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Markets: Down Shift
New York: September 29, 2006
By John R. Stephenson

If you've been experiencing some sleepless nights lately, you're in good company. Every day seems to bring another American financial horror story, with each successive chapter more unbelievable than the past one. Markets have been swinging to and fro with each new revelation, bailout or bankruptcy. Then there's a complicated alphabet soup of acronyms to wade through, everything from CDOs, to swaps and shorts. So confusing is the jargon that seasoned experts are left tongue-tied and at a loss for an explanation. Capping it off is the bizarre spectacle of watching the Fed chairman and Treasury secretary from the world's largest economy begging the US Congress this past week for a massive bailout to save Wall Street from ruin. Yechhh! No wonder investors are scratching their heads and wondering what to do.

Was it greedy bankers or perhaps irresponsible lending, or maybe, foolish home buyers? That debate rages on while lawmakers discuss the merits of the biggest bailout of all time. With each passing day, the spectacle grows more bizarre and the pronouncements become more dire. According to some, nothing short of the survival of Wall Street and the American way of life is at stake.

For lawmakers, this political hot potato has landed in their laps in the midst of a presidential election campaign. They are trapped between a rock and a hard place. Do they ignore the predictions of experts and let the economy falter, possibly throwing thousands of their constituents out of work, or do they rush in with a massive bailout that could be seen by many as a helping hand to a bunch of multi-millionaires — the very same bunch who put America on this collision course?

Over the last decade, the financial industry grew large and profitable by riding an ever expanding wave of consumer credit. The financial industry grew to become one of the most dominant industries in the US and, at its height, it accounted for 22 percent of the country's gross domestic product. But the industry was more than dominant, it was also immensely profitable and was the envy of the world.

Today, the shining example of America's ingenuity is looking a little tarnished. Foreign investors have been abandoning the US credit markets as disaster after disaster has come to light. Once held up as shining examples of American ingenuity, the investment banking landscape has changed forever. Morgan, Merrill, Lehman, Goldman, AIG and Bear are either obliterated or forever changed. These giants were once a swaggering example of American strength, but now they are dependent on a government bailout for their survival.

Figure 1: Foreigners Have Been Yanking Their Cash from the US!

Source: Credit Suisse

But survive they will and so too will American capitalism. For sure, things will be different, but, at the end of the day, American lawmakers will have no choice but to bail out the US financial system. Credit is the lifeblood of the American economy and right now the patient needs a transfusion and fast. With a deteriorating economy and an unwillingness on the part of banks to lend to consumers and businesses, the grease that keeps the economy running is, at least temporarily — absent.

How did this all come to pass? What we are witnessing today is payback for years of excess on Wall Street. To hear the masters of the universe tell it, the whole thing was just an unfortunate happenstance. Sure, they have lots of equations and gobbledygook to explain why they thought it was a solid investment — but come on, isn't it reasonable to think that someone who lied about their assets, put no money down to buy a house and just lost their job was going to walk away from a mortgage in which they didn't have a stake? Of course it is!

The financial Frankstein created by Wall Street investment banks made perfect sense in the lab. The idea that investment bankers created and sold around the world was to bundle up debt and sell various pieces of it to willing buyers. The more debt that was out there and the more ways it could be sliced and diced, they argued, the better! For a while, the bankers had their day, as things worked like a charm. There were plenty of pension funds, hedge funds, as well as, commercial and investment banks lining up to buy these products.

Consumers also lined up to get some easy money in the form of cheap and readily available credit. Credit cards, mortgages and car loans were pretty much available to anyone — just for the asking. The more consumers bought on credit and the more products the bankers could create, the more money they could make for themselves.

The same was true for businesses who had plenty of money thrown their way. With the world awash in cheap money, real estate, as well as other corporations, could be had, just for the asking. Not only that, but these new products were safe — or so Wall Street claimed — because investors world-wide were lapping up U.S. financial products, thus spreading the risks far and wide.

But the experiment went horribly wrong. Many of these products were based on the value of residential real estate, which the experts predicted would keep on rising. Unfortunately, they were wrong. According to the S&P Case Shiller home index, the average house price in the top twenty American cities is down 15% — oops.

Making matters worse is that the same financial folks who created, sold, bought and traded these securities didn't understand them. Sure, they all claimed to, but when it came right down to it, the much-vaunted risk management practices were, for all intents purposes, missing on the street. All Wall Street seemed to care about was profits, profits and more profits plus the hefty bonuses that went along with those profits.

With a slowing economy, house prices in the US started to fall. Banks began to fail, as the chickens came home to roost. Uncertain about their own financial house, banks have been unwilling or, in some cases, unable to lend to one another, as well as to businesses and consumers. And that's a big problem.

Figure 2: Banks Have Been Unwilling to Lend

Source: Credit Suisse

With credit evaporating, as banks fight for their survival, the once unbridled spending of the US consumer is slowing. Reeling from tumbling real estate and stock prices, not to mention a soft economy and job market, the engine that drives US and global growth is sputtering.

The consumer is not the only one feeling the sting, as the credit crisis late last week claimed Washington Mutual Inc., the biggest bank failure in US history, as the latest victim in this unfolding saga. Businesses are struggling along with consumers to get credit as short-term interest rates have seized up as interest rates have soared.

While it appears that US consumers have downshifted their spending, a complete slowdown in consumption could be catastrophic for the economy. The US consumer accounts for two-thirds of US economic activity and a big proportion of world GDP. Keeping the US consumer spending is a key consideration for US lawmakers as they mull over the bailout package.

If the $700 billion bailout package isn't passed, a dysfunctional financial system could get a whole lot worse. If that were the case, an already cash register-shy consumer might really begin to roll over making the American economic slowdown a lot worse.

At stake is a confidence building move aimed at removing the most toxic securities from the balance sheets of American financial companies and warehousing them in a government fund. The idea is that by removing the worst of the worst and infusing capital directly into the balance sheets of these institutions the US financial system can once again begin extending credit. If that were to happen, businesses and consumers would once again have much-needed access to credit, a vital lifeline that allows them to grow and expand economically.

And so the world waits. At stake is the economic leadership role that the world's largest economy can provide. Already the credit crunch is causing growth in mortgages and car loans to stagnate, and could easily start declining — a first since 1992.

If and when the proposed bailout package passes into law, look for a strong relief rally followed by some more market weakness. In the meantime, your survival guide is to think about great defense. That means, keeping plenty of cash at the ready and think about adding to your gold and agricultural names on weakness. If this plan goes forward, and it likely will, the cost will be absorbed by the American taxpayer. That will be perceived as a negative by the stock market for the US dollar which will likely sell off in the ensuing months.

Making things even more interesting is the fact that, all of sudden, some of our favorite names have gotten a whole lot more attractive lately. Great fortunes, such as the one that Warren Buffett was able to amass, have occurred by buying when stocks were out of favor and the world appeared to be ending.

Right now, opportunity is knocking at the door. Risk is right alongside opportunity, but by being careful and buying only high-quality stocks with solid fundamentals, you can go a long way to positioning your portfolio for the substantial opportunities that lie ahead.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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