LIVING OFF DIVIDENDS & PASSIVE INCOME

In the last post I speculated that the bailouts would end up costing the taxpayers upto $1 Trillion. It looks like that has become reality. Here’s an email I recieved from Asif Suria, of SINLetter:

In an unprecedented move, the current administration unveiled a simple three page plan on Saturday that will provide the treasury with $700 billion to buy toxic assets off the balance sheets of financial institutions. Combining this bailout plan with the $85 billion loan to AIG and the $200 billion to rescue Fannie and Freddie, we the taxpayers are eventually likely to incur a bill of $1,000,000,000,000. In case you did not have the time to count all those zeros and calculate what you might be liable for, that is $1 trillion and works out to a little over $3,250 for every man, woman and child living in the United States.

We have come a long way in this crisis that has devoured most of the independent mortgage lenders and left just 3 out of the 6 investment banks that started this year. Almost every weekend there is news of yet another small bank going under and real estate shows no signs of turning around. Nearly 47% of all homes sold in the state  of California last month were foreclosures and the median home price in the San Francisco bay area fell from $655,000 in August 2007 to $447,000 last month.

Following in the footsteps of our neighbors across the pond, the SEC temporarily banned short selling in the stocks of 799 financial institutions in an orchestrated effort to shore up markets. While I felt that the SEC’s move to ban naked short selling was a good move, I think a ban on short selling of any kind makes no sense. Essentially we can only buy stocks to go long or sell our existing positions but cannot hedge our portfolios by selling stocks that may be overvalued?

Short selling is an activity that even noted British economist John Maynard Keynes indulged in as far back as 1919 and is not the evil activity it is being painted out to be in the media. Try telling fund managed Ken Heebner who graced the cover of Fortune magazine just a few months ago that he has to change the structure of his 130/30 fund (130% of assets are invested in long positions and 30% are invested in short positions) because he can no longer sell short even if he identifies overvalued or mismanaged companies in the financial sector.

In its press release regarding the short selling ban the SEC admits, “Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets.”. Clearly this action is targeted towards institutions that were aggressively short selling financial stocks and unless extended, it should end on Oct 2, 2008. Thankfully naked put options and the ultrashort ETFs, our instruments of choice to hedge the SINLetter model portfolio, were not included in the ban.

We are already beginning to see the dollar weaken against other currencies and the best way to play this (besides shorting the dollar) could be to take long positions in other currencies through ETFs like Currency Shares Australian Dollar Trust  (FXA), Currency Shares British Pound Sterling Trust  (FXB), Currency Shares Canadian Dollar Trust  (FXC) or Currency Shares Swiss Franc Trust (FXF). If picking a specific currency is too daunting a task (it is for me), then the “carry trade” ETF PowerShares DB G10 Currency Harvest Fund (DBV) could provide a useful alternative. The simple premise of this ETF is that higher yielding currencies tend to outperform lower yielding ones and hence this ETF goes long the highest yielding currencies while simultaneously shorting the lowest yielding currencies. You can learn more about the carry trade and DBV from this BusinessWeek article titled Trade Currencies Like A Hedge Fund.

Bond prices have also dropped in anticipation of the U.S government issuing more debt to finance this bailout. Most homeowners tend to either move or refinance their homes within a 10 year period. Hence 30 year mortgages are closely correlated to the 10 year Treasury note and have already jumped last week in response to this bailout plan. Not only are financial institutions being given a “get out of jail free” card but responsible first time home buyers who waited out the real estate bubble are going to pay the price immediately through increased financing costs.

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