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Who bails out Uncle Sam?

By Vitaliy N. Katsenelson, Forbes
September 25, 2008 14:14 IST
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"Don't worry they'll bail them out."

Those words are jumping off my tongue a couple times a day now when my clients call and ask if I think their auto insurance policy with AIG or their money market fund will be around tomorrow. My only concern is that at some point the government will not be able to afford to bail companies out or will have to start printing presses to keep affording it.

In the past, we did not really have to worry about the financial strength of the U.S. government. Today, that financial strength has been tested. I doubt it will happen but I would not be surprised if Microsoft's new AAA-rated bonds will have a lower yield than US Treasuries.

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Give me a just one-armed economist, demanded President Harry Truman. I feel his pain. This is how I feel when I talk about theĀ US dollar. Only last week, I thought the odds were that the US dollar would appreciate against other currencies. Today, after the bailout announcement, the prospects are a lot less clear. The US government possibly starting a gigantic printing press is not good for the greenback, but currency strength and weakness are driven by relative economic performance--not absolute performance.

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This where "the other hand" comes in. Maybe foreign governments' printing presses will be even bigger than ours? We don't know. So prepare for both.

On the bright side, the bailout may or may not end up being a bailout. If the government were to buy loans for 30 cents on the dollar that are worth at least 30 cents, then the government is providing liquidity--the cost to taxpayers is zero. Not necessarily a bailout. But there is a reason why there is a liquidity problem.

The market is not really sure what those 30-cents-on-the-dollar loans are really worth. Derivative securities that derive value from other derivative securities--so-called "derivatives squared"--are very hard to value.

Unfortunately, the government is not better equipped to value those loans than the market, though it does have a longer time horizon to discover what they are worth. In other words, Mr. Taxpayer is buying a cat in the bag and hoping it's not a rat when we open the bag a year or two from now.

Of course, there is also an issue of moral hazard that Mr. Paulson created when he insured money market funds. Usually the difference in performance between the best and the worst market fund is 10-15 basis points.

So if you ran a money market fund why wouldn't you be loading on the riskiest highest-yielding paper you could get your hands on? You'd just make sure it matures in less than a year (this is when the government put runs out). There is only upside and no downside. If the risky bet pays off, the fund manager will make a load of money for holders and get a nice juicy bonus. If the bet goes wrong, well, you still made a decent amount of money, fund holders will not lose money and Mr. Taxpayer will bail the fund out.

Now I only wish Paulson offered stock investors the same opportunity; we'd be buying warrants on penny stocks.

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Vitaliy N. Katsenelson, Forbes
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