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Wednesday, September 24, 2008

Connecting the Dots on Buffet's Bet

This morning brought some welcomed news from Wall Street.

One of the world's shrewdest dealmakers is betting $5 billion of his investors' money that the U.S. financial system is not about to collapse.

Warren Buffett's Berkshire Hathaway Inc. said Tuesday it investing at least $5 billion in Goldman Sachs Group Inc., a huge vote of confidence for one of the survivors of the credit crisis that felled two of its investment banking peers.

In addition to buying $5 billion in preferred stock, Berkshire also got warrants to buy another $5 billion in Goldman's common stock. Goldman also said late Tuesday it would raise another $2.5 billion in its own public stock offering.

The news sent shares of Goldman Sachs and stock index futures soaring in electronic trading, after the Dow Jones industrial average posted a triple-digit decline for the second day in a row.

Not only is Warren Buffett among the most respected investors around, but a $5 billion position is quite significant even in his massive portfolio. Is this finally the sign that the bottom feeders are ready to take flight and usher in the recovery. As any astute follower of the economy knows a clear sign of a recovery is when capitalistic sharks begin to make serious investments in beaten down companies and industries betting that there is finally value there. This position is certainly an indication of that. Or is it?

I initially thought as much, but then I read this.

Billionaire Warren Buffett told CNBC that he wholeheartedly supports Treasury Secretary Henry Paulson's planned bailout of Wall Street by backstopping the banks holding failed mortgages.

"It's what I would do if I were there," he told the network in an interview over the weekend. That sentiment was echoed by Federal Reserve Chairman Ben Bernanke, who told Congress on Tuesday that anything short of Paulson's bailout plan would invite certain recession.

"The financial markets are in quite fragile condition, and I think absent a plan they will get worse," Bernanke said.

No, it appears that Buffett doesn't so much think that Goldman is ready for a recovery as he thinks that the bailout will usher in Goldman's recovery. In my mind, if ever there was a reason to oppose this bailout, it is watching Buffett's dual positions. At the same time he stakes a massive amount of money in Goldman Sachs, he proclaims that we need this bailout. In other words, obviously this bailout is good for Goldman Sachs. Would he have staked out such a position without a recovery being imminent? That is highly unlikely. The timing of the two events are far too close. All this really means is that he sees this bailout propping up a company that wouldn't make it on its own. How is that good in the overall scheme of things?

Clearly, financial services are nowhere near recovery on their own. What this tells me is that financial services can't make it on their own and they need this bailout for a recovery. Propping up failing industries is not a good idea. I will let Ron Paul explain why this is such a bad idea.

In this case, this manifested itself in overbuilding in real estate. When builders realize they have overbuilt and have too many houses to sell, too many apartments to rent, or too much commercial real estate to lease, they seek to recoup as much of their money as possible, even if it means lowering prices drastically.

This lowering of prices brings the economy back into balance, equalizing supply and demand. This economic adjustment means, however that there are some winners -- in this case, those who can again find affordable housing without the need for creative mortgage products, and some losers -- builders and other sectors connected to real estate that suffer setbacks.

The government doesn't like this, however, and undertakes measures to keep prices artificially inflated. This was why the Great Depression was as long and drawn out in this country as it was.I am afraid that policymakers today have not learned the lesson that prices must adjust to economic reality. The bailout of Fannie and Freddie, the purchase of AIG, and the latest multi-hundred billion dollar Treasury scheme all have one thing in common: They seek to prevent the liquidation of bad debt and worthless assets at market prices, and instead try to prop up those markets and keep those assets trading at prices far in excess of what any buyer would be willing to pay.

Additionally, the government's actions encourage moral hazard of the worst sort. Now that the precedent has been set, the likelihood of financial institutions to engage in riskier investment schemes is increased, because they now know that an investment position so overextended as to threaten the stability of the financial system will result in a government bailout and purchase of worthless, illiquid assets.

It appears everything will be just fine at Goldman Sachs. After they staked positions they couldn't maintain, the government will buy up all those bad investments. On top of it, a major Wall Street investor will stake a major position in their firm. Looks like all that mismanagement will have little consequence if this bailout occurs. As for Warren Buffett, talk about being in the right place at the right time. He buys up a beaten down company and with this bailout, there is an inherent increase in value. If ever there was a reason to oppose the bailout it was the fact that a master investor believes the bailout is an opportunity to buy one of the bailed out.


Jason Gillman said...

I would love for the government to listen to the people and say... "No, dont think we should get hooked up in this issue.."

Let the chips fall where they may. I pay my bills with my own money.

Anonymous said...

We need to follow Thomas Jefferson's advice more often. These people have put together a petition using only Jefferson's words. If it gets to 10000 signatures, it will be forwarded to the members of congress and the senate.
Jefferson's Plea.
People are opposed to the bailout, because it is a shortcut to tyranny.