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The Financial Bailout: A Case Study for Trading

The government's $700 billion bailout provides traders with some compelling lessons underscoring the importance of education in protecting assets and creating wealth. Not since the period leading to the stock market crash of 1929, has the stock market seen an equivalent loss of investor confidence, market volatility, and a division within the ranks of investors and regulators about the appropriate method to return stability to the markets. The educated trader will not only understand the state of the market, the reasons for the crisis, but more importantly trading strategies that will allow them to take advantage of market volatility and make profitable decisions now.

The Credit Crisis

The market trouble signaled by failures in the mortgage and banking sectors and investment banks beginning with Bear Stearns in March, and more recent trouble for Fannie Mae, Freddie Mac, Lehman Brothers and AIG is being dubbed the credit crisis. The crisis ensues because these finance institutions issued, securitized, or insured high risk loans that began defaulting in increasing amounts. Loan defaults followed while other assets were marked down in value. This further increases reserve requirements straining capital ratios and reducing liquidity, all inhibiting the ability of financial institutions to issue new loans or other credit facilities. This problem was also fueled by the insolvency of "shadow banks". These, finance companies, hedge funds, and some government enterprises encouraged the credit boom and did so without the regulation and constraints placed on commercial banks.

The current fear is of "deleveraging" as finance institutions in an attempt to stem balance sheet damage inflicted by mortgage related securities, sell assets further reducing prices and worsening the balance sheet of other investors. These other investors do the same, sending asset values in a downward spiral. Present fears circle around mortgages and foreclosures. Investors are also concerned about the finance effects on credit cards, car loans, corporate debt and their cumulative impact on the economy and global financial markets.

The Bailout

The "bailout" refers to present government intervention in saving insolvent or failing financial institutions. The theory behind the bailout, now expected to cost taxpayers $700 billion, is that by buying equity in some companies and buying the distressed assets of others, credit will again become available funding new investment, job creation and market stability. The bailout proposal, in addition to loans already provided to Bear Stearns and AIG, is estimated at 6% of GDP almost double the cost of the S&L bailout of the late 1980's. Supporters of the plan suggest that bolstering the system will increase the value of these purchased assets providing a positive investment return and ensuring repayment. Both legislators and investors are divided on whether government intervention should reward risk taking on the backs of the American taxpayer. However, most assume that the alternative, financial collapse and a deep world recession would cost Americans much more in the long run.

The news has been filled with explanations of the bailout, also known as the Troubled Asset Relief Program (TARP) and its rocky road toward government approval. Government and the central banks have been intervening in the crisis as far back as August 2007. Intervention commenced when Bear Stearns was promised loans after two of its hedge funds exposed the portfolio damage done by subprime mortgages. The public became more aware of government intentions on September 7th when they nationalized Fannie Mae and Freddie Mac. These support activities were criticized as subjective and inconsistent when the Federal Reserve Bank decided to save AIG but allowed Lehman Brothers to fail. By the 15th the failure of Lehman and near failure of AIG caused financials to plummet, borrowing costs to soar, and companies began hoarding cash or investing it in Treasury bills at such a rate that it nearly eliminated their yields.

Averting a total breakdown in the money markets and restoring investor confidence was at the center of the proposed plan and the bailout of AIG. Unlike Fannie and Freddie that have always had implied Federal support, or the investment banks that have been sold or can attract new funding as bank holding companies, AIG posed a unique problem. AIG is an insurer not a bank, and by insuring the positions of highest risk and the lowest probability of failure, it became a leader in the global financial system. Not constrained by the regulation and capital requirements of banks, it used derivatives, such as credit default swaps (CDSS), to insure hundreds of billions of corporate loans, mortgages, money market funds, and other debt. The subprime meltdown and its effects on AIG assets and liquidity were enough to fell the giant. A predominant amount of this insurance was provided to American and European banks. A failure of AIG and the unwinding of CDSS contracts would have resulted in additional bank write downs, more strain on capital ratios, and a worse deleveraging problem.

Although AIG is over leveraged, short term support means it can be deleveraged over time and lessen the immediate impact on the financial system. More importantly a failure of AIG and other financial institutions would have obliterated investor confidence. Add that to public concern over the overall economy, increases in oil and food prices, and the political ramifications of an election year and you have the recipe for market meltdown.

The Result

The crisis and the bailout have revealed the chaos that ensues when corporate insiders, market makers and government regulators are divided about the appropriate methods to solving market instability. Legislative successes and failures have contributed to large swings in major stock indices suggesting further "whip saw" events in short term stock prices.

When experienced institutional investors are bewildered about future investment prospects, where does that leave the retail "buy and hold" investor? They are placed in a quandary having to choose between liquidation and "safe havens" or putting their head in the sand and riding out the storm. But safe havens give little comfort at current price levels with gold being at historic highs with no other place to go but down after markets stabalize. The other alternative is equally unattractive as most buy and hold and retirement investors do not have the stomach to watch their wealth ebb and flow until stability finally sets in. The continuous news about the proposed bailout and the impact of potential future defaults are omnipresent and almost impossible to ignore. How many committed investors missed the VIX Index, a popular measure of the implied volatility of S&P 500 index options, also known as the "fear index" having almost doubled in September? Unfortunately for some, the short term trend has been liquidation as investor confidence wanes and financial advisors not knowing what to do convince some clients to store their capital under the mattress. Add the institutions hording cash and you get the modern equivalent of the pre 1929 crash bank run.

All these events have experts questioning the hypothesis that markets are efficient. The theory suggests that all public available information is reflected in stock prices. Also being questioned is its relevance when current financial news has the most effect on price movement and when rumor and innuendo produce market swings as large as the truth. Regardless of the potential success of the bailout and a return to normalcy, investors are conditioned by experience to expect down markets to go up and the best bull markets to turn. Ibbotson conducted a famous study that is considered the cornerstone of the buy and hold strategy. It concluded that, assuming you had the capital and you invested after the '29 crash, or held steadfast during the crash in 1987, the subsequent market yields would have more than compensated for the losses incurred by the downside. Basically it inspires the buy and hold investor by saying that if it goes down the market will rebound. Although it may bolster the long investor, there isn't a better rationalization for trading market volatility.

The Lesson

Anyone that is willing to risk capital in the stock market should be aware of the trading options available to them and methods to mitigate risks. In order to invest effectively it is imperative to understand both Fundamental Analysis (a method of forecasting stock prices by analyzing a company's financial statements, business prospects, management and markets) and Technical Analysis (the art of forecasting the future direction of stock prices by studying past market data). But even experienced investors can be thwarted when there is so much relevant news concerning the market. This is because market news trumps fundamental and technical analysis in explaining large movements in stock prices.

Learning multiple trading strategies is not only for protecting existing assets from unexpected events, but also for taking advantage of all the trading opportunities available. The key to becoming a successful trader is education and planning. These are some considerations when forming a trading plan:

• Set Goals - before creating any investment plan you must know what it is that you want to achieve by putting your capital at risk. These goals will have a big impact on the strategies you ultimately decide to use.

• Plan your trades and trade your plans - Decide what strategies fall within your risk/return tolerance and will achieve your money goals. Paper trade these strategies until you become an expert. Determine what time frames (short, intermediate, or long term) that you are comfortable investing in. Once your plans are set and you are comfortable with your abilities, trade them.

• Think outside the box - Don't limit yourself to only one trading strategy. If you do, think about the possible risks to your positions and how you will counteract negative situations or take advantage of new opportunities.

• Learn the Rules - Learn the rules that successful traders have designed for your particular strategy and stick with them. Know when and how to exit positions. After a period of success, make rules specific to your style that you have determined lead to profits. Doing so will greatly increase the probability of success.

• Manage and Diversify - Manage the number of your strategies or the amount that you trade in manageable chunks. Diversify among manageable strategies. This will insulate your overall position against unforeseen risks or keep you from getting spread too thin that you make mistakes.

• Practice - When learning new trading strategies practice what you learn. Practice your exit strategies and what the appropriate moves would be under various scenarios. There are various software products available that will allow you to practice and apply the lessons you learn so that eventually they can be executed immediately and appropriately.

In the last few months many investors wished they had received better training in what to do about the current market situation. Many have lost capital because they were indecisive about what to do with their investments. The key to avoiding this trap is education and knowing in advance your specific plan in dealing with uncertainty. Learn from those that have been there before and from their mistakes. Ask anyone who has been there; experimenting with your capital at risk, or even worse doing nothing at all, can be very, very, expensive.

- by BetterTrades Financial Analysts

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