The Big Bailout: Measuring the Aftershocks

(page 2 of 2)

A major uncertainty is what impact it will have on the creditworthiness of the U.S. government itself and whether or not that is reflected in the value of the dollar, he says. That's hard to gauge since the number of other countries with possibly more complicated problems may leave foreign investors no better alternative for where to stow their money, he adds.

An Iffy Supply Increase

With the national deficit expected to double next year to $800 billion as a result of the bailouts, a hike in inflation is very likely, say investment strategists. The extent to which the money supply expands will depend on how much money the Fed decides to create, vs. swaps and transfers says Herrmann. If the Fed decides to sell more Treasury bonds to help finance the programs, and the public gives cash to the Fed in exchange, does that really increase the money supply? he wonders. And how might the bond market react to a big expansion in Treasury debt? Treasury yields plunged this week in reaction to an enormous flight to quality into government bonds.

"The Fed can attempt to sterilize some of this by selling Treasuries and taking some money out of the system, but I'm not sure they have the latitude to do that," says Joy at RiverSource. The central bank's balance sheet has gone from 80% Treasuries to 50% since the crisis began, he says.

Herrmann also allows for the possibility of deflation as a result if the government moves lead to more risk-averse behavior from the banks and credit remains hard to come by. That would translate to less economic expansion and probably reduced concerns about inflation, he says.

The SEC's sudden ban on short-selling on 799 financial stocks—perhaps the most controversial move—has already had an unintended disruptive impact on the options market, where market makers rely on being able to short underlying stocks in order to hedge their risk.

Another Crisis?

By implementing the new rule on options expiration Friday, the busiest day of the month for the options market, without consulting the exchanges or firms that make a market in options, the SEC caused liquidity to freeze up and the bid-ask spread on options to widen on Sept. 19, says Joe Kusick, senior market analyst at OptionsXpress (OXPS) in Chicago.

"Depending on what the SEC does right now, we have an extreme problem on our hands come Monday [the day the ban takes effect]. The exemption has not been made for market makers," he says. "This is adding another potential crisis. The options exchanges with the short-stop rule cannot provide the liquidity necessary to stay open."

He says the SEC needs to make a definitive statement about the impact that the rule, which lasts until Oct. 2 but could be extended for up to 30 days, will have not only on retail customers but on the exchanges and how they provide that liquidity.

As for whether the government's new rule book has overturned long-standing assumptions of how free markets are supposed to operate, Alec Young, equity strategist at Standard & Poor's Equity Research, thinks it's too soon to tell. "It's dangerous to make heavy-duty judgments when you're still sort of in the eye of the storm," he says. "This has been a fairly run-of-the-mill bear market if you see the percent decline. It will reinforce the fact that equities tend to outperform other assets like Treasuries over time because you take on more risk."

He doubts that many investors will turn away from stocks in the long run because of the extra volatility. Most people, he believes, own stocks for retirement purposes in tax-deferred accounts and don't rely on them for short-term gains.

Joseph Biondo Sr., senior portfolio manager at Biondo Investment Advisors in Milford, Pa., says he's not worried about a challenge to the free market philosophy but warns that the regulation likely to be imposed could become too confining.

Ironically, the comprehensive bailout plan could turn out to be the ultimate moral hazard, encouraging more reckless risk-taking behavior in the future. There's certainly potential that by providing a backstop for money market funds, the government might exacerbate the temptation of overly reckless behavior, unless it puts regulations in place to prevent inappropriate practices, says Herrmann. Those regulations would add an extra layer of expense on those running the money funds, however, he adds.

Bogoslaw is a reporter for BusinessWeek's Investing channel.