Bailout, Recession, Depression.....Oh My!

So now it's done...finally. The $700 billion bailout package in the USA is done. It went from a three page document to over 100 pages but at least it's in place. Will it work? The jury is still out on that. As I have written in previous articles, it will take some time to see if it was enough. Hopefully, it will start to put some confidence back into the credit market. In case you haven't followed the details, this package has a few interesting wrinkles.


First, the package comes in three stages. The first releases $250 billion to purchase debt securities that have no market. It covers mortgages, credit card debt and auto loan, to mention a few items. The second stage is a second $100 billion that can be authorized by the President. The third stage of $350 billion must be authorized by congress.

Secondly, any financial institution using these funds must issue stock warrants to the government. Warrants are a financial item that allows an investor to purchase shares at a fixed price in a future period. The idea is that if the financial institution makes money by shedding their bad loans, the US government will be able to make some money on their shares.

A third provision raises the FDIC deposit guarantee from $100,000 to $250,000 as a temporary measure until December 31, 2009. This is designed to assure depositors that their fund are guaranteed to help forestall a run on a bank.

There are many, many more items in this bill but these three items are the meat of it, in my opinion. Is this enough to stop the slide? By itself, no. But that is not all that is happening. Around the world, national banks are moving in to make sure that there is enough money to stop banks from failing. The US has also announced a measure that will help businesses acquire short term loans to cover their operating costs, when they are having a problem getting the funds from their banks. I am sure that there will be more to come to stay tuned to this.



Are We Going Into Recession?

Probably. At least, we are having a big economic slowdown. Until confidence is restored, the domino will continue to fall. But over the years, national economies have learned much from previous tough economic time and we may weather this one better than others. Recessions are a fact of the economy. We've had them before and we will have them again. Governments can only do so much. No nation is big enough to rule world commerce. So until the lemmings stop jumping off of the cliff, we are going to have problems. As I have said before, it's all about confidence.


Are We Going To Have A Depression?

I doubt it. That being said, there are a lot of things conspiring together to raise concern. The subprime mortgage crisis, the rising cost of oil and the world food shortage are merging together and could create the perfect storm. Let's hope that we can head this one off at the pass.


So Now What?

Now, we wait. For the small investor, I would suggest that you look at your portfolio, dump the dogs, hold the quality stocks and keep an eye out for bargains. There are a lot of undervalued stocks of quality out there right now. Keep your eyes open.

If you are just trying to keep your head above water, try keeping your debt load low. Right now, interest rates are low but a little bird told me that they may be going up again. The last thing you need in a tough economy is larger debt payments.

If you are a homeowner, don't sell unless you have to. The inventory of unsold real estate is driving prices down and probably will for the foreseeable future. If you have a low rate mortgage, if could be time to lock in.

And as I have mentioned before, become a valuable person at your place of work. If downsizing happens, you want to be one of the people left standing. Try doing a bit extra at your job and perhaps show your boss that you have skills in other areas as well as being very good at what you do. If you are a small business person, start a campaign to keep in touch with your existing customers as well as attracting new ones. It is far cheaper to keep an existing customer than find a new one. Keep close touch with your financial statements and watch for unusual increases in costs or drop in revenue. Finding problems fast will allow you the time to fix the problem before it overwhelms you.

For My Canadians Clients and Friends

No matter what you hear during the current election campaign, Canada is not having the same problems as the USA. We don't have a subprime mortgage crisis, our housing market is not in free fall and the Canadian banking system is strong and sound. Beware of politicians doing their Chicken Little impersonation, screaming the sky is falling and yelling "FIRE!!" in a crowded theatre. This is not the time to panic. Yes, we have a problem. Yes, we need to be vigilant. But please, don't let the economic problems become a self-fulfilling prophecy. Canada is a small nation in a big world and we can't change the habits or actions of other countries. Our fundamentals are sound and we are in better shape to take a hit then most. Shoveling money off the back of the truck is not the way to solve this problem.

Credit Crunch: It's Not Just For Breakfast Anymore!

In my last article, I discussed the subprime mortgage problem and how we got into this global credit mess. And now that we are actually here, let's examine what governments are trying to do about it, whether it will work and what might happen if it doesn't. I know, this is all very depressing but knowledge is power so you should know what is happening.

A Crisis of Confidence

First, credit is all about confidence. People and businesses loan money if they believe that they are going to get paid back. You must have confidence that the borrower has the ability to repay the loan. And here lies the root of the problem. The banks have been badly burned with their mortgage loans. They are owed large amounts of money. They also own large amounts of assets that are decreasing in value very quickly...ie. houses they can't sell.  Banks have not only stopped or reduced lending to businesses and individuals, they have also stopped lending to each other. 

Traditionally, when a bank has their cash tied up in loans, they have more value in their assets than in the loan. Also, they are usually getting cash by way of their mortgage payments. When a bank is short of cash to loan out or meet their current obligations, they will borrow the money from a bank than has cash available. Investment banks on Wall Street, such as Lehman Brothers, Bear Sterns, etc., often fill this roll, either loaning the money to the bank, buying the assets from the bank or even buying the loans. Right now, this is not happening. At least, not happening as much as is needed to keep the system functioning smoothly. The system has lost confidence due to the large amount of bad mortgage loans.

Even banks that are in good shape are afraid to loan out their money. They have lost confidence in the ability of the borrower to pay them back. The system is structured that when this happens, a chain reaction follows:

1. A business can not get a loan
2. The business can't pay their suppliers or employees
3. To reduce costs, employees are laid off.
   
4. The supplier doesn't get paid so they can't pay their employees.
5. People without jobs can't buy goods and services.
6. Businesses don't sell good and services, so they go out of business.
7. More people are without jobs and can't pay their bills.
8. Businesses that have failed and people without jobs don't pay taxes.
9. Public service employees are laid off. Government projects are put on hold.
10. More people lose jobs and more businesses fail.

Recession,  Depression and The Bailout

This is how an economy get into recession and eventually, depression. Governments right now are desperately try to stop this before the dominoes start to fall. In Europe, governments have been nationalizing banks and financial institutions, trying to stop failing institutions  from causing a ripple effect. The USA has done the same thing with Freddie Mac and Fanny Mae, that nation's two largest guarantors of mortgages. And then there the big $700 billion bail out in front of the US Congress right now. The idea is that these funds will be used to "buy up" the bad debt so that banks will again start lending money to each other.  

At this writing, the first congressional vote on this package had failed. The main reason for this is political. Members of congress have been getting an earful from the voters. There is a theory out there that many congressmen believed that they had to vote against the package so that their constituents would see what would happen. What happened was the stock market had one on its biggest one day falls in history. I, for one, believe that some kind of package will go through, probably this week.

Naturally, the question is, will it work? That will remain to be seen. The other question would be, is it enough? Probably not, but it might be enough to put confidence back into the system and oil up the credit system gears. Let's all hope so because this is as much about Main Street as Wall Street. Who caused it and why it happened are questions for a later date. When the house is on fire, you put the fire out before you try to find out why it happened.

In his work, "A Life of Reason", George Santayana wrote, "Those who cannot learn from history are doomed to repeat it". This is what appears to be at work here. At the beginning of the Great Depression of the 1930's, the stock market crashed in 1929, ruining the fortunes and lives of many individuals and businesses. One of the main reasons attributed to this was that too many people were into the market on margin, or credit. Many assumed that the market would keep rising forever. They would buy stock on credit and after it went up, they would sell their stock, pay off the broker and pocket the profit. Due to problems in the economy of those days, the market began to go down and people panicked, selling off their shares to pay the debt. That caused the market to fall even faster and the prices crashed. Replace the words, "stock market", with "real estate market", and your can see the similarities.
 

So Now What?

For the time being, there is not much to do but watch, and watch carefully. Sudden moves right now, before the current scenario has played out, could be disastrous for the small investor. One provision of the US bailout package appears to be an increase in the FDIC limit from $100,000 to $250,000. This means that bank deposits are guaranteed by the US federal government to $250,000. Hopefully, this may cool the idea of everyone pulling their money out of their bank. That would make the problem even greater. So for now, here are three things I would suggest:

1. Keep your self as liquid as possible. Right now, cash is king. But if you own stock in major corporations and they have sunk like a rock, don't sell out too quickly.
2. Don't move. If you can, stay in your happy home. This is not a great time to sell. 
3. Stay out of real estate for now. I doubt that prices have bottomed out. However, if you can afford it, there are bargains to be had. But don't do it with big debt.
4. Be indispensable at work. Try and be the last person standing if your company is downsizing. Try and have more than one skill that your company can use.

One final note. We will be writing more articles on this and other financial subjects in the near future and if you like what you read, I would suggest that you subscribe to this blog. You can do this two way. If you are into RSS and have a reader, look on the right side of the page to subscribe. If you prefer, you can subscribe by email. Just put your email address in the box shown on the right side of the page and click on "Subscribe me!". Be assured that your email will remain confidential and not available to anyone else.