Positive Thoughts on the Bailout

Looks like this whole blogging thing is more time consuming than expected, especially when the site is blocked at work. I would love nothing more than to steal work hours to blog throughout the day, but no such luck. Before I get going on some positives on the bailout package, I have a quick positive on the kickball situation. I went up to my cowardly friend and asked if he was ready to shake my hand last night. I think that was a positive step. That is until he gave me the cold shoulder yet again! He still would not put his pride aside and shake a friendly guy's hand at a bar. I should have updates on this every week since I now know how easy it is to get this kid going. I will make a valiant effort to bother him every week for the next few months. Now back to finance...

Since my last post, a lot has happened in the markets. This seems to be a recurring theme. We had a massive sell off last Friday. Then the G7 met and came up with a worldwide, comprehensive plan to help support the world's financial markets. Finally other central banks (even that lazy Trichet from France) agreed that action must be taken. The markets liked this news and we had the biggest point gain in history on Monday. We gave most of that gain back on Tuesday and Wednesday and had a decent recovery today. It's been difficult to follow and understand the action in the markets over the last few weeks due to the extreme volatility. For the first time in a very long time, 700 point swings throughout the day are becoming a common occurrence. It is the longest, wildest roller coaster I have ever ridden in my life. As much as I would like to talk about the intra-day action in the markets, I promised in the last post to focus on a few of the positive items in the U.S. bailout package and other positive steps that have been announced recently.

1. Ability to buy illiquid mortgages from the banks - I have already discussed the positive implications of this part of the bailout in my post entitled "A Glance at the Fed Bailout" on September 28th, so I will say no more on that topic.

2. Raising the FDIC insurance level to $250,000 from $100,000. This is a very important item in the bill. In the past, if you had more than $100,000 in a bank account at one institution, anything above that 100k was not insured by the federal government. So if the bank went under, there would be no guarantee on that money. This is a big issue, especially for small businesses who need to have well over that amount to finance their every day operations. When rumors came out about Washington Mutual being in big trouble, people with money at Wamu, especially more than $100,000, began withdrawing cash. This is commonly referred to as a run on the bank. Before JPMorgan decided to buy Wamu, billions of dollars were withdrawn. As discussed earlier, banks cannot operate without these deposits. These runs on banks caused big problems during the Depression and the S & L Crisis in the 80s and 90s. If you Google bank runs, you can probably bring up images of people waiting in lines at the bank to withdraw money. That problem today is even more prevalent since we can withdraw all of our funds electronically. It only takes a click of the mouse for me to pull all of my assets out of Sovereign Bank (soon to be Banco Santander). By raising the insurance limits, people will feel more comfortable leaving their money in the banks and these "runs" will hopefully subside.

3. Taking an equity stake in 9 of the largest U.S. financial institutions. Part of the $700 billion bailout gives the Treasury the ability to inject capital directly into the banks in exchange for an equity stake in the bank rather than simply buying distressed assets. This is the method that many of the governments in Europe have decided to implement. The U.S. followed suit on Wednesday by agreeing to inject $250 billion into 9 U.S. financial institutions. So what the hell does all this finance jargon really mean? The Treasury is basically buying senior preferred stock in the 9 companies. The Treasury will therefore now be an equity holder in the banks. They will get paid 5% per year on this money for the first 5 years and 9% thereafter. This is a win/win situation. The Treasury is making money for the taxpayer on this investment and the banks are able to borrow money at a very cheap rate for 5 years. The idea is that the banks will begin to lend out some of this money to unfreeze the capital markets and get the financial system back on its feet. There is more to the agreement, including the issuance of warrants, but I just want to get the most important points across.

4. The FDIC will now guarantee senior unsecured debt of eligible institutions issued before June 30th of 2009. This is also happening in Europe. This is a very big deal. This means that banks can raise money by issuing debt that is FDIC insured. This insurance will lower the cost of borrowing for the banks and also encourage people and institutions to invest in this debt. Typically during a difficult period in the market, debt (bonds) are considered safe investments. If a company is liquidated, the bond holders are the first ones to get paid. This crisis has been much different. Even the bond holders of U.S. companies, especially financial institutions, have been severely punished due to the lack of confidence between banks. When the Fed let Lehman Brothers fail, every institution holding Lehman Brother's bonds took a big hit. These same institutions then took a look at their other bond holdings and began to get rid of the debt of other banks that they thought were unsafe. If one of these banks wanted to issue new debt, they had to do so at very high interest rates in order to attract investors. This new insurance should lower the cost of capital for the participating institutions and bring back at least a little confidence in the system.

5. The last part of the package I want to discuss tonight is the Fed's recent announcement to enter the commercial paper market. Check out investopedia.com for a pretty good explanation of the commercial paper market. It is one of the most vital parts of the every day operations of businesses in America. Commercial Paper is basically very short term debt issued by companies to help finance their payrolls, inventories, etc. The market is huge and gives businesses access to capital at very low rates to help them operate. Over the past few months, this market has basically frozen up. Here's an example: Joe Plumber used to sell commercial paper to Barack McCain in order to finance his purchases of toilet plungers. He was able to borrow the money at a very low interest rate, so it made perfect sense. When the financial crisis began to trickle down into other businesses, Barack McCain began to get nervous about Joe Plumber's business, so he stopped buying the commercial paper. In fact, everyone stopped buying Mr. Plumber's paper (not toilet, commercial). Joe now has no financing and no way to buy more plungers to keep his business going. This is happening across every industry in America right now. This market is well over $1 trillion, so that's a lot of money to have frozen up. The Fed has announced that they will begin buying highly rated commercial paper from companies - I believe the facility will be set up in 2 weeks. This should help to unfreeze some of this vital market.

As stated previously, the credit markets will not be fixed overnight. We must be patient. It is important to understand that times are tough and will be for a while. But I think it's equally important to focus on some of the positive steps that are being taken. It's great to see governments and bankers all over the world working together to help get us through these difficult times. I'm sure the pain will continue, but I will make sure that I focus in on some of the positives as well. Hope this helps and as always, please feel free to ask questions if anything is confusing. Enjoy your Friday everyone.