Profiting From Bailout Nation

It’s bailout season and every overleveraged business that failed to plan for a downturn is lining up for a share of the $700 billion pie.

General Electric (NYSE:GE) is about to come a bank with access to the Fed’s free money. American Express (NYSE:AXP) anticipates such rough times ahead, it plans to become a bank with access to the Federal Reserve’s deep pockets as well.

Over the weekend, Bloomberg reported Home Depot (NYSE:HD), Dow Chemical (NYSE:DOW), and Textron (NYSE:TXT) asked for the Fed to fund their ongoing operations by buying their second-tier commercial paper.

Even city governments are throwing their hats into the ring. Falling real estate prices (and falling lower if REIT values are any indication), which reduces local tax revenues Philadelphia and Atlanta asked for multi-billion dollar bailouts as well.

It seems like everyone wants a handout. But there aren’t enough pieces of the $700 billion pie to go around. Regardless of how you feel about the bailouts, I urge you to look at the profit-making opportunities created by them.

Every decision the government makes will have consequences. When a government takes taxpayer money from one person and gives it to another, there will be winners and losers. I’m not saying I like it, but there are ways to take personal advantage of Bailout Mania.

The Auto Bailout

The automakers are pulling out all stops to get $25 billion in cash from the government. All signs point to a bailout here merely delaying the inevitable failure of one of the Big Three.

$25 billion, even if directed to fund new electric cars won’t fix the real problem. That’s because the real problem is too much capacity…way too much capacity. The supply/demand fundamentals are upside down and it cannot last.

The supply side of the equation is absolutely horrendous. At the end of October, GM North America had 799,000 vehicles in stock. That’s a big, but manageable, amount of unsold cars. It’s about five months worth of sales (when measured against the 166,000 sold in October).

But the inventory is only getting bigger. GM expects to produce an additional 567,000 over the next two months. If October sales rate holds up (pretty optimistic considering rising unemployment, falling housing values, further declines in retail spending, etc.) GM will have 1,234,000 unsold vehicles by the end of the year.

The demand side is just as bad. Just look at the fundamentals. In the last Department of Transportation report on vehicle ownership in the United States, there were a total of 250 million cars, trucks and motorcycles registered in the United States. But there are only 203 million drivers. That’s an average of 1.23 vehicles for every driver.

No wonder sales are way down. Everyone who wants a car has (at least) one. And when money gets tight; buying a new car is last thing on most people’s shopping list.

One way or another, some of the capacity must be eliminated. If the government sees that it’s in the “rational” interest of society for the Big Three to continue to pay its workers $73 an hour and taking an $800 loss on each car, so be it. We’ll just take advantage of it.

There are two ways to take advantage of this. First, you can short Toyota (NYSE:TM). It’s going to be paying the big price for this bailout. The maker of high quality cars that consumers actually want just won’t be able to compete. After it pays for all raw materials and $48 an hour for its workers, Toyota makes about $700 in profits for every car it sells.

The other way to take advantage is to get ready to buy Toyota shares in a few months. Tough times are coming for a company that is forced to make a profit while its competitors aren’t.

Not only will Toyota not get the advantages of getting bailed out, it’ll actually be hurt by it. And the bigger the bailout for inept Big Three is, the bigger the problems for their competitors.

Commercial Paper Guarantees: A Gateway Drug

Big Three’s bailouts may be dominating the headlines, but the line for government handouts is growing more diverse by the week. Companies funding their short-term cash requirements with borrowed money (commercial paper) are starting to get pinched by tight credit.

Short-term loans have been extended to businesses for years. If a company got in trouble and needed a few dollars to keep the lights on and a lender considered it a worthy risk, the company would get the money. That’s how the commercial paper market came into being.

Commercial paper allowed businesses to access capital for extremely low interest rates. After all, commercial paper obligations are short-term and the interest rates are usually very low.

Here’s the problem though. Once companies discovered this very cheap funding source, they began to abuse it. They took short-term loans and used them to build long-term assets. In the case of General Electric, it borrowed money in the short-term and lend it out over the long-term. Since short-term rates were low and long-term rates were high, they would profit from the difference. That is, as long as they could recycle the short-term loans every few months.

It was a great business. GE was borrowing money for 2% and lending it out to finance car and home loans from anywhere between 6% and 12%. GE’s finance division eventually accounted for more than 1/3 of the company’s profits. GE Finance was hailed as an innovator.

When the credit markets seized up and GE couldn’t get short-term financing to keep this business going, it all came crashing down…until the Fed stepped in.

Now, the Fed is making these short-term loans to companies by buying their commercial paper. But the U.S. central bank stipulated it would only buy the highest rated commercial paper to “reduce risks to the taxpayer.”

Who has the highest rated debt? The strongest companies do. The strong companies, which generate plenty of cash and have the most stable balance sheets, have access to artificially cheap loans.

Senator Bob Croker of Tennessee said it perfectly, “Manufacturers that have A-2 paper are getting nailed. All of a sudden, they’re at a 500 basis-point disadvantage and basically getting ready to lay people off.”

The end result, the strong companies which get shoveled cheap money will be able to lower costs while weaker companies (although still competitive in a free market) will be penalized.

If the Fed refuses to buy any commercial paper lower than the highest grade (A-1), a line in the sand will be drawn between the leaders and laggards. Over the next few months, we’ll start to see the impact of higher interest expenses in a few industries which rely on commercial paper to fund operations.

The chemicals industry provides the perfect example. Dow Chemical (NYSE:DOW) is having a tough time finding buyers for its commercial paper. Meanwhile, the Fed is buying DuPont’s (NYSE:DD) commercial paper rated at P-1 at below market rates.

For active traders, the opportunity for a long/short trade is being created by the Fed’s refusal to support second-tier companies. The old strategy of buying shares of industry leaders and shorting shares of smaller competition will have even greater success. As long as the Fed is helping out the biggest and safest borrowers and sending the rest to a lending market which doesn’t want to take on any risk, there will be a big difference in costs and profitability.

A Final Word on Bailouts

Now, don’t get me wrong, I’m all for people having the opportunity to work, buy what they want, and live however they choose. I don’t, however, agree it should come at the cost of everyone else.

There is a much simpler solution when it comes to bailouts. If $25 billion in tax breaks were given to the automakers (same net cost to the taxpayer) they all would have the opportunity to benefit. There would be no discrimination of who gets what amount of cash. If you are profitable, you’ll get a break.

A tax break would also change the investment economics for profitable automakers. It might even make it economically viable for a successful automaker to take over some assets of an automaker in bankruptcy.

Tax breaks for every industry would guarantee the government assistance went to the most efficient, successful, and profitable firms. It’s not some trickle-down theory, just a way to ensure bailouts are given to the most efficient companies that can best take advantage of some extra cash flow.

In the end, I’m a firm believer in taking what the markets give you, even if that requires a more conservative investment strategy. Right now, the market is giving us the chance to buy great companies at possibly even cheaper prices (i.e. Toyota) and accelerating the process of making the strong stronger and the weak weaker.

By Andrew Mickey

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