An Alternative Cure for the Financial Crisis

After reading 50 blog posts this morning about the end of the economic world being near, I have had enough. Time to propose a solution.

First we should restate the problem, which I have done as recently as last week. The current problems have been brought on by issues of liquidity, leverage, transparency....and confidence. The status of each factor is shown below.

Liquidity--the situation has improved significantly in the last few months

Leverage--improving, particularly as the government invests in the troubled companies and lenders become more conservative in their lending practices

Transparency--not likely to improve until the SEC stops thinking like lawyers (who have to win court cases) and starts to proactively investigate bums, con men and avaricious corporate types. However, at this point, transparency is the least of the problems except as it affects government bailouts, e.g. AIG. More on this below.

Confidence--there is none and therein lies the real problem. When Warren Buffett is confused, suffice it to say there is no confidence left in markets and particularly stock markets.

To understand the lack of confidence look at the 30 day volatility index, VIX, which is shown below. As you may recall from Finance 101, volatility is the measure of the standard deviation in the compounded returns of a financial instrument. As volatility increases, the risk increases and the price of the underlying financial instrument declines. The VIX is based on the S&P 500, so it is a measure of the volatility in equities for the next 30 days. The VIX 52 week trading range is 15.82--89.53 with a current price at about 50. Anything above 30 is considered unusually volatile. The last time it traded below 30 was September 2008. The last time it touched 40 was in January 2009 when the market rallied. Therein lies the first clue to how to get the economy back on track. Reduce perceived risk in the stock market.

The second factor that needs to be addressed is the short sellers, particularly in equities and equity indexes. Every pundit, expert and honest man has been on television or the Internet calling the bottom of the stock market ("buy") or saying the world is ending ('sell"). Nearly everybody advocating for a bottom, cheap stocks or some positive economic indicator is long equities, such as Mr. Buffett. Nearly everybody saying that the DJIA is going to 5000 is short equities (probably Soros). Logic would indicate that short positions are at an all time high (although it might be hard to prove given the low per share prices). So, the second clue we have is that we need to squeeze the shorts in order for the market to rebound and for some confidence to return. (When the shorts are squeezed they have to buy stocks to cover their position and prices go up.)

To summarize my argument so far, I think we need to see a rally in the stock market to restore confidence in the economy and we need to squeeze the short sellers in order to have a sustained rally.
Yes--I am saying rally the equity markets and that will restore confidence--and not restore confidence and the markets will rally. Therein lies the magic in my plan, which has two parts:

1. First, we need to get all the bad news out. Whatever the total amount of the bailout is for AIG needs to come out. No more piece meal information or partial investments. Whatever the capital requirement for Citibank and/or B of A or any other institution we can not let fail, figure out the numbers, disclose them and fund the problem--now. Every time there is an announcement on AIG or Citibank the VIX spikes. The government's poor management of the information/problem is exacerbating the market risk and leading to a decline in investor confidence. Do not tell me you can not price the securities. If that were the case then maybe the mark to market or fair market value is zero. Deal with it.
2. Now for the outrageous original part!! Drum roll. The U.S. government should announce a plan to purchase up to $1 trillion in exchange traded U.S. equities, beginning in 90 days, over the next year (or two). Exchange traded equities would exclude bulletin board stocks, indexes (which the shorts like) and options (also liked by shorts). For clarity, the government could also trade the positions or in other words be a seller. To pay for this, we could cut back on the economic stimulus package (which will not work), forget about health care reform for another four years or economize on military spending, just to name three obvious alternatives.

The benefits to the plan are as follows:

1. By announcing it in advance, everybody will start buying before the U.S. government. In fact, everybody jumping into the market might actually not require the government to buy much equity in order to sustain a rally. A few token purchases to make the program look real may be all that is required.
2. Such an announcement/rally will draw many foreign investors, strengthening the U.S. Dollar and making imports here much cheaper. Cheaper imports could kick start some other economies like China or Mexico, who would then start buying U.S. exports.
3. Consumer demand would return with a better stock market and consumers have lead the U.S. economy out of the last several recessions.
4. Capital gains tax revenue would increase as long equity holders took some hopefully taxable gains in the rally, in a small way helping to pay for the program.
5. The short sellers of equity would have to cover their positions by buying stocks quickly, which would greatly contribute to the rally. They would also be somewhat timid about going short again for fear the government might re-enter the market as a buyer.
6. The equity markets might have enough life in them to support some IPOs or secondary issues by listed companies that need equity capital. Some people might even buy bank stocks.

In pondering my outrageous idea I realize that everybody will hate it. The Republicans because it is another government stimulus but.... a lot of Republicans are still long equities. The Democrats will hate it because it does nothing for the foreclosure problem but....I think it would create jobs more quickly than infrastructure investment.

Unless Obama calls me this week while I am in Washington, I do not expect my idea to get much traction. However, I am reasonably certain that confidence in the markets is a key stumbling block to economic recovery and we need some new ideas for how to restore confidence. I am going to continue to think about the current problems but the next proposal will probably be equally outrageous. Maybe Mr. Buffett will come up with something in the mean time.

Enough fun for today. Back to work.

VIX chart credit: Yahoo Finance