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A primer on the financial bailout

This article first appeared in the St. Louis Beacon: September 25, 2008 - To help make sense of the current economic crisis, the Beacon asked local experts in finance and investing for their answers to basic questions. The experts are: Stuart Greenbaum, former dean of the Washington University School of Business and now Bank of America emeritus professor of managerial leadership; Radhakrishnan Gopalan, assistant professor of finance at Washington University; Rick Hill of Hill Investment Group in Clayton; and Pamela Kuehling, a financial planner with Smith Barney. Here are their responses:

What principles should guide policy makers as they craft a bailout package? What dangers should they avoid?

Stuart Greenbaum: I have great confidence in the plan's two authors. There need to be modifications to ensure integrity and success. One, I am very much in favor of a board of overseers, preferably people of independence and competence, neither government officials nor industry representatives, but people who could look at transactions one at a time and opine as to their authenticity. The other thing I would very much favor is government demanding equity for each transaction they undertake, so there is some upside for the public in this, and it's not just a free ride for the shareholders and managers.

Radhakrishnan Gopalan: Any bailout is going to be very political. There are a number of thorny issues: Which banks will participate, how will the market look at the participating banks (will they see it as a further sign of trouble), at what price will the government buy these assets? Added to this is the problem of how the government should be compensated for bailing out the banks: Whether the government should get equity in the banks. Also if the government only wants to buy out mortgages, then why not do it through Fannie and Freddie as those are already in the business of buying mortgages.

Rick Hill: This is a unique situation that demands some government involvement, but few officials clearly understand the complex financial instruments that contributed to the current conditions. Just as they did with the savings and loan debacle, the government may want to call on those who exacerbated this situation, as they know where the bodies are buried.

Have regulations been too lax, not properly written or just not properly enforced?

Gopalan: In my view, regulations have not kept pace with financial innovation. For the past few years, the United States has strongly believed in regulating with a light touch and allowing the market participants to innovate in creating newer and more complex financial instruments. This had its benefit in enabling the participants to identify and allocate risk to the party best suited to bear them and fueled the huge liquidity boom that we experienced since the dot-com bust. This reduced the cost of mortgages and made them more available. But as with all good things, we just overdid it.

Greenbaum: What we have is a financial crisis that is sweeping all these institutions aside. It's the very essence of systemic risk. It's in dysfunction mode. Given the challenges of last six months, these institutions turned out to be undercapitalized and overleveraged. No one anticipated this financial tsunami, even though you know these things can happen.

What lessons can be learned and applied from past crises, like the savings and loan bailout, to the current situation?

Greenbaum: The Resolution Trust Corp., with all of its problems, was a resounding success. Going into the exercise, the prevailing estimate of the cost of the savings and loan debacle was widely half a trillion dollars; it ended up costing $125 billion. That's not chump change, but it's a fourth of what it was initially estimated to be. If you do this one right, it may end up costing between $100-200 billion. I think that's a reasonable estimate going in.

Gopalan: The current crisis is unique in its magnitude and the speed with which shocks get propagated through the system and the number of players who can cause a systemic problem. Added to this is the complexity of the financing instruments that we are facing. So while the lessons of the past crisis are quite useful, they have to be modified to suit the current situation.

How will all of this affect the federal deficit and taxes to pay for it?

Gopalan: All this is going to significantly increase the federal deficit. That is going to constrain the policies of the next administration, both in terms of tax cuts and in terms of expenditure increases. Added to this, if our economy also goes into a recession that will only worsen the problem.

Greenbaum: I'd rather see the money going to education or health care, but it is what it is. This is the challenge we're facing right now. Do you want to just let it go? It would be stupid to do that. It's not going to be the end of the world. We may have to live through a recession. If we're lucky, it won't be so severe and won't be so prolonged. The more demagogues who get involved in the planning of this thing, the less chance we'll have to be lucky.

What's the safest place to put your money now?

Hill: Safety is a relative term. Is it safe for me to put my money under the mattress? You may sleep better (depending on how you pile the money), but you will die a slow financial death from inflation. Inflation is far more powerful than most retirees realize. Volatility does not hurt the savvy passive investor the way it does the active speculator, but inflation is sure to get those who become too conservative.

Pamela Kuehling: The answer totally depends on your risk tolerance and your time horizon (how long before you will need the money). It's tough to remember your strategy when chaos is all around you, but unless your underlying assumptions change, your strategy should still be sound. The factors that determine risk tolerance include our age, time until retirement, comfort with portfolio volatility, and level of wealth. Other factors, however, should include family situation, employment stability, short term vs. long term wealth needs, tax and estate issues. Your risk tolerance will change over time and every time your life changes.

Knowing how much to put in stocks, bonds or cash is key. I can't support the "mattress strategy" unless a person never wants to retire. Both bonds and stocks have risk factors -- interest rate risk, market risk, company risk and more. However, putting your money in a CD can have a risk, too. You can lose purchasing power and not overcome inflation over time.

What effect will all this turmoil have on the housing market and mortgage rates? How about the availability of other types of credit?

Hill: The housing market is great -- if you have cash and are looking to buy, but it is terrible for sellers. Mortgage rates are still historically very low, but credit is tightening and it may get tighter. Our advice is to ignore the things you can't control. Do what you do best to earn a living and hire someone very smart to help you invest your savings.

Are FDIC-insured accounts safe? How about money-market accounts? How much ready cash should you keep at home as an emergency reserve?

Hill: FDIC insured accounts are safe as long as you don't exceed the limits. Most money market funds are safe, but they have not had guarantees in the past. This is changing as we move forward. We wouldn't recommend keeping any cash at home, but it is wise to keep at three-six months worth of living expenses at the bank, rather than in your passively managed investment account.

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