Dear ETR: How Do Bailouts Affect Stock Prices?

“In his article entitled ‘Financial Word of the Week: Bailout,’ Charles Delvalle said that if a person holds stock in one of the companies that is being bailed out, it may be nearly worthless. He further suggested that ’selling is usually your best option.’ This does not make sense to me. He, himself, said that bailing out Chrysler helped them stay in business.

“So, with this in mind, wouldn’t it stand true that this bailout should help most (if not all) the bailed out banks to remain in business? If they can remain open for business, it might be wiser to hold those shares. Then, later, they could be once again worth at least what shareholders originally paid, if not more.

“I do hope Charles will comment in ETR for all to hear his thoughts on this matter.”



Dear Steve,

You are correct. When Chrysler was bailed out, it marked a great time to buy that company’s stock. But the bailouts happening today are very different.

Stockholders suffered the most when Bear Stearns was bailed out. That’s because the bailout was structured to protect ONLY bondholders (very unlike Chrysler’s bailout, which was really just a loan to them from the government).

In fact, practically every financial sector bailout that has occurred this year has been structured to protect bondholders, not stockholders. The only stockholders who might hope for some protection are holders of preferred shares. But even for them, the losses realized can be huge.

For instance, the bailout of Fannie and Freddie effectively killed the steady dividend payment that their preferred shareholders had been receiving. This helped drop share prices from over $20 to under $2. And while it is true that Fannie and Freddie’s preferred shareholders “may” eventually see their shares worth $20 again, it could take years.

The only recent bailout that was a plus for shareholders was the bailout of Ford, Chrysler, and GM. Under the government’s terms, the big three are eligible for $25 billion (split amongst the three), and they won’t have to begin to repay the loan for a few years. In this scenario, the bailout adds a layer of safety to their shares, since the companies are gaining access to cash during a credit crunch – allowing them to survive while the economy suffers.

The lesson here is to stay away from financial companies that are being bailed out. They are structured so that stockholders suffer while bondholders get all the benefits.

Makes you want to buy some bonds, right?

– Charles Delvalle

[Ed. Note: The economy may be in an uproar these days, but there are still ways for you to make money. The real secret to banking riches in today’s market is to look in unconventional places. You can access one of these “hidden treasure troves” just by keeping an eye out for “Red Flag” alerts.]