Dodge the Pitfalls and Uncover the Profits From the $700 Billion Banking System Bailout

By Martin Hutchinson
Contributing Editor

With the exception of a few curmudgeonly old Republicans, there has been general rejoicing at U.S. Treasury Secretary Henry M. Paulson's $700 billion banking system bailout. Indeed, to hear some commentators you would think it was cost free - they explain joyfully that assets will only be acquired at a discount, so of course there is a good chance the taxpayer will not be out of pocket on the deal.

Well, if you believe that I have a bridge to sell you. The deal has large costs to taxpayers, and considerable negative implications for our economic future. Investors didn't buy into the upbeat spiel either: U.S. stocks were routed yesterday (Monday) on fears that the bailout's cost could sink the U.S. economy.

The Lowdown on the "New" Banking Sector

Let's begin with the implications for investment banking. There aren't any, because there will no longer be any investment banks. The decision by Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) to apply for banking licenses means the 1985-2008 investment banking model - of institutions leveraging their balance sheets to the max to take on all kinds of assets (debt, equity, real estate … the lot) - is as dead as the proverbial dodo. [For an analysis of Goldman and Morgan's transition into commercial banks elsewhere in today's issue of Money Morning].

It was always likely to meet that fate. Very high leverage - combined with illiquid and hard-to-value investment positions - is a recipe for disaster as soon as any kind of downturn occurs. One might think that such sophisticated operators would have figured this out. But the reality is that these "experts" use their sophistication only to maximize their own compensation, not that of their shareholders. I have said for many years that an individual investor buying shares in investment banks was playing a mug's game; the events of the last few months have proved me right.

Going forward, Goldman Sachs and Morgan Stanley will have to reduce their leverage by about half in order to become acceptable to U.S. Federal Reserve regulators. This means that either their assets will have to be cut in half or their capital will have to double - or some combination of the two. But understand this point: No matter which way they go, it will be highly dilutive to each firm's earnings per share number.

For commercial banks, the economics are more interesting. They will have more access to the investment banking business, because the traditional Wall Street houses will no longer have additional "cachet" in this business; the mergers-and-acquisition-advisory business, for example, should become a significant contributor to profits at many of the top-tier commercial banks.

Even more interesting: The sector may find its compensation costs declining. Traditionally, investment banks have paid outrageous amounts in compensation to their senior employees, and commercial banks have discovered that in order to keep top quality talent, they have to come close to investment bank packages - a difficult undertaking with their shares being much less exciting than investment banks' as compensation. Now there are no more investment banks, outrageous compensation packages will be more difficult to come by (in any case, they might cause difficulty with the Fed regulators), so specialists in onetime investment-banking operations will find their pay packages considerably diminished.

While it's unlikely that top earnings will drop until a senior vice president (the new term for "partner") at Goldman Sachs National Bank makes only $300,000 or so by 2018, money-center banks should find that their overall savings on compensation would be enormous. And those savings will flow straight to the bottom line.

Profits and Losses

Don't assume this bailout will solve the housing finance problem completely. It won't. Remember, a pretty high portion of the housing loans made in the 2005-2006 time frame were called "liar loans" for a reason - they involved out-and-out fraud, with no proper checking having been done on the borrower's earnings, other debts, or on the actual value of the property itself. [For an analysis of the bailout deal elsewhere in today's issue of Money Morning].

Assuming the managers of the government's new $700 billion slush fund are even halfway competent, they'll avoid the real rubbish, and leave the biggest losses for banks' shareholders to absorb. Since the total losses from this mess - including those from credit cards and others from leveraged loans - have yet to fully materialize, and could actually reach $2 trillion to $3 trillion, there will be plenty of losses to go around.

The bottom line is that the best banks - those that maintained some semblance of underwriting standards - are a better bet than the worst, even if the worst may receive (in cash terms) more of the $700 billion from the bailout fund.

The U.S. economy will be afflicted by inflation, however much the authorities may wish to deny this. Theoretically, since the new fund will resemble Herbert Hoover's Reconstruction Finance Corp. of 1931-1932, and might bring about the same result - an intensified recession as the public sector borrows in the weak capital markets to finance politically connected rubbish. In practice, the Fed will do everything it can to avoid this: It will monetize the new debt, adding the $700 billion to the money supply, resulting in roughly a 7% increase in the M3 portion of the U.S. money supply.

That will cause inflation. The market thinks so, too: Otherwise, why would gold prices have zoomed $40 an ounce and oil $16 a barrel yesterday, once the shape of the package had become clear? We're basically talking about $700 billion of demand that's being injected into the U.S. economy, but the Organization of Petroleum Exporting Countries (OPEC) and other oil producers are likely to capture a substantial percentage of that through oil-price increases.

The Winners and Losers in the Bailout Bonanza

Treasury bonds are a major loser, since inflation is rising and $700 billion of extra debt must be issued. Go for the Rydex Juno Inverse Government Long Bond Fund (RYJCX), a fund designed to move inversely to Treasury bonds. Up to now, it's been a poor play as T-bond yields have trended steadily downward and prices steadily upward, but it's about to become a good one.

Gold has to be a winner, so you should consider the StreetTracks Gold Shares Fund (GLD), which may be the most efficient way of getting a pure gold play.

Finally, for the first time in two years, I will venture to recommend a U.S. bank. With $700 billion being poured into the sector, one of the major banks has to be a big beneficiary. But the question is, which one?

Avoid Citigroup Inc. (C): With so many different ways of losing money worldwide, it's bound to find another one in this downturn.

Avoid Bank of America Corp. (BAC): I would be very bullish on BAC after its Merrill Lynch & Co. Inc. (MER) buy - if the morons hadn't previously bought Countrywide Financial Corp., a black hole of losses.

Wachovia Corp. (WB): The bank's leaders were as dumb as bricks when they bought a huge California home mortgage operation right at the top of the market in August 2006 - and they probably made other mistakes also.

Wells Fargo & Co. (WFC): Possibly, but I don't like the California emphasis or the fact that it was among the most active in the subprime market.

By a process of elimination, I am left with JPMorgan Chase & Co. (JPM), which was relatively less active in mortgages and picked up a heavily subsidized investment-banking bargain in Bear Stearns. It will doubtless get its share of the $700 billion, and not be left with so much rubbish that even the Feds won't buy. With an earnings multiple of a fairly modest 13, an asset multiple (market capitalization/ stockholders' equity) of a modest 1.1, a dividend yield of 3.2% and a dividend that appears at least moderately secure, there is comfort on the valuation side too.

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