Getting Rich from the Fiscal Cliff

By Jeremy L. Bartell - October 22, 2012 | Tickers: AIG, GS, WB | 0 Comments

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A product of congressional can-kicking, the fiscal cliff is a nasty combination of government spending cuts and tax hikes beginning in 2013. As with most cliffs, driving off it will hurt. And even if we survive the fall, we'll be right back in Deep Recession, that seedy and stagnant town we thought we'd left in the rear-view mirror.  

"Regardless of ideology, virtually all economists agree that going over the fiscal cliff will tip us back into recession." Morgan Housel, explaining the fiscal cliff to readers of The Motley Fool. 

So what is an investor to do? Let's look back at the last time we drove off a cliff. The housing cliff. We didn't call it a "cliff" at the time. We preferred slightly slower-moving concepts such as crisis, crash, collapse, meltdown, scandal, fiasco and total f*$# up. In retrospect, though, the housing thingamajig qualifies as a cliff. Over its lofty edge, with nary a tamp on the brakes, flew Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia, Countrywide, AIG (NYSE: AIG), Fannie Mae, Freddie Mac and a slew of other storied and not-so-storied institutions both large and small. It was a cliff all right. With a big pile at the bottom. 

Looking back, however, it's clear not everyone loses when we careen from economic cliffs. Some folks profit big. Very big. From the mega-yachts named "Irrational Exuberance" following the dot-com crash to the breathtaking CDO bets recounted by Michael Lewis, we are reminded that one investor's death spiral can be another's ticket into the 1%:

Whenever there is a major market disruption, there is potential for profit. Perhaps the most famous example is hedge fund manager John Paulson's $15 billion gain made betting against the housing market. But there have been many others, including those described in Michael Lewis's The Big Short. The hard part is mustering the guts necessary to bet that a massive market failure will occur even while countless powerful people vigorously endeavor to prevent it.  

Betting that the fiscal cliff will happen involves (among other complex factors) predicting the actions of politicians. While most politicians may want to prevent another recession, they are operating in a largely dysfunctional Congress. The cliff itself is a product of that dysfunction. Predicting the actions of a dysfunctional Congress is difficult. A fair dose of luck is needed. Nevertheless, it seems the odds are stacked against the fiscal cliff happening. There are too many people trying to prevent it. As Morgan Housel explains:

"Now, almost no one wants the fiscal cliff to happen, particularly in its entirety. There's something in it for everyone to hate: tax hikes if you're conservative and spending cuts if you're left-leaning. Both parties have voiced their desire to avoid the cliff by making a deal to extend current policies, if only in parts. Odds are that will happen with a last-minute deal hammered out just like last summer's debt-ceiling deal. Goldman Sachs puts the odds that a deal won't be made at just 35%. Moody's puts the odds of failure at 15%."

If the fiscal cliff does happen, however, Bullzie won't be the only one minting money. Out there right now, with or without the help of Goldman Sachs (NYSE: GS), are hedge fund managers developing clever ways to profit if the economy drives off the cliff. They are short, our fiscal cliff.

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