In what can only be described as a shocking turn of events, the House failed to pass the Emergency Economic Stabilization Act (EESA). This, in turn, caused the Dow Jones Industrial Average to drop over 777 points. Equity markets around the world have responded with similar disdain.

  

 

A financial backstop of some sort will most likely be necessary to maintain stability in the financial markets. Without it, the financial markets may continue to refuse credit to even the most capable of borrowers, be that business owners, farmers, cities, or consumers. We have spoken with a number of people that are closely connected to this situation, and they have informed us that they believe that most people in the House and the Senate understand why this type of legislation is necessary to protect the financial system. Therefore, we think there is a strong probability that this legislation, or some other form of it, will pass in the near future.

 

If this legislation is passed, it will likely restore some level of confidence and reduce uncertainty by infusing badly needed “new” capital into the banking system’s balance sheet. Banks have been reluctant to lend, even to each other, due to a basic mistrust of what others may have on their balance sheet. Cleaning up balance sheets is necessary to build trust back into the system. The government’s purchases of these securities may restore some form of trading in the mortgage backed securities market, and thereby the values of these securities on all bank balance sheets will become more transparent and trustworthy. Once this stability and confidence is returned to the market, this may encourage opportunistic investors (who are currently sitting on the sidelines with lots of cash) to provide much needed capital.

 

Of course, if the EESA is not enacted, or its ultimate enactment is delayed too long, the credit contraction will continue, and growth within the global economies will also be impacted further. Europe and Japan are already slowing. Policy mistakes, in our country and in others, could have severe consequences. Many have looked to the Japanese Banking crisis as a roadmap of how NOT to deal with a banking crisis. There were many missteps along the way (including, public opposition to using government funds to “bail out the banks”). After a severe recession and stock market declines, the government ultimately injected capital to major banks, followed by stronger regulation. At this point, some argue that the U.S. is already ahead of the curve. According to Goldman Sachs, at least 311 financial institutions, large and small, have already failed. Fannie Mae and Freddie Mac have been nationalized, Lehman went bankrupt, and a number of larger banks have been folded into stronger institutions (including the wipeout of the equity holders). The U.S. has always been willing to deal swiftly and responsively to crisis.

 

At this point, economic activity is undoubtedly slowing, and there will likely be additional bankruptcies in the future (including more financial institutions). GDP may have contracted in the 3rd quarter, and some are predicting a further contraction for another 1-2 quarters. If some sort of backstop is not provided through this legislation (or others), economic activity may continue to suffer as banks continue to be reluctant to lend.

 

There is a significant amount of news discussing how this could turn into another Great Depression. Undoubtedly, if you unwind this scenario to its worst case, with asset prices continuing to decrease against a large amount of debt (for both the banks and the consumer), you can picture some dire consequences. If we look at the major policy mistakes that were made during the 1930s, we see a very different backdrop than today. By comparison, there was a very tight monetary policy versus today’s easy monetary policy, adherence to the gold standard versus a free floating U.S. dollar today, protectionist tariffs versus a more global trade situation today, and liquidations of significant amounts of government owned assets versus the current buying that the Fed and Treasury have been doing. Of course, during the 1930s, the situation was as dynamic as it is now, and many of the decisions were made with the best of intentions. There is a possibility that the government will make policy mistakes that could lead to further decay of the system.

 

When helping clients decide on a long term investment policy, we review the probable outcomes of many scenarios. A review of the probable outcomes facing us leads us to conclude that there is a higher likelihood of success for the U.S. and World economic environment than ongoing economic contraction. It also leads us to conclude that the passing of some form of the EESA legislation has a higher probability of occurring than not occurring. If the legislation passes, there will likely be a significant upside market reaction. Additional stability in the system may allow stocks and bonds to begin trading based on their long term fundamentals. There will be an incredible amount of volatility in the market until these uncertainties are better known. As always, having an appropriate investment policy and ample liquidity to meet spending needs can provide peace of mind during periods of market duress.