A New Crisis for the Financial Crisis: The Presidential Transition

On November 6, 1860, Abraham Lincoln was elected the 16th President of the United States. The country was in a political crisis, with some Southern states threatening to secede. At that time, Presidents-elect were not sworn into office until early March of the year following their elections. During the four months between Lincoln's election and his inauguration on March 4, 1861, seven Southern states seceded, establishing the Confederacy. Lincoln's predecessor, James Buchanan, who may possibly have been the worst President ever, was entirely ineffectual in dealing with the dissolution of the Union. In the ensuing civil war, 600,000 Americans died.

Things are nowhere nearly as bad today. The Civil War turned the country from these United States of America to the United States of America, and so unified it has grown to be the most powerful nation on Earth. But we have a nasty financial crisis on our hands that shows every indication of getting worse. Today, the Dow Jones Industrial Average fell 5% and the more comprehensive S&P 500 index fell 6%, mostly on more bad economic news and lowered prospects of immediate assistance for the American auto companies. The Bush Administration has taken down its tents and packed up for its departure. The Treasury Department has suspended further application of its bailout powers under the $700 billion TARP (the now troubled Troubled Assets Relief Program), leaving some $60 billion uncommitted and another $350 billion untapped that can be spent only if Treasury requests it from Congress (and no request has been made). The Federal Reserve will continue to prop up the financial services industry, but its ability to support and stimulate the larger economy is virtually gone. While it may lower interest rates again, there's little reason to believe that such a step would do much good. The level of interest rates has little to do with the amount of lending these days.

Banks aren't lending because their continuing losses from mortgages, real estate, consumer credit and myriad other sources compel them to deleverage and hoard funds. The $250 billion from TARP that Treasury is investing in a number of banks will help to keep them afloat. But it won't have much impact on ordinary folks whose home equity lines of credit, credit card limits and other sources of credit are being cut back by the banks. Securitization of loans, the primary way banks have offloaded loans in recent years so that they could lend more, has virtually stopped. Vast numbers of investors were burned badly by the securitization of bad, dumb and fraudulent mortgage loans, and that way of doing business will never come back. Perhaps a new form of securitization will some day rise from the ashes. But, at least for now, the phoenix remains a mythological figure in the world of finance.

The stock market had risen yesterday, partly because of a perception that the market might be bottoming out and partly due to signs of potential progress on an auto company bailout. These hopes were dashed today; and there's nothing on the horizon to indicate near term improvement. The G-20 conference last weekend in Washington turned out to be a marshmellow roast where prominent leaders from around the globe sang "Kumbaya" in their native languages. It was a short seller's dream.

Two months--the time until Barack Obama is inaugurated--is an eternity in the financial markets. Two months ago, the stock market was mostly trading over 11,000. Since then, we've lost 3,000 points, or around 27%. Another 27% drop from today's price levels would produce a Dow of around 5840. That would make a lot of people unhappy. Could it happen? That's anyone's guess at this point. A couple of months ago, some market professionals were calling a market bottom around the mid-11,000s. They probably now have a heightened appreciation of the undesirability of egg on one's face.

If the Treasury Department had begun purchasing mortgage-related assets immediately after TARP was enacted on October 3, 2008, some of the banks selling those assets might have gotten higher prices than they could get today. Secretary Paulson's plan to buy such assets, and his recent decision to drop that idea, left the banks holding the bag. Mortgage-related assets have fallen in value since October 3, 2008 (as foreclosures have increased and real estate prices fallen). Selling banks will have to book larger losses now than they would have had they sold in early October. This illustrates the price of delay in today's hyperfast financial markets.

The unpleasant but unvarnished truth is that only swift and substantial government action can have any significant impact on the economic downturn. Two months delay means another two months during which layoffs increase, consumers pull back further, credit disappears, stock, real estate and other asset prices drop, bank losses build and confidence evaporates. Government policy and action for the economic crisis can't wait two months while George W. Bush ruefully packs boxes and entertains pardon petitions.

President-elect Obama should make the selection of his Treasury Secretary the top priority for the transition. Selection of the rest of the Cabinet can come later. Planning the Inaugural celebrations can come later. He must name a Treasury nominee now; every day could be costly in the stock markets. He and his nominee should immediately begin coordinating with Treasury Secretary Paulson, Fed Chairman Ben Bernanke and their staffs about what to do now (i.e., as in not in January). The Obama camp will have to call the shots. They'll have to make decisions with only incomplete information and not enough time to think things through. They'll have everyone in the world screaming at them for every mistake they make; and they'd better expect some of those along the way. The outgoing administration may have to swallow hard, avert their eyes and do some things they dislike for the sake of Old Glory. They may have to abandon their own policies and let the incoming administration have its way, because it will anyway. If there ever was a time to rise above partisan politics, now is that time.

What Might a GM Bankruptcy Look Like?

The Bush Administration has made clear that it will not sign off on a bailout of GM. GM's management has said that the company might have to file for bankruptcy by the end of this year. If so, the company will be in the tank before President Obama has a chance to put together a bailout bill. Let's take a look at what might happen in a GM bankruptcy.

Sales would probably fall off. A new car is a five or more year proposition for many buyers. They wouldn't want to buy a car from a bankrupt company that might not be around in a year or two to support the warranty and ensure a steady supply of replacement parts. GM would have to institute large, and perhaps massive, layoffs. Its suppliers would, in turn, have to make large, or even massive, layoffs. If the suppliers go into bankruptcy, their ability to supply not only GM, but also Ford and Chrysler, could be adversely affected. Ford and Chrysler, already seriously weakened, could begin circling the drain.

In order to reorganize and emerge from bankruptcy, GM would need "debtor-in-possession" financing, a special form of financing provided to bankrupt companies. But how many lenders are there, in these days of the credit crunch, who would fork over the billions needed by badly crippled GM for a reorganization? Maybe only a few. Very possibly none.

So GM might be unable to reorganize. In that case, its bankruptcy would be converted to a Chapter 7 liquidation. Some argue that this would be a good thing, that competitors would buy pieces of GM and get those pieces up and running again. But what competitors have the money to buy parts of GM? The financially strong ones, like Toyota and Honda. What might Toyota and Honda do if they bought some of GM's plants and facilities. Hint: it wouldn't be to operate them. The auto industry is plagued by serious overcapacity. Toyota and Honda could expand their share of the U.S. auto market by permanently closing any GM plants and facilities they bought in a Chapter 7 liquidation.

Would any leveraged buyout firms buy parts of GM? Not after Cerberus got clobbered for its investment in Chrysler. There don't appear to be any American investors who could come up with the money to establish a new company to take on Toyota and Honda. Any such transaction would require billions of dollars in bank credit lines, and what banks in the credit crunch era would finance such a business plan against such capable competitors? Today, banks only want to invest in U.S. Treasury securities. There wouldn't be a lot of them volunteering to finance a startup to compete against the likes of Toyota and Honda.

So GM's bankruptcy could end up with the U.S. auto industry seriously diminished. No nation remains great without a strong industrial base (compare the U.K. before and after World War II for proof of this proposition). Bailing out GM would be distasteful, since government bailouts are, as a matter of principle, not to be encouraged. But after the hundreds of billions of federal dollars that have flowed to Wall Street, it's hard to stand on principle because one ends up standing on hypocrisy.

One good thing about a Chapter 7 liquidation is that GM's current management would lose their jobs. That needs to happen anyway. After 8 years as GM's CEO, Rick Wagoner hasn't got the job done. He bet the company on a commodities play: that the price of oil would stay low and that the company could keep building high profit, low fuel economy trucks. He was wrong, and even though he is CEO, he like everyone else should pay for his mistakes. Is Rick Wagoner a bad man? No. Is he stupid? No. Did he try his best? No doubt he did. But he gets paid millions and should deliver performance commensurate with his pay. He hasn't. Besides, GM needs a new face in order to credibly promise better future performance. If GM goes into bankruptcy, its one real chance may be federal assistance in lieu of debtor-in-possession financing. A new face has a better chance of winning over skeptics with a believable promise of improved future performance.

Let's recall that the 1979 Chrysler bailout, along with management changes at that company, worked and provided U.S. taxpayers with a profit. GM can produce quality vehicles (check out the new Buicks). It has innovative engineers and perhaps the best styling among the U.S. auto companies (most of the time; the Cavalier was sad looking on its good days and the Lumina was hardly luminous). If we deviate from dour, rigid application of free market principles and provide some taxpayer support, we might end up a lot better off than we would without GM.

The Next Two Months: A Most Dangerous Time for the Financial Markets

We're now in the interregnum, with a Democratic President-elect to replace the Republican lame duck two months from now. The Republicans, grumpy about being clobbered in last week's elections, aren't eager to take up Democratic initiatives, like a bailout of GM. Treasury Secretary Hank Paulson has put the $700 billion bailout plan on hold. About $290 billion of it has been committed to supporting banks and other financial institutions, primarily through capital infusions. Another $60 billion is authorized to be spent by Treasury, but remains uncommitted. The rest of the funds, $350 billion, cannot be spent without further approval by Congress, and Paulson doesn't plan to ask for it. While the Federal Reserve and Treasury can use existing authority to lend to and invest in financial institutions, there won't be any significant new initiatives by the government until Barack Obama is sworn in.

In today's hyper volatile stock market, two months is a lifetime. The market dropped 17% in October. What will November be like? Within the past two and a half weeks, the market rose almost 20%, dropped 14% and then rebounded 7%. If there's one thing we've learned in the last six months, it's that we have no idea what will happen tomorrow, let alone next week or next month. This year, entire nations--like Iceland, of all places--have become insolvent. All the major investment banks in America have disappeared or been converted into commercial banks. Almost all major commercial banks in America have received capital infusions from the federal government. AIG, the nation's largest insurance company, has been virtually nationalized. The U.S. government, by taking control of Fannie Mae and Freddie Mac, effectively runs the mortgage business in America. Europe is on the ropes, with the Euro dropping like a rock against the dollar. Oil prices have been manic depressive. The recession, in America and overseas, promises to be worse than we expected yesterday.

Today's 552 point jump in the Dow may appear positive at first glance. But it seems to be mostly speculative frenzy. Not only did stock prices rise, but so did oil and wholesale gasoline prices. That doesn't make sense, since an increase in energy costs would only depress an already weakened economy. However, this kind of price activity could be explained as bottom fishers buying up any asset that has recently dropped a lot--in other words, speculation. Some market mavens claim there is a floor to stock prices at the 8,000 level of the Dow, because the market has twice hit that level this fall and rebounded. But it's risky to believe in talismanic stock index levels. Looking at the underlying economics makes more sense.

Good things could happen during the next two months. The sharp drop in oil prices may stimulate consumer spending, which is now lagging badly. Perhaps--just perhaps--truck sales might increase a bit, giving GM, Ford and Chrysler badly needed profits. The stronger dollar may bring in foreign investment, supporting U.S. stock and other asset prices. Japan and China may infuse capital into the IMF, which could lend it out to smaller nations with faltering economies and soften the worldwide recession.

Bad things could happen during the next two months. Consumer credit is tight and could easily get tighter. Consumers have started to realize that they haven't necessarily never met a debt they didn't like. They're deleveraging. That means lower consumption, which will lead to higher unemployment.

GM could go into bankruptcy. The outcome of such a bankruptcy is extremely difficult to game out. It's possible GM could successfully reorganize. But it's also possible that, with the auto industry severely burdened by overcapacity, GM wouldn't be able to attract enough new capital to effectively reorganize. The uncertainty of the situation would probably depress stock values, since the market hates uncertainty.

Housing prices could continue to drop. There is no reason to think that they've bottomed out. The Bush administration's latest mortgage relief proposal might help 10% of the homeowners who are underwater on their mortgages. And it wouldn't help those that are already in the foreclosure process, which includes a lot of homeowners. Mortgage rates are, if anything, rising.

Corporate earnings could fall more than expected. That's certainly been commonplace in the third quarter of 2008, as the nation and the world have slipped into recession more quickly than initially thought. Beginning in early December, we'll start getting indications as to how the winter earnings season will go. Much more information will come out in the two weeks before the Inauguration. The picture might be grim.

Thus, the next two months will be a most dangerous time for investors. There will be plenty of risks and no hope of any new major government initiatives to offset the risks. Don't think today's 7% market jump means much. Buy stocks, if you're feeling bold or your investment horizon is way off in the distance. Don't invest anything you can't afford to lose. At the same time, don't lose heart. There's nothing about the current economic crisis that tells us the U.S. can't recover. Recovery may be a ways away. But things were a whole lot worse in the 1930s. This, too, will pass.

Enlist Private Capital to Combat the Economic Crisis

Barack Obama has a lot on his plate: a financial sector in crisis, an economy in recession, unresolved wars in Southwest Asia, a health insurance system badly in need of reform, a national infrastructure that is sometimes, as in Minneapolis, literally collapsing, a needlessly complex tax system, and a national zeitgeist that is dispirited and has very high expectations of him. At the same time, the resources for addressing these problems look thinner by the day. If one tries to total up the cost of covering the financial sector's losses in mortgages, CDOs, credit default swaps, credit card debt, car loans and other bad loans and investments, the number reaches several trillions. Then, there's the potential cost of assisting defaulting homeowners avoid foreclosure. That's hundreds of billions more, and maybe another trillion.

What are the resources that could be tapped to alleviate the problems? America's gross domestic product is something on the order of $14 trillion. The federal government's budget for fiscal 2008 (the year ended Sept. 30, 2008) was something around $3 trillion, with a deficit of about $450 billion. The total federal debt outstanding is $10 trillion. The government simply can't wrestle trillions more from the domestic economy in order to deal with the financial crisis. Presumably, some of the needed money can be borrowed overseas, since the whole world is sliding into recession and the dollar retains its image as a safe haven. Indeed, about a quarter of the outstanding public debt (or $2.5 trillion) is held by foreign lenders. But borrow another $4 or $5 trillion overseas? Not likely. Even the hundreds of billions needed over the next few months to fund the Treasury Department's continued financial sector bailouts (pursuant to the $700 billion bailout bill enacted this fall) and a proposed $60 to $100 billion stimulus package now being touted by Congressional leaders will seriously test the world's appetite for U.S. government debt.

Plainly stated, the U.S. government doesn't have and cannot get enough resources to fully deal with today's economic crisis. Given the near complete disarray on Wall Street (evidenced by the continued credit crunch), and shrinking options for Main Street companies (does GM have a corporate strategy aside from getting federal bailout money?), the government has to tap new veins of capital or see the economy slide further.

Fortunately, there is a substantial amount of cash sitting in private hands. It's unclear how large this hoard is. But you know it's there from the large amounts of mutual fund and hedge fund redemptions, and withdrawals from money market funds. Trading volume in the stock markets has been very light in recent weeks, which is part of the reason for the extraordinary volatility in stock prices. A lot of investors have yanked their savings from anything that presents risk and parked it in ultrasafe places. And they're not putting it into stocks, real estate or anything else that appears to be a sinking asset. This money represents a pool of funds that, if put back to work in the stock and real estate markets, and through the banking system, could do much to revive the economy.

How can private capital be enticed to assist in the economic recovery?

Home buyers tax credit. All the talk of assistance for defaulting homeowners raises questions of fairness and exploitation of government aid. The large majority of homeowners with mortgages pay on time, even though many are under water. If defaulting homeowners receive government sponsored reductions of principal and interest rates, other under water homeowners have an incentive to cash in on the government program by defaulting as well (even if they can continue to make payments) and angling for a better deal for themselves at the taxpayers' expense. Another way to support real estate prices would be to give home buyers a tax credit--not just for first time buyers, but for all buyers. The point of this credit is to increase demand for real estate and not redistribute income. Maybe some sort of limit could be established to avoid subsidizing rich and famous lifestyles. But a tax credit such as 5% of the purchase price up to a limit of $50,000 would do much to encourage buyers to step in. Mortgage relief will be messy and expensive. A tax credit may be expensive, but it would be simply and direct, and therefore likely to have a faster impact.

Interest and Dividend Income Deduction. It's essential to encourage Americans to save more. That would increase the amount of domestic capital (a good thing regardless of what it is used for, because the U.S. is overly dependent on foreign capital). Since savings would often be placed in bank accounts, the banking system would get a low cost and stable source of funding, something it desperately needs. Other such savings would go into money market funds, and could flow from there into the badly frazzled commercial paper market. Such a deduction should be provided for interest income and dividend income now taxed as ordinary income (like dividends from money market funds). Allowing individuals to shelter from income taxes up to $20,000 per year of interest and dividends would do much to encourage saving, and increase funding for banks and money market funds.

Double the Deductions for Retirement Account Contributions. Increasing the deduction for retirement account contributions (i.e., for accounts like 401(k)'s, 403(b)'s, IRAs, Roth IRAs, SEP-IRAs, etc.) would stimulate savings, because many people use the amount of the deduction as a retirement guideline and save the maximum amount allowed. Even though this isn't necessarily good retirement planning (you should estimate your retirement needs and save enough to meet those needs, not save the amount the tax code allows you to deduct), it's a behavioral pattern that would bring more capital into the financial system and the stock markets. That capital is badly needed. Doubling the deduction would also assist older workers (especially those close to retirement). Many of them have suffered recent losses in the stock market, and would benefit from a larger deduction to beef up their depleted retirement funds.

These measures would negatively impact taxes collected. And most of the tax benefits would go to upper middle class people. But one must offset those considerations against the advantages of bringing private capital back into the real estate and stock markets, and into the financial system. The government can't do it alone; President-elect Obama's remarks last Friday (Nov. 7, 2008) acknowledged as much. We can either let this private capital sit on the sidelines, while the government tries to tackle an impossible task, or we can work toward a combined effort that may help to stave off a really deep recession.

Time for a New Approach to the Economic Crisis: End the Government Confidence Game

The stock market has dropped 10% over the last two trading days since Barack Obama was elected President. President-elect Obama shouldn't take it too hard. The market's drop has little to do with him. It's the result of the George W. Bush Administration's failed confidence game in dealing with the financial crisis.

All financial markets are based on confidence. This is true whether we're talking about stock, bonds, options, currencies, mortgage-backed securities, synthetic CDOs, or derivatives of derivatives. The Bush Administration's focus in responding to the mortgage crisis and credit crunch has focused on trying to restore confidence in order to get credit flowing. The Federal Reserve's ever-expanding programs of loans to an ever-widening circle of business enterprises, the bailouts of Bear Stearns and AIG, the nationalizations of Fannie Mae and Freddie Mac, and the still somewhat amorphous $700 billion bailout bill which will be used in some fashion that will eventually be defined are all meant to prop up the financial system by instilling confidence.

In the ten days preceding the recent election, the stock market gained about 18%, after central banks around the world announced a plan to make coordinated interest rate cuts in order to stimulate flagging economies. The surge in stock prices may also have been driven in part by the relief that the uncertainty of the presidential campaign was about to end (the financial markets hate uncertainty, because it's very hard to price).

However, after the election, the markets had to face the fact that the recession hadn't gone away, notwithstanding all the government bailouts, programs and policies. The Bush Administration's policies have lagged behind the economic tailspin, which is no longer driven only by falling real estate values and rising mortgage default rates, but also by a widespread slowdown in consumer spending driven by a number of disparate factors. Among other things, job losses are worse than expected, European banks turn out to have nastier problems than we thought, larger nations are quickly nationalizing their banking systems and smaller nations effectively admitted their insolvency by seeking IMF assistance. Retailers are almost all reporting bad financial results, with only Wal-Mart having something positive to say because it's focusing on serving the down market portion of the down market segment. Manufacturing is hurting and the U.S. export market will weaken as a result of the recent strengthening of the dollar.

It may be tempting to President-elect Obama to say something about our having nothing to fear except fear itself. That wouldn't set the right tone now. The Bush Administration's confidence game has failed, because confidence games don't work when assets are falling in value. Almost all asset classes, from stocks to bonds to commodities to real estate to the economy as a whole, are now falling in value. Everyone knows it, and everyone who has money to lend also has good reason to be cautious about lending. And a lot of people who have money invested in the stock markets are trying to get out.

Instead, President-elect Obama should use words that invoke Winston Churchill's promise of blood, toil, tears and sweat. Candor from the White House is essential. We're at the early stages of battling a difficult economic crisis. Few of us will escape wholly unscathed, and all of us will have to make sacrifices. While America's problems today do not begin to approach the depths of Britain's problems in the spring of 1940, we need to unify and find a sense of national purpose, step back from the partisan rancor of recent years, and work together to find lasting solutions. Further, we can't expect government to fix all problems. Those Americans who now reach for their bootstraps will end up much better off than those that wait with hands held out. The new President should be candid about what the government can't do and the importance of self-reliance and self-help. We Americans have always wanted a government of limited powers, and we'll have to work for it if we still want one.

Barack Obama, and the Revival of the Rust Belt and Hope

The election of Barack Obama as President includes a lot of firsts. One that has received little media attention is that for the first time in more than a generation, the Rust Belt has played a crucial role in electing a President who would serve its economic interests. Since the late 1960s, the Rust Belt has drifted away from the Democratic Party (or perhaps one could say that the increasingly liberal Democratic Party drifted away from the Rust Belt). The Republicans, normally the shrewder political operators as compared to the Democrats, took full advantage of Rust Belt disillusionment to repeatedly swing crucial swing states in their direction. Yet, all this support for the Republican Party resulted in little federal economic assistance for the Rust Belt while jobs and industries shifted to the Sun Belt or other nations.

This time, Wall Street greed and mismanagement, coupled with benign neglect by financial regulators, created the recession into which the nation is now descending. Republican sloganeering couldn't shift voters' focus away from stagnating middle class incomes, increased inflation, greater unemployment and falling real estate and retirement account values. Rust Belt voters from Pennsylvania to Wisconsin and Minnesota went for the guy who most clearly promised to do something for them. In one of the rustiest of states, Ohio voters told Joe Wurzelbacher to pipe down and go back to plumbing.

None to late, either, because the United States needs to revive its manufacturing capacity. The wealth of a nation ultimately comes from its ability to produce. Wall Street's financial engineering, dabbling with derivatives and corporate takeovers all too often create little more than paper wealth that isn't worth the paper it's printed on. The Bush administration's policies make sense to the Wall Streeters who now hold senior positions in the Department of the Treasury. They wouldn't question why the banking system must be preserved. But ask a laid-off auto worker why it makes sense for the government to subsidize J.P. Morgan Chase's merger with Bear Stearns, but not GM's merger with Chrysler. Considerations of government interference with market mechanisms and moral hazard ring hollow when the government subsidizes the banking system while allowing dividends still to be paid to private bank shareholders.

America needs to strengthen its productive capability if it's going to achieve a lasting recovery from the recession. We can't afford to revive the economy again with a methadone-like dose of easy money (although that seems to be the Bush administration's principal policy). That would only set the stage for more asset bubbles and bursts. Barack Obama's election provides an opportunity to rebuild a crucial economic sector.

It will also help to restore America's standing among nations. The George W. Bush administration's record of unilateral militarism has done much to mar American's image. But John McCain's honorable conduct of his campaign--hard fought, but without Willy Horton moments or Swift Boat ambushes--avoided the rancor that delegitimized other recent presidential elections, and strengthened the nation's integrity. And Barack Obama's election vividly demonstrates to the world that America is, as it was in 1776, a nation of principles and dreams, where voters are fair-minded and are willing to look beyond the bigotry and prejudices of the past, where society and life can get better, and where anyone--anyone--with talent and the willingness to work hard can become President.

Can the Federal Reserve Handle the Volatility?

As we discussed in our preceding blog, volatility in the stock market discourages investors. Buy and your investment suddenly drops in value. Place an order to purchase, and the market jumps before your order can be executed, causing you to pay more. With investment opportunities like these, you might prefer to sit in front of the TV, drink beer and eat potato chips. Better to pork out than take trading losses.

Volatility is also a macro-level problem. Two months ago, the Fed had to be cautious about lowering interest rates because of the high price of oil. The dollar was in the doldrums, adding to the inflationary pressure. Today, oil is regressing back to 2005 levels, and some low tax states may soon see gas under $2 a gallon. At the same time, the dollar has rebounded briskly against the Euro (although it's slumping against the yen). The Fed is now concerned with deflation--that rarely seen phenomenon where overall price levels fall. Deflation discourages consumption, because consumers wait for prices to drop before buying. Inventories pile up, manufacturing slows down and layoffs increase. Debt becomes more burdensome to repay, since borrowers must use more expensive dollars to pay their obligations.

In order to forestall deflation, the Fed lowered interest rates recently, a measure that is also meant to stimulate the recessionary economy. Monetary policy tends to take effect at a glacial pace. Interest rate changes often require 12 to 18 months to have a significant impact. Do we really think that oil prices will stay low for the next 12 to 18 months for the convenience of central banks around the world? Or is it possible that they may pop unexpectedly, as they did this past spring? Could the dollar slide again when investors get a fix on the size of future U.S. government deficits after the costs of all the bailouts and lending facilities becomes clear? The recent federal bailouts and interventions have, if anything, only increased America's status as the biggest spendthrift of all. This isn't good for the dollar.

Will the Fed be able to handle the unexpected volatility that we now know to expect? Will it be willing to change policies if a few months from now inflation, not deflation, turns out to be the problem? Events in the current financial crisis have moved very fast, and the government has been forced to improvise extemporaneously. At this point, its response consists essentially of just one measure: pumping as much liquidity into the financial system as fast as it possibly can. Methadone does work, in a manner of speaking. But it substitutes one addiction for another and the financial system is now addicted to government interventions and bailouts. The stock markets surged last week amidst a sequence of coordinated worldwide interest rate cuts. But you can't have a financial system that's all government all the time. The Soviets and Communist Chinese tried that idea and it didn't work out so well. One scary scenario is that the stock markets might soon bubble up on a cushion of government interventions and become disconnected from economic reality. The disconnect with reality has happened in the recent past--in the real estate, mortgage, and derivatives markets. Re-connecting was painful. Let's hope that the stock markets' current frothiness isn't irrationally exuberant.

All of the economic news from last week went from bad to worse. The nation's slide into recession may be sharper than the stock market expects. Layoffs are increasing quickly. Consumption is falling as people are actually saving. This is really weird. When Americans start saving, you know times are tough. The full picture may not have shown up in current official statistics, but it would basically take the appearance of the Yeti on people's front lawns to get red-blooded Americans to save. But they are, and that means, aside from confirmation of the existence of the Yeti, that we're probably in for a full-bore recession, the kind where parking enforcement officers find deep in their hearts the compassion to overlook illegally parked cars with people sleeping in them, close to where the soup kitchens are located.

Why Stock Market Jumps Discourage Investing

On Tuesday, Oct. 28, 2008, the stock market jumped about 11% in a single trading session. Good news, yes?

Well, not necessarily. Let's say you had been watching the market fall for most of the preceding week, and decided after the 300 point drop in the Dow Jones Industrial Average on Monday (Oct. 27) to start buying stocks. Your buy orders would have been executed in a rising market on Tuesday. If you have tried to buy mutual fund shares, you would have paid the closing prices for Tuesday (which could have been around 11% higher than the prices you saw Monday evening). The big jump on Tuesday might have been very costly. Most years don't provide investors with an 11% return. Anyone buying stocks or stock-based mutual funds on Tuesday could have "lost" more than a year's gain.

Everyone understands how downward volatility in the stock markets discourages investors. Upward volatility also contains traps. To some degree, you might be able to lessen this risk by buying ETFs, which can be purchased at intraday prices. But in a highly volatile market, getting an ETF order executed at the price you see one moment may be difficult if the market moves abruptly the next moment (which, these days, can easily happen). Consumers would be discouraged if the price of lettuce could rise between the time you took it down from the display case to the time you brought to the cash register. Stock investors can similarly be discouraged by a divergence between the prices they see and the prices they pay.

Much of the volatility may be attributable to big players trading the entire market, using program trading or comparable derivatives contracts. This kind of trading can run right over individual investors (see our blog at http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html). There's actually quite a bit of liquidity sitting on the sidelines right now. But the volatility of the market will encourage it to stay on the sidelines. That isn't good. Without a significant inflow of liquidity, the market cannot truly recover.

No federal intervention or bailout can directly reduce stock market volatility. The volatility is a product of the uncertainties about the financial system and the economy, and these uncertainties abound. Perhaps the various federal measures aimed at helping an ever-increasing array of institutions, companies and individuals will eventually lead to calmer markets. Then, again, perhaps the large amounts of still unrecognized losses from the mortgage crisis and the slowing of the world economy will keep the markets jumpy. Until things calm down, though, don't expect a true market recovery.

Financial Projections for This Year and Next

Here are our predictions for the near and not so near term in the world of finance.

The Federal Reserve Board will lower interest rates this week. A half-point cut to a fed funds rate of 1% seems likely, and will very possibly be coordinated with interest rate cuts by the central banks of other major nations.

It won't make much difference. The financial markets will probably rally briefly on the interest rate cut(s). Then, the now familiar credit crisis malaise will settle back in, because interest rate cuts do little to restore confidence on the part of lenders. Banks are starting to lend to other banks again, only because banks have more or less been nationalized and the government will ensure that their debts are repaid. But banks are reluctant to lend to operating businesses in the real economy, because that involves actual risk. With the large amounts of mortgage-related losses that they probably still have to write off, banks would want to hold onto whatever capital they have to offset those write-offs. Making new loans is probably a lower priority than funding the company Christmas party.

Cash will be your new best friend for the next year or two or three. They that holdeth cash sleepeth well these days. That, by itself, makes saving worthwhile. In addition, cash can be used to buy stocks and real estate when they're cheap. Cash provides a buffer in case of job loss, illness or disability. The value of cash can be eroded by inflation, and the government isn't doing anything to combat inflation. The Fed's current anti-inflation policy is to hope that the economic slowdown will constrain price increases. That might work. But economic slowdowns and inflation aren't mutually exclusive. There was a time within living memory when seemingly normal men wore leisure suits and economic stagnation co-existed with nasty inflation. There have been some signs of leisure suits making a comeback. Let's hope that stagflation doesn't come along, too. Whether or not it does, cash has replaced the home equity loan as the latest measure of prosperity. Indeed, much of the purpose of the recent bailouts of banks, brokerage firms, and money market funds is to ensure that there are safe places to keep cash besides your mattress. The government will protect your cash even if it won't prop up your stock holdings or the value of your house.

Taxes will increase. Barack Obama has been pretty straightforward on this point. John McCain won't have much choice, with all the demands of the various federal bailouts along with the wars overseas. Fortunately for both candidates, the Bush 43 tax cuts expire soon, and whoever is the next President can monkey around with "extending" those cuts in ways that effectively raise taxes from current levels. Alternative minimum tax relief, which is needed every year, provides further opportunities for increasing the flow of dollars into the Treasury under the guise of giving taxpayers a break.

The recession will get worse before it gets better. At this point, only the most Panglossian of optimists (e.g., the members of the Board of Governors of the Federal Reserve System) don't see a stomach churner of a recession coming. The economic crisis has gone global. Nations from Iceland to the Ukraine to Pakistan to Hong Kong (which is part of China) are struggling. Even Kuwait, which by numerous measures is a wealthy place, has instituted bank deposit guarantees and bailed out a bank. There won't be any great safe haven overseas for your investment dollars. Even Switzerland, long time bastion of stability, recently infused capital into one of its major banks, UBS. Sovereign wealth funds won't be a source of succor, not with the price of oil falling by more than half in a couple of months. There are storm clouds in every direction and they all seem to be blowing toward us.

Eventually, things will get better. They always have, and that's a reason to think that they will again. Both the stock market and real estate market will find their way out of the abyss. But it's hard to see a quick recovery. Meanwhile, keep in mind the possibility of buying stocks and real estate when they are cheap. It's not clear that you should be buying now. Take your own counsel on that question. But buying low and selling high is probably a strategy you can implement beginning some time in the next year or two.

Reforming the Credit Rating Process

Recent news accounts report that employees at certain credit rating agencies sometimes knew that some of the deals they were evaluating were pigs without lipstick, and questioned the wisdom of rating them. The fact that the credit rating agencies are typically compensated by the issuers of the debt they are rating, instead of by investors, fuels concerns over potential conflicts of interest. Since many mortgage-backed securities that initially received AAA-quality ratings have since been downgraded for reasons that may have been foreseeable, the integrity of the credit rating process has become intensely important. This is particularly so since many institutional investors are required by law to rely on credit ratings with respect to some of the investments they can make.

Probably the greatest concern is the way the credit rating agencies are compensated. When you're paid by the person you're evaluating, how objective can you be? No matter how many rules and procedures are in place, will the credit rating agencies ever be willing to bite the hand that feeds them?

It would be much cleaner to have the rating agency funded by investors. There is a large community of institutional investors--mutual fund management companies, pension funds, university endowments, and so on--that has a powerful interest in disinterested and objective ratings. They also have the money to fund a nonprofit rating organization, and the market power to demand that issuers of debt agree to ratings by nonprofit rating agency.

An investor funded credit rating agency isn't as far fetched as it may sound. The credit rating process began with investors paying the fees, and it can return to that. In the consumer products arena, an independent nonprofit, Consumer Reports, stands as the most credible evaluator. Consumer Reports does not accept advertising from the companies whose products its evaluates, and it buys those products rather take free samples. By maintaining independence from manufacturers, its credibility is enhanced. If you want to find out how much pizazz a car has, you can read an ordinary car magazine. But if you want to find out the hard facts about how reliable a car is, you're better off reading Consumer Reports.

The established credit rating agencies are for profit organizations. Don't look for them to convert into nonprofit do-gooders. The buyside community (i.e., investors) will have to take the initiative to establish a new rating agency. Doing so may seem to involve a lot of work and expense. But, perhaps institutional investors could tally up their losses in the past couple of years from rated securities, and then they might see what's been truly expensive.