Should We Bail Out Main Street or Wall Street?

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The short answer to the headline's question is neither -- in theory. In practice, the U.S. government is now attempting to do both. There may be a rationale for that (to a limited extent), but there are significant problems with the way they're going about things.

The new, new plan
The Obama administration announced a plan to stem home foreclosures, with $75 billion in subsidies to help lenders reduce mortgage payments for 3 to 4 million borrowers. In addition, the plan calls for 4 to 5 million borrowers to refinance their mortgages through government mortgage giants Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) . $200 billion in supplemental capital has been allocated to the two firms, doubling the government's commitment.

These measures characterize a "bottom-up" approach to the current crisis, targeting falling home prices and rising foreclosures directly. The bulk of the government's efforts (under both the Bush and Obama administrations) to date has been directed toward the blighted financial sector, with a very mixed record.

Dealing with "Wall Street"
The only private organizations that should be bailed out are terminal institutions that pose a genuine systemic risk. Fannie and Freddie fit the profile, and AIG (NYSE: AIG  ) probably did, too. The criterion of systemic risk alone sets a high bar, as there are only approximately 20 banks in the U.S. with total assets in excess of $100 billion, including Wells Fargo (NYSE: WFC  ) , US Bancorp (NYSE: USB  ) , Goldman Sachs (NYSE: GS  ) , and Morgan Stanley (NYSE: MS  ) .

Those organizations that are not both terminal and posing systemic risk should be allowed, nay encouraged, to fail. (Note that I do not, however, consider coercing healthy financial institutions into accepting a government investment either a bailout or a good use of taxpayer funds.)

The trouble with "Main Street"
Dealing with home foreclosures looks rather more tricky. My instincts suggest that one shouldn't interfere with home foreclosures in order for the housing market to find its proper level. The trouble is the scale of the problem – the resulting massive wave of foreclosures could cause housing prices to understate fair value when they bottom. This could hurt the values of loans and mortgage securities and leave some banks technically insolvent when they are, in fact, viable. Cue a slump in confidence regarding banks, reduced lending, and…  well, you know the drill.

Do the pieces fit?
Of course, temporary aberrations in the price of those securities would be like water off a duck's balance sheet for an institution with a long-term perspective and deep pockets -- which brings us back to another one of the government's initiatives: a "bad bank" plan that would have the government take soured assets off bank balance sheets. Perhaps there is some coherence to the government's approach, after all, although as I pointed out last week, that "bad bank" has some holes in it, too.

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. US Bancorp is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 20, 2009, at 8:54 AM, WilsonIndiana wrote:

    If we really want to stimulate the economy, we will repeal SarBox. Or at least article 404.

    Until the government does that, all its stimulus is smoke & mirrors ... for something else.

  • Report this Comment On February 20, 2009, at 9:41 AM, catoismymotor wrote:

    If I must choose between the two I would say Main Street. That is where the backbone of our economy lives, the small business. The owners of those small businesses would take the money to buy new equipment, expand their operations, hire more people. This would immediately inject the economy with money. As we have seen giving money to the banks has done little to nothing to help. They have held onto the cash. Money is like water, it needs to stay fluid in order to stimulate growth.

    I like the idea of giving “we the people” the stimulus money instead by waiving income taxes for a set number of years. Imagine what you could do with the extra 15 – 35 %! Pay off those credit cards faster, thus giving capitol to Visa, Amex, Master Card, BoA . I am sure they would like the infusion of cash. Maybe catch up on your mortgage? Maybe stick away dough for a rainy year fund? I am sure that you would agree that for most people the year has been filled with monsoons. Maybe increase your IRA? If now is the time to buy having more money to buy with would be good. Maybe pay cash for that new car? We all know the best car is one that is paid for. I like this idea a lot better than trusting the oblivious Republicans and the socialist Democrats in D.C. with making any kind of competent decision.

    At the end of the day it is you that is going to have to bail out yourself. Fool on!

  • Report this Comment On February 20, 2009, at 10:29 AM, anzalone2 wrote:

    Oh how I so agree with catoismymotor!

    Didn't T Boon Picket do the math for the "what if" the $700 Billion went directly to the people scenario?

    I do understand the impact and importance of keeping large businesses afloat - but let us remember who actually keeps them solvent and profitable? The small businesses of America and the consumers who buy from both small and large companies.

    The wealthy will not stay wealthy without us for very long. The big $$ investors will no longer have the big $$ to invest without the "little people".

    So often I hear and read comments from the "big money" about how the minuscule spending dollars of low and often middle income people are not going to save or improve the economy. I totally disagree and I think that if you asked McDonalds (and countless others) if a $1.00 sale has an impact on the bottom line they would disagree as well.

  • Report this Comment On February 20, 2009, at 8:10 PM, 7footmoose wrote:

    Can anyone explain to me how something in excess of 20% of ALL (not just mortgage) assets held by financial institutions have within the past two years become virtually worthless? I ask this question because that is what appears to have happened in order to wipe out the entire tangible equity that once appeared to exist within these institutions. If I actually thought anyone was smart and stealth enough to do so I might think that there was some type of conspiracy afoot.

  • Report this Comment On February 23, 2009, at 7:57 AM, DarkravenArc wrote:

    The thing that I honestly don't understand is why people don't want to invest in many different stocks at the moment that have high yields in dividends. Motley, one thing that I do not like about the way you state things is the fact that you do, as I agree with many other writers, is instill fear into people, and pressure them into wanting to sell off stocks. One thing that I can definitely vouch for is the US Bank (USB) Also known as US Bancorp. Their stock has been fluctuating for a while, and has tripled, quadrupled, and fallen, and throughout the entire time, my family has kept their money invested in US Bank stock, without fear. The money from the Dividends keeps flowing, with US Bank happily paying those dividends because of the fact that we keep our money with them. This is the time for any rookie investor to get their extra money lying in the couch to invest in stocks such as US Bank that have high yields in their dividends. (US Bank paying roughly 16%), it can't be any better than that, especially since we all know that dividends can stand as fixed income, extra cash.

    Don't let all of the commotion of all of the gurus hold you down, while others make killings off of dividends. An example would be in Germany, back in WWII times, you had to bring a wheelbarrow full of cash to purchase a loaf of bread for your families dinner. Times were rough, and after the fall of the Third Reich, the United States stepped in, rebuilt, and overall stimulated their economy and got it back to working shape. Sometimes you have to fall flat on your face to get the extra momentum to get back up, same with the economy. There are going to be slumps, but there are going to be times when you get to hold your head up high and ultimately gain from the success of large companies. Why not jump on the bandwagon and put some cash in your pocket just by investing in companies?

    The thing is, stocks will plummet, but they will also rise in time, so the time is now to invest in dividend yielding stocks, yes I have repeated myself three times on that notion, because of the fact is that you cannot stress enough that it will be a wise investment, that may yield a higher return than it would from a regular CD that will pay 7% or less. So if you have extra money that you can spend on stocks, definitely invest in those stocks with high dividends.

  • Report this Comment On February 24, 2009, at 3:33 AM, steven107 wrote:

    If a company is too big to fail, and we bail them out; we are telling other companies that they should become too big to fail in order to take advantage of similar safety net. We will need to find a way to do something about that. I suggest, if a company is too big to fail, and it accepts or we give it a bailout; that we break it into multiple pieces immediately in exchange for the cash; to resolve the size problem. Perhaps also, one of the pieces will be better managed than the other, and will not need to come back for more. At least it resolves the grow bigger for its own sake benefit. I just read that AIG has burnt through 60+B. :( Where is this money coming from, my pocket is empty.

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