Government Intervention Changes the Rules of Stock Market Investing

By: Hans_Wagner

The government is stepping in to rescue Wall Street and Main Street. This money comes with many strings attached that stem from good intentions. We will get further "help" from the government when a new administration takes over, even if we do not want it. Therefore, investors need to prepare themselves for all this help and the unintended consequences.

The rules of the game of investing will be changing. We are experiencing history when governments around the world have decided to rewrite the rules by which financial transactions take place. Trading of stock, inter-bank lending, commercial paper and the role of private sector ownership are all being rethought with greater government involvement the most likely outcome. As investors, we need to understand the rules of this new game, especially as they change. While we do not know the details of these new rules yet, investors need to be thinking ahead since they are on their way.

Unintended Consequences

Very often the good intentions of people will have unintended consequences. What seems like a good idea can create an unforeseen problem that negates the good intention. Wikipedia provides the following “. . . each cause has more than one effect , and these effects will invariably include at least one unforeseen side effect . The unintended side effect can potentially be more significant than any of the intended effects.”

Much of the current credit problem stems from the encouragement the government (Congress and several administrations) gave to the financial sector to promote homeownership among those who had not been able to afford to pay for a mortgage. Remember the rules against redlining. In addition, the Government Sponsored Enterprises (GSEs) Freddie Mac and Fannie Mae expanded their sub-prime mortgage programs with the support of Congress. To help fund the expansion of mortgage purchases, government oversight allowed the GSEs to lower their credit ratios, which increased the leverage and risk profile. This worked very well as long as the delinquency rates remained low. When they started to climb, the high leverage turned from a positive to a big negative. Freddie and Fannie imploded. No one intended this to happen. It was an unintended consequence of what many thought was a good idea – encourage homeownership among people who were unable to afford normal mortgages.

Wall Street, using their creative capacity, extended this idea to provide new forms of mortgages to many people. After all, shouldn't everyone have access the benefits of high risk, highly leveraged loans? What started out as loans for low income people turned into a loan program that was used by many to buy houses they could not really afford. Others used these loans to “flip” houses, as the price of houses climbed dramatically. The easy credit fueled the housing bubble. Now we are suffering the unintended consequences of what many though was a good idea.

US Congress

In the spring of 2008, Federal Reserve Chairman and US Treasury Secretary recommended to Congress that new regulations for financial institutions are necessary. They indicated the current regulatory agencies and laws have not kept up with the global changes in the financial industry.
Then we encounter the credit freeze and the need for up to $700 billion to rescue the financial sector. We should expect the next session of Congress to include efforts to change the current financial regulations seeking to place additional controls over the “run away” Wall Street. Just like a swing in the pendulum, there will be a tendency to over react as members of congress attempt to show they are fixing the problem.

If Congress is not careful, the new regulations might stifle innovation. Further, many investors are concerned that Congress get the right incentives in place. It will be important to get risk taking right. The financial sector is a critically important component of the economy. Credit provides the fuel to power the economy.

I agree that changes must be made in our financial regulations. The market has evolved and our capacity to regulate the industry is lagging behind. Congress needs to be careful that they do not cause new problems.

Unintended Consequences: If Congress passes legislation that overly restricts the capability of the financial market to create the necessary credit that the rest of the economy needs, it can have significant negative consequences for the economy. Restrictive credit policies raise the cost of borrowing. Higher borrowing costs increase the cost to produce products and provide services. When costs are higher, companies find it more difficult to grow, lowering profit growth and slowing job growth. With the economy trying to recover from recession, legislation that is too restrictive will hinder the recovery.

Federal Reserve

The Federal Reserve and more specifically the Federal Open Market Committee (FOMC) is responsible for monitory policy of the United States. This includes the somewhat conflicting goals of controlling inflation and encouraging economic growth.

History has shown that the Federal Reserve has had difficulty dealing with asset bubbles, when asset prices outstrip the underlying economic fundamentals. The Federal Reserve is learning how deal with asset bubbles that in the past have included commercial real estate, the dot com boom and bust, and more recently the housing and commodity bubbles. Hopefully, they will learn how to identify when such events are forming so they can take preemptive action to rein in these bubbles.

While these bubbles have helped many people make a lot of money, they have also caused significant economic dislocation to the country and many of the people who were not astute enough to get out before the collapse. In the future, the Federal Reserve and more specifically the Federal Open Market Committee (FOMC) may raise interest rates earlier and more often than they have in the past. Should the FOMC become more aggressive by raising interest rates as they try to control the next asset bubble, their action will likely encounter resistance from many people including members of Congress.

Unintended Consequence: Should the Fed move to try to control another asset bubble they will encounter more pressure to not raise rates. Some of the concerns might be legitimate if the higher rates cause the economy to slow too much, possibly triggering a premature recession. We could also see Congress try to influence monetary policy by proposing legislation to change the charter of the Fed.

There are seven members of the Federal Reserve Board of Governors. Governors are appointed by the President and confirmed by the Senate. They serve 14 year terms. As of today there are two vacancies and Randall Kroszner has completed his term, but is remaining until he is replaced. President Bush has appointed several people, but the Senate has not approved them. Most likely a new administration will be able to appoint three new members of the Board of Governors. Depending on how is chosen to fill the three vacancies, they could have an important influence on the monetary policies of the United States. A change in policy will affect investors, so it will be important to pay attention to who is appointed to these positions.

Criminal and Fraud Investigations

With every excess in the economy some business people take advantage of others to line their pockets. There are many others who try to do the right thing, but are caught in the turmoil of the asset bubble when it implodes. There will be calls from the press and Congress to prosecute those responsible for the most recent problems. We should expect the focus to concentrate on Freddie Mac, Fannie Mae, AIG, Lehman and Countrywide.

After September 11, the FBI slashed its criminal investigative work force to expand its national security role, shifting nearly one-third of all agents in criminal programs to anti-terrorism and intelligence duties. This means the FBI is lacking the right people for white-collar crime investigations.

Similar to the investigations and convictions against Worldcom, Adelphia, Enron and Arthur Anderson, we should expect another round of investigations. I would never defend anyone who broke the law. However, in the drive to punish those responsible, we can often overreact. Some feel this can result in an anti-business attitude that could chill corporate risk taking.

In 2002, Congress passed what is called the Sarbanes-Oxley act. The idea was to place more scrutiny on corporations by requiring more complete internal controls and attestation of the CEO and CFO on the accuracy of the financial statements. Part of the intent was to help investors. Sarbanes-Oxley added more internal and external review. However, companies will only disclose any information that has been vetted through the process. As a result, investors are receiving less information than before. Though I am sure this was not the intention of Congress when they passed the bill.

Unintended Consequence: Company executives may decide not to take on any business activity that is not fully approved by the government in advance. This will slow capital investment and risk taking. Companies will want to be sure they are protected from government prosecution before trying any new venture. It will be another boon for lawyers.

Should Congress press to enhance the Sarbanes-Oxley act, investors will expect to see less information, which they can use to make prudent decisions.

The Bottom Line

The US government will become more intrusive in the markets as they try to fix the housing and credit problems. At this point, we do not know what they will put into law. However, as investors we need to be aware of the law and the intent of the law. Further, there will be unintentional consequences from whatever law they pass. It will be incumbent on investors to assess the direct and unexpected outcome of any new laws and regulations that come into affect. Be sure to consider how government will change your view of companies.

Now more than ever it is important to examine the published data from companies. If you wish to learn more, I suggest reading:
Financial Statement Analysis and Security Valuation. by Stephan Penman.  Focuses on the output of financial statements to understand how to use them to value companies.  While expensive, this text book is an excellent reference for any investor and will pay for itself very quickly.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2008 Hans Wagner

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