The "Bailout Plan" was passed. Will it work? The answer depends
on what your definition of "work" is. If by work you mean no
more government intervention and no further costly programs and
a functioning market, then the answer is no. But there are
things it will do. This week I try to help you see what might
lie ahead around the Curve in the Road. We look at how the
rescue plan will function, see what is happening in the
economy, and finally muse as to whether Muddle Through is
really in our future. It will make for an interesting, if not
very upbeat, letter, so strap in. I would like your promise to
not shoot the messenger. I am just trying to give you some of
my thoughts as to what may lie in our future. And remember, as
you read this, we will get through it. There are better days
But first, a few housekeeping items. Let me welcome some
200,000 new readers from EQUITIES Magazine. I have recently
joined EQUITIES Magazine as a regular contributing editor. My
column, Back to the Frontline, is featured in both their print
publication and at equitiesmagazine.com. I am excited to be
associated with this esteemed magazine with a rich history
covering the global markets for over 57 years.
They've once again agreed to offer any reader of mine a free
subscription to EQUITIES Magazine. For those who did not take
advantage of the free subscription the first time, here is your
chance. You can go to http://www.equitiesmagazine.com/mwi
and simply register to get the magazine sent to your home or
office. There is also a link to an interview I did in April
with them. They have a lot of content and free resources like
"live" real-time stock quotes and "live" real-time portfolio
managers. Check it out!
Second, a quick commercial. There are managers who are
successfully navigating these markets. If you would like to
learn more about who they are and how you can put them to work
for you, my partners would be delighted to introduce them to
you. If you are an accredited investor (generally, net worth of
more than $1.5 million), please go to www.accreditedinvestor.ws,
register there, and my partners in the US (Altegris
Investments) or London (Absolute Return Partners) will show you
various alternative investments like hedge funds and commodity
funds which might help diversify your portfolio. You really
should see what is available behind curtain #3.
And for those with not quite that amount of net worth, I work
with CMG in Philadelphia. They have developed a platform of
money managers who can take direct accounts, and I recommend
that readers interested in outside money management take a look
at them. If you would like to talk with Steve Blumenthal and
his team about the managers on the platform, simply click on
the following link, fill out the form, and they will call you.
(In this regard I am president and a registered representative
of Millennium Wave Securities, LLC, member FINRA. And please
read all the risk disclosures.) And now, let's jump in to the
The Curve in the Road
When you are out driving on a strange new road, you can't see
around the curve ahead. But you can read the warning signs to
get an idea of what might be coming. And while we can't really
know how the developments in the economic world will actually
unfold, there are some signs we can point to that might give us
a few ideas.
First, let's look at the "rescue plan" as passed by Congress.
As I pointed out last week, this is a bad bill. But it was
necessary to pass something, and soon. Earlier this week I sent
out a report that reviewed a study of 42 major baking crises.
The conclusion: navigating them successfully depended upon
As everyone should know, the credit markets are almost
completely frozen. LIBOR is bid only, no offers. Commercial
paper markets are imploding. And what is trading is often at
rates that are much higher than they were a few months ago.
Corporations are being strangled on high rates. Corporations
have little or no access to normal credit markets, and they
will face massive problems when it comes time for them to roll
over short-term debt.
LIBOR has gone crazy. This is not an orderly market.
Look at the following chart from friend Greg Weldon. For most
readers, the commercial paper market is something you don't
think about. But it is the lifeblood of business. We have seen
this market drop by almost 30% in a year and by 10% in just the
last three weeks! I simply cannot overstate how serious this
is. Left unchecked, business activity in the US would soon slow
enough to bring thoughts of the Great Depression. It will not
be left unchecked.
The credit crisis is not simply a Wall Street issue. It has
fast become a Main Street issue. And Main Street is where jobs
are created and maintained.
As I have said repeatedly for months, the problem is that
financial institutions are having to deleverage. They have
massive losses and simply have to raise capital in order to
survive. If you can't raise equity capital (and most can't),
one of the ways you do that is to make fewer loans and to take
less risk. You also charge more for the loans you do make.
Larger institutions cannot raise capital on competitive terms.
GE is an AAA-rated company. Yet they had to pay Warren Buffett
10% to get $5 billion, plus in-the-money warrants worth at
least another 10%. Buffett is likely to double his money on
this deal over 4-5 years. A short while ago, GE could get
short-term commercial paper for a few percentage points. That
difference is going to significantly impact GE's bottom line.
But they had no real choice. They took the money.
As did Goldman Sachs. Yet another Buffett $5 billion
preferred-share purchase (with more warrants) at a rate that
even Goldman will find it hard to make money on. But they had
to raise capital quickly, and they had little choice.
I had lunch with Michael Lewitt and Joe Harch yesterday. They
were in town to meet with a client, and we took the opportunity
to get together and share notes. They run (among other things)
a collateralized loan obligation fund. They buy bank and
corporate debt. They now have the opportunity buy
well-collateralized loans from rated companies at prices well
below par. They related story after story of debt from quality,
highly rated companies selling below $.90 on the dollar, and
some much lower.
If GE and Goldman are paying 10%, what do you think it costs a
firm with "only" a B rating? 15%? More? Junk bond yields have
simply gone ballistic. Firms which used the credit market to
access capital now are simply shut out. If they are a small
public company, they can go to what are known as PIPE hedge
funds (Private Investment in Public Equity) and sell equity at
usurious rates (which is what Buffett does but on a larger
scale). But a small or medium-sized private company? It is a
hard time to go looking for money.
Left alone for the markets to work out, the economy of the US
and the world would be in a depression within two quarters and
would need years to recover. Think Japan.
Necessary but Not Sufficient
Now for the bad news. The Rescue Plan was necessary but not
sufficient to fix the crisis. There is going to have to be more
heavy lifting, I am afraid. Let me offer a few ideas about what
possible actions might be taken in the future. I am not
advocating these actions, I am simply telling you what might
happen. These are possible, because authorities will do
whatever they deem necessary to avoid a systemic economic
meltdown and a potential depression.
If you are a large investor or sovereign wealth fund which put
money into banks last year, you are down anywhere from 35-50%
(unless you invested in Washington Mutual, and then you are
down 100%). You are unlikely to invest more in any financial
institution without some very real understanding of what is on
the balance sheet of the bank that is asking for your money.
What the Paulson plan potentially does do is remove the
questionable debt. The bank may have to write down assets in
order to sell the debt to the government, but they end up with
a transparent balance sheet with hopefully known risks. Then
they can go to the market and try and raise capital.
Shareholders will get diluted. Such is the way of the world.
Sidebar: taxpayers really must demand that someone like Bill
Gross of PIMCO and/or other savvy market specialists run this
new government operation. He offered to do it, and I think we
should take him up on his offer. Taxpayer losses should be kept
to a minimum, and I believe someone like Gross would do his
best to see that would be the case. The point of this exercise
is to restart the frozen credit markets, NOT to bail out banks.
Some banks may get bailed out in the process, but it should be
at a cost to their shareholders and management, not to the
I am asked, why can't private money solve the problem? Because
there is simply not enough private money. Buffett offered to
take 1% of the new government pool. If that is all the largest
pile of free money in the world can take, why does anyone think
there is enough private capital to take the other 99%? Insuring
the mortgage bonds is not sufficient, because there is not
enough money to buy them in this market. When things have
sorted themselves out in a few years, I think the bonds can be
insured and sold, and likely at a profit if bought correctly.
But we do not have the luxury of waiting a few years.
Between the relaxation of the mark-to-market rules and removing
ambiguously priced loans from financial institutions at prices
which allow the government pool to make a small profit, if held
for five years, that part (the lack of a known price) of the
problem can be solved. Banks can hopefully buy themselves time
in which to work their way out of the problems they created.
It is much like 1982, when every major US bank thought it was a
good idea to loan lots of money to Latin American countries. It
was a most profitable business, right up until the countries
decided to default. Then every US bank was more than just
technically bankrupt. In a mark-to-market world, every large US
bank would have collapsed. It would have been the end of the
world as we knew it.
What did they do? The Fed let the banks keep the loans on their
books at face value. Over time, they worked their way through
the debt, making enough money to be able to write down the
loans. That was done simply to give the banks the ability to
We are in a very similar situation. We have to buy some time in
order for financial institutions to heal.
Why the Government Had to Step In
I had a lot of readers write me very nice letters this week,
starting out with how much they like my letter, my insights,
etc. Then they (mostly - but not all - and politely) launched
on me for backing the rescue plan. Many of you had much better
ideas than what was passed by Congress, which is not
I really do hate the idea of having to support a rescue plan.
It goes against my every instinct. But I also know that doing
nothing would result in an economy which would blow right
through 10% unemployment within a few quarters, and take years
to recover. The stock markets and the savings of millions of
retirees would be wiped out. Home values would really go into a
tailspin. Being right in theory is not worth seeing that kind
Herbert Hoover sat by and decided to let the market solve the
problems of 1929. He decided to run budget surpluses and ignore
collapsing institutions. Combined with disastrous Federal
Reserve policy (raising rates in a recession) and Smoot Hawley
(which caused major trade wars and a slowdown in global trade),
what should have been a serious recession turned into the Great
Depression and resulted in the conditions for World War II.
The rescue plan does not address the need for the increased
levels of capital needed by banks. As noted above, it simply
creates the conditions under which capital might be raised.
Banks have already raised $440 billion. They have written down
$590 billion. Losses are estimated from a mere $1 trillion to
as much as $2 trillion. About half of those losses would be in
banking institutions worldwide. That means anywhere from $200
to $400 billion more must be raised in order for banks to get
back to capital adequacy. It is probably closer to the latter
Until banks are adequately capitalized, they are not going to
be able to do normal business lending. Further, large deposits
are fleeing banks. Even with the new level of $250,000 of FDIC
insurance, there is $1.9 trillion in uninsured deposits. These
are mostly deposits of small to large businesses and financial
institutions, which can leave a bank at the push of a button.
Nouriel Roubini tells us that there are 800 billion dollars
deposited in US banks by foreign counterparties. Up until this
week, if you were a foreign operation, would you rather be in
large money-center US banks or European banks? Tough choice,
but on balance you would pick the US. Then this week Ireland
decided to simply insure every deposit in Irish banks, no
matter the size. Predictably, money started flowing from all
over Europe into Ireland. National banks and finance ministers
are furious with Ireland.
However, Ireland may have no choice but to backstop its own
depository institutions to keep them from losing deposits and
becoming insolvent from a bank run by corporations acting in
their own best interests. Belgium, The Netherlands, and
Luxembourg each took 49% of their respective parts of Fortis
Bank in return for a massive injection of capital, declaring
the bank too big to fail - also wiping out a lot of already
diminished shareholder equity. Europe has its own quite serious
But what if the various countries, one by one, decide to
guarantee deposits in order to protect their own banks? If you
are an international corporation, especially if you are outside
the US, do you want your $10 million in Europe or the US if
Europe guarantees your deposits with no limit? Could we see
silent runs on US banks?
I think it is about an even chance that the government will
have to guarantee for a period of time (say 6 months to a year)
every bank deposit, regardless of size, in the US.
That is a staggering thought. The potential will be large for
almost-insolvent banks to pursue risky behavior to try and work
their way through problems. If such a policy is pursued, tight
controls must be administered so risky banks do not offer high
CD rates in order to garner assets. The FDIC must closely
monitor such activity. Perhaps such guarantees should be for
existing depositors and not new customers. Insolvent banks and
those on the edge must be shut down quickly in such an event,
to prevent risky behavior.
Unthinkable? I bet you there is a working committee of
government and Fed officials thinking about just that very
thing and how to do it. It would be even more scary if there is
not one. We are in completely uncharted waters, and every
contingency needs to be thought through well in advance. We
simply don't need more last-minute Paulson plans.
In the next few weeks and months, I think you can count on more
extraordinary actions by the Fed and Treasury to try and
jump-start the credit markets. Actions which were highly
improbable a few months ago will be on the table. Will the Fed
open its balance sheet to non-banks? Possibly. If they can
guarantee money markets, will there be a scheme to insure
commercial paper at some price? Not out of the question. Will
European governments take more equity in large European banks?
Very likely. Will the Fed and/or the Treasury invest even more
capital in larger financial institutions? Given that We the
People now own 80% of AIG and 100% of Fannie and Freddie, it is
certainly within the realm of possibility that we will be the
proud owners of even more private institutions.
Again, this is not just a US issue. We will likely see similar
actions in Europe and some of the developing world. This is a
worldwide crisis, and the response will be from central banks
all over the world.
Understand, I am not advocating these actions. I am simply
trying to help you understand what actions might be put into
place by the various government of the world in an effort to
avoid systemic economic collapse.
All The King's Horses
The reality is that the rescue plan does not fundamentally
alter the US economic landscape. There can be no doubt we are
in a recession. I think it will be dated from the beginning of
the year, notwithstanding the odd 2nd quarter
growth. The manufacturing ISM was a dismal 43.5 (under 50 means
a contracting US manufacturing industry). Such a level is
typically associated with recessions, as the chart below shows.
Given the financial crisis and the freefall in auto sales, this
index is likely to fall further.
The "good news" is that the service portion of the economy is
right at 50, which means that at least that important area is
Unemployment rose by 159,000, with nearly every sector
affected. Almost 1,000,000 jobs have disappeared over the last
12 months, and it is likely that we will lose another 1,000,000
jobs in the coming year. Since December, the ranks of the
unemployed have grown by 1.8 million, and those not in the
labor force but wanting a job by 370,000. Almost 3/4 of the
increase in the unemployed have been job losers, with half the
increase from permanent job losers (not temporary layoffs).
(The Liscio Report)
Next week we will explore the economic landscape in detail, but
let me provide a few thoughts. As I have said for a long time,
we will be talking about deflation this time next year.
Recessions are by definition deflationary events. Given that we
have had two bubbles burst (housing and credit), there is even
more potential for deflationary pressures. Add into the mix the
deleveraging process, which will take years to finally abate,
and the recent bout of price inflation caused by energy and
food will pass, as demand destruction for oil will hold oil
prices in check.
As I have said for a long time, the next move of the Fed is
likely to be a cut. We are now close to such an action. A 1%
Fed funds rate is again a real possibility. I am not sure it
will help as much as some market participants think, but I
think it likely the Fed will move before the end of the year,
if not much sooner.
Europe and Japan are also probably in recession, and it is
likely we are going to see a worldwide global slowdown. It
would be nice if the European Central Bank, the Bank of
England, and the Fed could coordinate a joint rate cut to
signal that they are working together on the problems. I would
not want to be short the markets that day.
At the beginning of the year, I was predicting a small
recession with a lengthy and slow recovery period. I now think
that the recession could be deeper than a 1% contraction. I
think we could see a rather lengthy recession. Quite simply,
the credit crisis has been allowed to spin out of control. That
Congress almost failed to act is beyond belief. Given the above
circumstances, it is not out of the realm of possibility that a
recession lasts through the middle of 2009. As recessions go,
that is a long time. But trust me on this, it will pass. The
recovery will be a slow Muddle Through affair, though. It will
be a few years before we are growing at a sustained 3%. Over
the next few weeks, we will look at what that means for
earnings and the stock markets. Investors who utilize a
traditional 60% stocks, 40% bonds portfolio are not going to be
pleased. We will look at alternatives.
How Can I Be 59?
This has been a particularly hard letter to write, as I know it
is rather gloomy, and I wish had more encouraging news. I have
been writing this letter for over eight years. Every letter
since the beginning of 2001 is in the archives, so my record is
open for inspection. I have no particular axe to grind. Since I
basically help investors (in conjunction with my partners) find
investment managers and funds, we can adjust the choice of
funds and management ideas to suit the times, and frequently do
make changes in the mix. My goal in this letter is to help us
all think about the economy and our investments and to be as
"right" as I possibly can. Sometimes, like today, that means
not being very upbeat. But it also means looking for ways to go
with the tide rather than against it. I actually hope I am
wrong and the bulls are right. But that is not the way I see it
Tomorrow is my birthday. The years seem to roll by at an ever
accelerating pace. (I had the reason this happens explained to
me once. When you are 10, a year is 10% of your life. When you
are (sigh) 59, it is 1.6% of your life. It makes some sense.)
It is hard to believe I am 59. Maybe it is because I am around
my kids so much, but I don't feel that old. Seven kids from 31
to 14 (plus assorted spouses and their friends) can do that.
And they are all coming to town to celebrate next weekend, so
tomorrow will be a quiet day. And Tiffani is already planning
for a serious 60th birthday weekend next year.
Life has been good to me, for all its ups and downs. And I
firmly believe that my best years are ahead of me. I am simply
having more fun than at any time in my life, with more
opportunities than I know what to do with. I am blessed with
great business partners. I have the best readers of any analyst
anywhere. One million closest friends. I am truly one of the
world's wealthiest men when it comes to friends and family, and
at the end of the day that is what counts.
Thanks for being part of my life. I plan on writing for a long
time, so take care of yourself so you can keep reading. And
have a great week!
Your actually optimistic analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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