This Bailout Is Great!

By Richard Gibbons
January 30, 2009

A lot of people have been complaining about the bailouts. This is understandable. The basis of capitalism is that the strong survive, while the weak collapse. It's galling to see people rewarded for failure.

The problem is that, as a country, we can't make decisions based simply on anger or capitalistic dogma. We have a responsibility to do whatever will help ensure this country's future prosperity. And right now, that means bailing out the banks, increasing regulation, and stimulating the economy.

Capitalism's blind spot
Capitalism works well, generally allocating resources efficiently. It's the reason why there's usually food on the supermarket shelves, while there often wasn't in the U.S.S.R.

But capitalism has its blind spots, too. In a capitalist system, it's rational for bank executives to take huge risks in order to pad bonuses based on short-term metrics. Bank executives don't care about systemic risks -- often they barely care about their own shareholders. So, regulation is necessary to reduce systemic risk.

Unfortunately, our regulators disliked regulation, and last year, the resulting crisis drove the banking system to the brink of collapse.

House of cards
And I really mean collapse. Of the big five investment banks, only Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS) are still standing, with Lehman, Bear Stearns, and Merrill Lynch all either bankrupt or sold.

Same with the biggest retail banks. Citigroup (NYSE: C) fell from over $50 per share to under $5 per share despite huge cash infusions, and Bank of America (NYSE: BAC) looks to be getting there. Wachovia, the fourth-biggest bank, was acquired. Washington Mutual, the sixth-biggest, became the biggest failure in U.S. banking history.

Without government assistance, it seems likely that most of the top-tier banks would have collapsed. As if that weren't enough, the Bank Insurance Fund (BIF) -- which provides deposit insurance -- has less than $100 billion, enough to cover only 1.01% of outstanding deposits. Citigroup alone has over $600 billion in deposits. By itself, Washington Mutual would have drained the BIF if the Federal Deposit Insurance Corp. hadn't used sleight of hand to transfer WaMu's operations to JPMorgan (NYSE: JPM).

With widespread bank failures, deposit insurance would falter, and the taxpayers would be footing the bill regardless. That's why we see all these acquisitions -- because the banking system can't handle the failures. It's cheaper for the country to just save the banks.

The domino effect
If we do let the banks go under, there will be huge problems, because our whole economic system runs on credit. How many small companies use lines of credits to handle seasonality in their businesses? How many large companies rely on sales of commercial paper? If that money is unavailable, many completely viable businesses will go under because of liquidity issues.

Any company that uses debt is vulnerable. Procter & Gamble (NYSE: PG) is practically invincible in any normal situation. But it has $35 billion in net debt. What happens when its lenders ask for some of that money back, and it has to borrow at 15% to get the cash? Wal-Mart (NYSE: WMT) has $41 billion in net debt. When nobody wants to lend, how do you borrow $41 billion?

What happens when the farmers, truckers, and other businesses making up the backbone of our infrastructure, fail? Will there still be food on the supermarket shelves? I don't know, but I'm not eager to find out.

A New Deal
In fact, the history of the Great Depression shows what happens when you start killing the banking system. Between 1929 and 1933, about one in five banks went under. As you'd expect, these bank failures took a massive toll on the economy, with real GDP falling by 29% and unemployment hitting 25%.

At that point, President Franklin Roosevelt stepped in with a plan called the "New Deal." He shut down the banks and allowed only sound banks to reopen. He passed the Emergency Banking Act, which made federal loans available to banks. Then, he enacted the Glass-Steagall Act, establishing deposit insurance and preventing depository banks from being investment banks, reducing the risk of banks blowing up because of bad investments. (Unfortunately, Glass-Steagall was repealed in 1999, which is one reason why banks were able to trade asset-backed securities (ABS) and blow up the system nine years later.)

After these actions restored confidence in the banking system, Roosevelt focused on employment through numerous public works projects and agricultural programs.

The results of this government intervention were impressive. GDP skyrocketed from 1933 to 1937, posting real growth of 9.4% annually -- a huge rate for a developed country. Unemployment fell to 14.3%.

Reasons for optimism
Warren Buffett knows this history, and that's probably why he said that the bank bailout was "absolutely necessary to avoid going over the precipice." Now he's confident that America will bounce back.

The government's actions have helped to restore confidence in the banking system -- a TED spread down from 5 to 1 indicates that banks are more willing to lend to each other now than any time since September. Now, President Obama, like Roosevelt, is working on programs to help Americans get back to work.

The Foolish bottom line
To me, it seems likely that these government interventions will pave the road to recovery. The world's richest man seems to agree, and says that if stocks continue to trade at bargain prices, he'll put his entire personal portfolio into equities. That's why I think now is the time to find undervalued stocks, invest, and grow rich.