As the country (world) remains mired in an economic morass, there are as many opinions as to how to extricate ourselves as there are beggars at the collective government trough.  That said, the two most oft-mentioned problems dragging down the economy are the decline in real estate values (both residential and commercial) and the rotting of so-called “toxic” assets on banks’ balance sheets.

The Lamb has written about the former problem.  He remains adamantly opposed to the unilateral rewriting of mortgage terms, especially the reduction of any principal amounts.  Regarding the latter situation, the consensus view now is that, for better or worse, the FDIC will run a so-called “bad bank” that will purchase these toxic assets from banks.  The banks, with cleaner balance sheets, would then feel more comfortable lending, and this, the thought is, will help jump-start the economy.

As has been noted since the initial days of the government’s Troubled Asset Relief Program (TARP), the primary difficulty with a government asset purchase program is coming up with the “correct” price to pay for these assets.  Paying too low a price will leave the banks undercapitalized and do nothing to solve the problem.  Conversely, paying too high a price would saddle taxpayers with losses and reinforce moral hazard issues.

The Lamb discussed the latter problem back in September when the TARP was first brought into existence.  In a nutshell, The Lamb argued against paying 125 cents for a dollar bill.  So, how does this Bad Bank come up with the “right” price to pay for these assets?  The “right” price being one that is acceptable to the banks selling these assets, but one that also carries it with it taxpayer protection.

No financial institution should be forced to sell assets to Bad Bank that it doesn’t want to sell.  Banks that want to sell assets to Bad Bank should submit the asset and the amount of it that they are interested in selling.  Bad Bank would then bid for assets in a ratio equal to the amount of TARP money the Treasury has already invested in these banks in the form of preferred stock (i.e. — banks that have received the most TARP money would be able to sell the most assets).  This would have the effect of bolstering/protecting the preferred stock positions that the Treasury (taxpayer) has already taken.

In order to achieve transparency and reduce the use and risk of taxpayer funds, all Bad Bank bids should be public.  Additionally, any ready, willing and able third party should be allowed to “top” Bad Bank’s bid for any asset.  This will keep as great a portion of the troubled assets as possible in private hands, minimizing the role of the public sector.

Arriving at Bad Bank’s bid price for assets could be done by any of several proposed methods.  As Treasury Secretary Timothy Geithner detailed in his January 21 hearing in front of the Senate Finance Committee, Bad Bank could:

“Look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.  They all have limitations.  I think you need to look at a mix of those types of measures.”

Whichever method or combination of methods is used, they must provide positive convexity (the upside for a given degree up-move in the assets’ values is greater than the downside for the same degree down-move) to Bad Bank, hereafter called Convexity Bank.  All increases in asset values will be retained by Convexity Bank.  However, if after a set period of time (say, three years), a given asset has declined in value (as determined by an auction), the bank that originally sold the asset will then have to issue to Convexity Bank common equity in the amount of 110% of the asset’s decrease in market value.  The same downside protection would not be afforded the hypothetical ”private” buyer mentioned earlier.

While this may seem to be a bad deal for banks, let’s remember two things.  First, banks have argued that current market prices are not reflective of the potential value of these troubled assets due to extreme and unprecedented market conditions.  This would be an opportunity for them to sell at prices above otherwise-available market bids.  If the banks’ assessment of the situation is correct, they will have succeeded in selling these assets at prices above what the current market price would be in the absence of Convexity Bank’s bid.  Second, banks will not be forced to sell any assets they don’t want to, or at prices they don’t want to.  They would be free to take the risk themselves.

Since common shareholders are the ones that will most benefit from the disposal of these bad assets, they are the ones that should bear the risk of the assets’ decline in value via the risk of future share dilution.  This plan solves the problem of clearing troubled assets from banks’ balance sheets while also addressing the trillion dollar question of determining the “right” price for Convexity Bank to pay for the assets in question.  Furthermore, this plan alleviates the major risk of taxpayers subsidizing the bad investment decisions of banks while aiding in protecting the hundreds of billions of dollars that they have already invested via preferred stock.

In the early 1990s, when The Lamb first began trading, his boss gave him a piece of advice that he has kept in the forefront of his mind ever since:  hope is not a hedge.  The message was simple — if you want to protect a position, then take specific action.  Don’t just hope and pray that things will work out — they usually don’t.

As has been mentioned ad infinitum by the ubiquitous talking heads, today is a historic day for the United States.  A new administration takes the reins of a shaky economy and an equally optimistic constituency.  Comparisons of Barack Obama to FDR and Ronald Reagan have been tossed about as if to signify that all is about to be right in the world.

But despite revisionist history, let us recall that economic difficulties continued or worsened during the first few years of each of the above two administrations.  In fact, economic conditions deteriorated significantly during FDR’s second term in office as Americans came to realize that his alphabet soup public works programs were an ineffectual short-term bandaid for a lethal long-term wound.

Regardless of your political affiliation in general or opinion of Obama specifically, we are all rooting for this administration’s success.  The multi-trillion dollar question, however, is what steps will be taken and, more importantly, what will be the ramifications?

Will we have tax cuts (individual and corporate) or tax increases?  Increased government spending or less?  (OK, I think we all know the answer to that one).  What will the Federal Reserve and the Treasury Department do if/when the dollar begins to slide as short-term interest rates remain near zero while budget deficits and the cost of entitlement programs soar?  Remember, the Fed can control either the price or the supply of money — not both.

As we leave a trying 2008 and enter a (perhaps) riskier 2009, take the time to review your finances.  Remember The Lamb’s Rule #2 — Know and understand what you own, and what you owe.  Determine what can hurt you and actively take steps to protect yourself.  Don’t look back a year from now and regret that you had too much money in equities, inadequate protection from higher interest rates or a weaker dollar, or too much/little fixed-income credit exposure.

Remember, hope is not a hedge.

Last November, The Lamb wrote that Uncle Sam should eschew saving General Motors.  He argued that the attempt would be tantamount to keeping alive a terminal patient, with the suffering borne by the American taxpayer.

Fast forward nearly two months.  While The Lamb’s opinion on rescuing GM hasn’t changed, the status of the company’s finances has.  Last week, GM “received $4 billion in initial rescue loans from the U.S. Treasury to help it avoid collapse.”  Many more billions of dollars in loans and other financial assistance is likely forthcoming.  As the Treasury said last week in explaining its current and future assistance to the auto industry (via Bloomberg.com):

“Treasury may consider, among other things, the importance of the institution to production by, or financing of, the American automotive industry.”  The government will weigh “whether a major disruption of the institution’s operations would likely have a materially adverse effect on employment and thereby produce negative spillover effects on economic performance” or on credit markets.

Well, if that doesn’t telegraph that more aid to General Motors is in the cards, The Lamb doesn’t know what does; add to this a newly-inaugurated President Obama’s likely aversion to having one of the most iconic American companies go toes-up on his watch, and you have the makings of an open-ended rescue program.

Just as in the case of the AIG bailout, which carried an initial $85 billion price tag, Uncle Sam has a nasty habit of throwing good money after old money.  He hates to take a loss, especially one that would receive such loud press coverage.  Rather than lose a few billion of taxpayer dollars, he habitually continues to bolster old investments with new money.  With AIG, for instance, over $67 billion (now a total of $152 billion, if you’re keeping score at home) has thus far been promised to the beleagured insurer to protect/bolster/insure the original $85 billion.

Now recall last month that The Lamb advocated investing money in certain institutions that had received money from Uncle Sam in return for preferred stock.  The idea is that owning senior debt of companies that had issued preferred stock to the government was a good risk/reward trade in that Uncle Sam could not recoup any of his principal unless and until you received yours, as senior debt is ahead of preferred stock in a company’s capital structure.

As The Lamb said then and still fervently believes today, “Uncle Sam is gonna get his money back.  You will, too.”

The loan(s) that Uncle Sam provides GM will, in all likelihood, be senior to any senior debt of GM and will not obviate the risk of GM’s defaulting on its senior debt.  However, The Lamb believes that there is a better than decent chance, similar to that of the AIG situation, that Uncle Sam will be loathe to let a company to which it has lent billions of dollars go bankrupt.

Now, it is certainly possible that there will eventually be a (coerced) debt-for-equity exchange, a shotgun merger, or even a pre-packaged bankruptcy.  Each of these could easily result in a significant haircut for GM bondholders.  However, the recovery value for GM debt is likely to be around 10 cents on the dollar, somewhat mitigating any loss.  GM bonds are unquestionably very risky — both Moody’s and S&P have them rated well into the nether regions of junk status.

However, with all this in mind, one interesting and admittedly very risky investment idea is to purchase relatively short-dated senior debt of General Motors.  Though only for investors with the greatest predilection for pushing the risk/reward envelope, 2-year maturity senior debt of GM currently carries a tantalizing yield-to-maturity of over 100%.  Translation:  if the bonds mature at par (100 cents on the dollar), an investor will quadruple his money over a two-year period, including coupon payments.

The GM 7.20s of 1-15-2011 are currently (as of Friday) priced at a dollar price of 25.03, according to the bond market’s Financial Industry Regulatory Authority’s (FINRA) pricing service.  This equates to a yield of 100.46%, and is a low enough dollar price that even a 10 cent recovery value brought about by bankruptcy will not completely wipe out the investment.

As a final caveat, before making this or any other investment, The Lamb strongly urges you to repeat Rule #2 at least three times while standing in front of a mirror:  “Know and understand what you own.”

Disclosure:  The Lamb currently has a small amount of the above-mentioned GM 7.20s tucked neatly into a dark little corner of his portfolio.