Changing the Rules of the Game, During the Game

Let's say you're playing a game of chess with a friend. You've positioned your pieces in such a way that you would have checkmate against your opponent in 3 moves. Then your mom comes by and looks at the board. She realizes your friend is about to lose, so she takes some of his captured pawns and puts them all over the board.

Looking Forward...
1) How are you supposed to employ a chess strategy when there is a chance that an authoritarian will unexpectedly change the rules in the middle of the game? 2) If you're the losing opponent, why should you put the same amount of effort into the chess game when an authoritarian will likely protect you from losing?

1) Regulatory Risk
Gov't Rescue: When considering investment opportunities, you'll probably avoid companies on the verge of bankruptcy. In fact, you might want to short (or bet against) those companies.

But companies haven't been allowed to go bankrupt lately. Bear Stearns, Fannie Mae, Freddie Mac, and AIG are examples of companies that would've gone bankrupt, if it weren't for government intervention.

Currently, the auto industry lobby is pressuring legislators for a bailout. They argue that bankruptcy would be extremely bad. In truth, it would be bad. But how can we position our portfolio of investments--even non-auto investments--if we're not sure whether or not the auto industry would be protected? We have no idea what, if any, the ripple effects would look like.

Gov't Rules: Back in September, the SEC enacted a temporary ban on short selling on around 800 companies. Not only did this create significant inefficiencies in the market, but many investors flat out got screwed. Many used short positions to protect themselves from declining investments. This was taken away.

Perhaps this explains why many hedge funds sold their stocks and are now hoarding cash. Hedge fund managers are extremely smart. They understand the rules of the game, and they exploit those rules. Now, those rules have changed, and may continue to change. Garry Kasparov and Bobby Fischer probably wouldn't play chess if they thought those rules might change.

Yesterday, Treasury Secretary Hank Paulson said the Treasury would no longer use bailout money as initially intended. In other words, they said they would do one thing, but now they're doing something else. Who would want to invest in this erratic regulatory environment?

When the markets are stable...

Regulatory risk isn't a major concern because you won't see dramatic rule changes. You don't have to worry about investment rules. You only had to worry about the businesses in which you were investing. Isn't that what investing is all about? Right now, I think we need a stable regulatory environment so that people sitting on cash will feel safe putting money back into the stock market.

2) Moral Hazard
This is the risk that behavior will change if one thinks he/she will be rescued by the government. Maybe this explains why Lehman Brothers went bankrupt. Bear Stearns, Fannie Mae, Freddie Mac, and AIG were deemed to important to fail. Most would agree Lehman was just as important. (In hindsight it was; Lehman's bankruptcy exacerbated the Sept/Oct credit freeze) I was shocked when they were allowed to go bellyup. I'm sure Lehman's management strategically positioned themselves for some sort of rescue, which never came.

Everybody is Expecting a Bailout
...because everybody thinks they're too big to fail. There's no question that a failure at GM, Ford, or Chrysler would be devasting. But should they be bailed out?

Short Term Politics vs. Long Term Prosperity
Here's what it comes down to. If an automaker fails, the U.S. would lose at least several hundreds of thousands of jobs. It would almost certainly push us into a deeper recession. This is very bad...in the near term. Also, politicians can't win votes if they allow this to happen.

But bad businesses must be allowed to fail. This is how capitalism works. Auto makers took risks by focusing on gas guzzling SUVs and pick up trucks. Now they're hurting. If you rescue a bad business, then it let's people believe it's okay to run a business poorly. This is an extremely bad precedent.

At the very least, the government should not intervene. You should not force honest, hardworking taxpayers to bail out failed businesses. If leaders in the private sector believe auto makers are too big to fail, they'll figure something out.