Fed Bailout Probable – Buy Calls On Strong Stocks Heading Into The Weekend!

September 24, 2008
Author: Peter Stolcers, Founder of OneOption

The Fed Chairman is usually very balanced in his statements and the market tries to read between the lines every time the FOMC statement is released. In the last few days, he has not minced words. He has let Congress know that we were on the verge of a financial collapse last week. Legislators are well aware that the circumstances are dire. They do not want to write a blank check and they do not want to grant Treasury Secretary Paulson unbridled power. As is typical of these congressional hearings, some are using this opportunity to get on their political soapbox. In the end, I believe a bailout plan will be passed. The longer this process takes, the more impatient the market will grow. We will see a continual decline in stock prices and that will pressure legislators. Overnight, Goldman Sachs secured $5 billion in capital from Warren Buffett. They are the best Investment Banker on the street and as a result, they have access to capital. Other financial institutions are not as fortunate. During his interview, Warren Buffett said that he would not have made the investment if he did not believe that a bailout plan was imminent. Goldman Sachs paid a hefty premium to attract this capital. If the government under-bids for ill-liquid assets (and it should) it will be the last resort for financial institutions that need cash. Consequently, banks may wait until the final hour before they come under the "TARP". If this happens, shareholder equity will already be in jeopardy. The Fed's priority is to stop a run on the banks. When needed, they should assume the obligations of the company and wipe out shareholder equity. This will stop the systemic risk from spreading. They are taking risk in doing so and we should all benefit if there are rewards. This is no different then JP Morgan's involvement in the Bear Stearns bailout (except that the Fed backstopped that deal). If taxpayers have to bear risk, they should be rewarded. Chairman Bernanke seems reluctant to go this way because he feels that financial institutions will not embrace the terms. I disagree. Many firms are already teetering on disaster and new capital is not coming into the market. CEOs know that there aren't any alternatives. They can try to salvage some shareholder equity or they can risk it all, putting our entire financial system in peril. When Goldman Sachs secured capital, they diluted shareholder equity, this is no different. Legislators are angry and they have little pity for financial corporations. Equity will be the sticky point for getting the deal done. Stay short until Friday and use stops. If a deal gets done, the market will gap higher. Traders will speculate that a plan will get signed over the weekend and I would close short positions Thursday and Friday. I am playing this by scaling into stocks that have held support well and looked poised to rally. If the plan does not get passed, the market will tank. Being in the right stocks will help mitigate the damage if this unfolds. If the bailout is finalized, these stocks will jump. image

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