildly throughout the U.S. market, and jumped across the Atlantic, as well.

The point I’d like to make with this little historical foray is the same one that legendary investor Jim Rogers made to me this past April during an exclusive interview at his home in Singapore: “History,” Rogers told me, “is filled with bailouts,” and their track record is spotty, at best – particularly in recent years as the increasingly intertwined nature of the global financial markets makes them more complicated than ever before.

Clearly that’s problematic.

Especially when a new study by Luc Laevan and Fabian Valencia covering 42 recent bailouts in 37 countries since the early 1970s shows that each time the “tab” was vastly underestimated. And that only reaffirms our oft-repeated contention that the “Bailout Boys” – U.S. Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry M. “Hank” Paulson Jr. (or, more likely, their successors, as this will be with us for quite some time) – will be back on Capitol Hill, hats in hand, seeking additional money to continue their bailout battle.

The only question in my mind is whether or not we’ll have to pay back what we owe (courtesy of Wall Street) through a bailout plan that’s put together to rescue the current $700 billion bailout should it prove ineffective, or if we’re facing a second Great Depression that will even things out only after a number of painful years pass.

The Laevan and Valencia study suggests that the cost of the current bailout will be high, regardless of which alternative becomes a reality. According to researchers, the average bailout – net of asset recoveries – costs a staggering 13% of gross domestic product (GDP).

Assuming historical relationships hold true and there is no more bad debt uncovered (which seems highly unlikely at this point, particularly given how severe the current crisis has proved to be), that would put the bill at almost $2 trillion, which is more than double current projections.

And the bad news doesn’t stop there. The average public recovery is a meager 18%.

That’s not to say that the current bailout couldn’t beat the averages and end up costing less, which is exactly what Phillipa Dunne and Doug Henwood, writing in the Liscio Report, discovered. They note that the most successful bailouts are those involving recapitalizations, as opposed to the wholesale purchasing of bad assets that Paulson and Co. are pursuing. The researchers also found that that use of public money to engage in recapitalization is often less costly than the afore-mentioned bailout strategy – on average, it costs about half that of conventional bailouts – and results in an average hit to GDP of roughly 6%, which in the case of the United States works out to roughly $850 billion.

Detractors will no doubt object to the Laevan-Valencia database because many of the countries included are so-called developing nations. We don’t think that objection is merited, particularly since Japan and Sweden are included, and since both provide startlingly divergent experiences.

For instance, in a well-publicized case of foot dragging, Japan engaged in a thorough pattern of denial that ultimately resulted in that nation spending a stunning 24% of its GDP to dig itself out after falling into a severe recession referred to as the “Lost Decade.” Sweden, on the other hand, took immediate and severe action and not only avoided a recession, but spent a mere 3.6% of GDP to get back on its feet.

It’s too early to tell whether the United States will fall into Japan-like slump, succumb to Zimbabwe-style inflation, or even re-enact the Great Depression. But it is clear that the U.S. economy is likely to experience a recession along the way – a possibility we’ve been warning readers about since this financial crisis began. Indeed, a mountain of data suggests we’re already there.
But there is a glimmer of hope.

As noted by researchers Dunne and Henwood, IMF data for Japan, Korea, Norway and Sweden all show generally lower inflation, moderating bond yields, generally stable employment and higher stock prices three years after each of their crises began. [For a nice graphical illustration of these results, refer to the chart that follows].

Japan is the obvious exception having fallen into a severe deflationary period by virtue of half-hearted solutions and a full five years of denial that preceded any serious governmental action. [Money Morning Executive Editor Bill Patalon has written extensively about the eerie similarities between that collapse and the potential for a “Lost Decade” here in the United States.]

So what should investors do now?

There’s no question that a properly diversified portfolio with an emphasis on defensive investments is going to be an investor’s best friend right now. Just because stocks are cheaper than they’ve been in years doesn’t mean they’re not garbage.

Fully 50% or more of investable assets should be concentrated in “safety-first” holdings, with balanced funds and municipal bonds high on our list at the moment. History suggests that an exposure to metals and commodities is warranted – as are the use of speculative “inverse funds” that generate profits as they continue to bleed off excess in a process we’ve termed the “Great Deleveraging.”

Such investments are also proper, given that the real danger we face is that of “The Greater Depression.”

News and Related Story Links:

• Contrarian Profits:
  Banking Crises Around The World.

• Wikipedia:
  Panic of 1792.

• Money Morning Jim Rogers Interview:
  Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve.

• Wikipedia:
  Alexander Hamilton.

• The Liscio Report:
  Banking crises around the world,

•  Wikipedia:
  William Duer.

• WhiteHouse.gov:
  Martin van Buren.

• Wikipedia:
  Second Bank of the United States.

• Money Morning Special Investment Report:
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it.

• Money Morning Market Commentary:
  Four Ways to Sidestep the Damage Wall Street’s Big Money Movers are Inflicting on Main Street.