vaughnwoods

“Bernanke is an academic who specialized in studying deflation”, (Credit Suisse, 9/22/2008).

A new government financial bailout is underway. While Congress continues to argue over features yet to be included in the entire package, we can begin to explore how the new bailout package will work and what it means to investors going forward.

To explore this question it is important to note that to be effective, prices paid by a Resolution Trust Corporation (RTC) styled entity for bad investments, must be high enough to provide a good proportion of the $200 billion in additional capital which analysts estimate is needed for banks. According to World Bank estimates, the expense of the bailout may reach 7% of U.S. GDP. The first RTC, which was established from 1989-1995 to liquidate assets from the 1980’s Savings & Loan crisis, cost an estimated 4.2% of U.S. GDP.

Most experts agree that regulators are highly motivated to act quickly, the consensus being there has been enough “moral hazard”. The collapse of Bear Stearns, Lehman Brothers and AIG, along with the taming of Merrill Lynch, Morgan Stanley and Goldman Sachs, are sufficient objects of atonement to appease authorities. All of these institutions are either gone or domesticated to the point where they are incapable of leveraging themselves to such previously high levels.

Congressional leaders are participating in this decline, and like many people, have passed the pain threshold. To a member, congressional leaders are willing to do whatever is required to stabilize the US financial system. If the current $700 billion bailout plan is not enough, then the Fed is authorized to buy securitized assets.

The specifics of the bailout package are being worked out. However, according to Credit Suisse researchers, a general bailout framework should include:

• 1. A RTC-type vehicle that will buy $700 billion of bad investments from banks
• 2. A $300 billion guarantee of money market funds
• 3. Some type of mortgage restructuring vehicle
• 4. An inclusion of foreign bank assets with operations in the U.S.
• 5. All property-related assets will be included and the Fed can add any further assets it deems necessary. Banks need to sell their worst-quality assets to reliquify their balance sheets.
• 6. Goldman Sachs and Morgan Stanley probably have to deleverage further since the average commercial bank maintains an 18x levered position while both are levered in the 24-30x range.
• 7. It appears this package is financed by debt, not by printing money, which has important positive implications for the dollar. This would suggest that as this recognition moves forward the price of oil should be capable of remaining range bound. Bottom line: this does not look inflationary because the velocity of money in circulation is falling more than money supply is rising.

It may seem counterintuitive, but as deleveraging continues, the dollar should rally. At the end of the day, U.S. authorities have shown that they are willing to aggressively tackle the symptoms of the decline brought about by the U.S. housing/banking debacle. Other positives for the economy include limits on short selling, a cut in interest rates in China, and the recognition that from an historical measure, the equities market remains much oversold.

Meanwhile, since credit leads equities before market turning points, this may be the final trough before the next move upward. As the following chart shows, bonds rally several months before equities during historic financial bailouts. At this point, the next bull market may therefore begin under a new presidential administration after a final trough in November.

Please remember that I am an available resource should you or anyone you know need someone to talk to regarding this wild market. You can always feel free to get in touch with me.

Contact us to learn more about working with Vaughn Woods Financial Group.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views off Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0025

**Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse Global Equity Strategy 09/22/2008