How to Bail Out Main Street....

[audreyh1]

It seems to me that a "credit crunch" should hit the heavy borrowers first. We should be hearing today about companies with fine sales and healthy profit histories who have to lay off workers simply because they can't get loans renewed. This should be happening months, even a year, before the "average" companies are impacted. When those stories add up, and someone with credibility can show that we've got a million unemployed (less than 1% of the labor force) just because their healthy employers can't get loans, then Joe Sixpack will conclude that his job is at risk due to credit problems.

Actually, we are starting to hear those stories of businesses who will not get renewal on loans or are unable to execute on plans due to the credit crisis. I expect these stories to become more and more prevalent as the credit crisis extends. I'm concerned about the snowball effect and resulting panic that cause things to happen much more quickly than anyone expects or is prepared for.

I honestly can't say whether the government action at this point will avert this credit crisis or help improve the situation significantly. I'm stuck on the point of who is willing to lend and what is the most direct way to avert the credit crisis for main street. Seems like right now only the US government is willing to lend.

Audrey

 

[Gone4Good]

It seems to me that a "credit crunch" should hit the heavy borrowers first.

Ironically this may not be exactly the way the story unfolds. Heavy borrowers (junk credits) tend to plan their liquidity needs very deliberately because access to capital is always uncertain for them. Strong companies, however, take their liquidity much more for granted because they "always" have access. In a systematic failure of the credit markets you could actually see large, financially strong companies hit first because they run their finances very lean (holding cash on the balance sheet is considered wasteful). It's possible you could see disruptions in just-in-time inventory deliveries that result in plant shut downs, defaults on short-term borrowings, missed payroll etc. for large name brand companies that are otherwise financially healthy. One might argue that a sudden elimination of credit would hit the most efficient companies first.

 

[audreyh1]

...Yrs to Go - that is exactly one of my concerns. This recent hard credit freeze is a sudden business environment change for American business. A very well run company may suddenly be facing an abrupt withdrawal or shrinkage of a credit line. Up until now they have never had do deal with such a problem - or at least it hasn't been so drastic. It's so sudden that backup plans were not made. Now they are in crisis management mode themselves and have to take some drastic (non-optimal) actions.

Audrey

 

[Gone4Good]

A very well run company may suddenly be facing an abrupt withdrawal or shrinkage of a credit line. Up until now they have never had do deal with such a problem - or at least it hasn't been so drastic.

This is clearly part of the fear. Simply put, we don't know how this will flow through the system. But here is one possible example . . .

Ordinarily a financially strong company has plenty of options if something bad happens . . . If they get forced out of the CP market they draw on their revolving credit facilities. If the R/C's are unavailable they can try to arrange secured bank financing. If the banks won't lend they can try to go to the private placement market where people like Buffett and KKR are usually more then willing to invest on a secured basis at usurious rates while taking some equity upside . . . but all of these sources of capital are getting tapped out.

So what does an otherwise strong firm do if none of those sources of funds are available? They start rationing their liquidity . . . they probably suspend the dividend, they might stop paying principal & interest on their bonds while asking lenders for "forebearance", they might shut down operations at some of their more marginal plants or operations to conserve cash, they might delay paying vendors or even employees, etc. etc.

So now vendors are getting squeezed, maybe employees too. Some business operations are shut down, which is going to hurt local economic demand for the other buisnesses in the region that are still running. Equity and fixed income investors run for the exits because they're not getting paid, which further constrains available liquidity.

All of this feeds on itself in a vicious cycle of tighter liquidity, reduced output and reduced demand.

Multiply this a thousand times accross the economy and you can begin to see why some people claimed this could result in a Great Depression II . . . and remember we started here talking only about financially strong companies.

That is why we need a lender of last resort (or in the case of the Paulson plan, a buyer of last resort). Unfortunately, only public money can fill that roll. I truly do think this is a case of pay now, or pay more, possibly much more, later.

 

[Independent]

So what does an otherwise strong firm do if none of those sources of funds are available? They start rationing their liquidity . . . they probably suspend the dividend, they might stop paying principal & interest on their bonds while asking lenders for "forebearance", they might shut down operations at some of their more marginal plants or operations to conserve cash, they might delay paying vendors or even employees, etc. etc.

So now vendors are getting squeezed, maybe employees too. Some business operations are shut down, which is going to hurt local economic demand for the other buisnesses in the region that are still running. Equity and fixed income investors run for the exits because they're not getting paid, which further constrains available liquidity.

All of this feeds on itself in a vicious cycle of tighter liquidity, reduced output and reduced demand.

Multiply this a thousand times accross the economy and you can begin to see why some people claimed this could result in a Great Depression II . . . and remember we started here talking only about financially strong companies.

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It seems to me that the first steps would be delaying payment to vendors (essentially getting a loan at the vendors' late pay rate) and laying off workers. I don't know about "asking for forbearance" on private loans. I always thought that that not paying on bonds is legally bankruptcy, so it would be the last thing on the list. Cutting dividends seems to be one of the later things.

Even if we believe that it's "strong companies" that will have the first problems, I can't believe that everyone is equally vulnerable. Someone has to go first. The visible action is laying off workers - and that seems to be one of the earlier actions. So I'm still saying that before we have a complete meltdown of the system, we should have some profitable companies cutting staff and blaming it on "can't get operating cash". I'm not seeing those stories in my newspaper. I'm not saying I'll never see them, just that it's easy to see why a lot of people are skeptical of sending $700 billion to "rich bankers" to deal with a crisis that hasn't hit their jobs yet.

 

[Gone4Good]

I hear you, Independent. The problem is if you wait to the point where otherwise healthy companies can't get financing, it's already too late. I think that is the definition of "melt down". Once the cascade starts, it might not be reversible.

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A technical point with respect to bondholders and "forbearance". Failure to pay principal or interest is a default under almost every bond indenture I've ever seen. The remedy available to lenders in the event of default is to accelerate the maturity date. This is typically a right, not an obligation. But the situation we're envisioning is one of a healthy company that is having a liquidity squeeze. Bondholders might be convinced to "forbear" on exercising their remedy (and avoid a bankruptcy filing) if they think that the company can at some point regain access to capital.

This exact situation happened with Southern California Edison during the California power crisis back in 2000 or 2001.

BTW, you're right that a company probably wouldn't chose to skip a coupon payment, but a $1B bond maturity might be a different story.

 

[Gone4Good]

Oh, and I forgot to add to my disaster scenario above . . . When company's file for Chapter 11 bankruptcy protection one of the first things they do is get "Debtor in Possession" financing. Essentially a super senior bank loan that allows them to keep operating their business while they try to reorganize their capital structure. With no DIP financing, there would be no Chapter 11 reorganization. Instead a lot more companies would go straight to a Chapter 7 liquidation. These companies would flood the market with assets where buyers would be few (a good reason existing bondholders might choose to forebear, btw). That flood of asset sales would push down valuations for companies with similar businesses and the vicious cycle would take another leg down.

 

[OAG]

Hang on after we get the Bank Bailout done this weekend we can anticipate the "Bond Bailout" program to start wending its way through congress along with the 2d $25 Billion for the US Automakers (yes, they got the first $25B today in the Senate Bill passed and on the way to President Bush for signature (which BTW he will have to sign or the Government has no money next week (so it will be signed))) and the "Airline Bailout" program which is due to high oil prices. Even heard of some Grocery Store in Manhattan, NY, putting a surcharge on grocery bills due to high transportation costs - wonder how long that will take to get some traction.

 

[audreyh1]

Finally - some credit relief directed to Main Street!

I want to say that after the move by the Fed yesterday to start providing some short term relief to companies by getting involved in the commercial paper market, and the globally coordinated interest rate cuts today, I feel that the Main Street issues are finally being addressed more directly, and I'm glad to see Europe finally step up to the plate and recognize their own messes and be willing to coordinate.

The Fed/Treasury now has a huge number of weapons in their arsenal, and now it's a matter of using the tools and working through a bunch of the mess. It's a matter of time now. The rest of the year may be really bloody markets wise, and main street companies will likely underperform for the quarter, but things could start to settle down and even start to improve next year. We're just going to have to be patient.

I'm starting to feel better about things. Yes, we'll get lots of bad numbers before seeing some good ones, particularly on the employment front, but I think it's now more of a matter of time than anything.

And people can only stay panicked so long! At some point "fear fatigue" comes into play. Credit analyst Tony Crescenzi says historically it usually takes about 60 days from the start of a major financial crisis for the initial panic/fear to settle down. That would mean late by Nov 2008.

Did anyone notice that August pending home sales showed a big jump last month? The foreclosures/low prices are finally starting to attract some buyers. Hopefully the subsequent credit squeeze hasn't completely scared them off again!

Audrey

 

[ziggy29]

I feel that the Main Street issues are finally being addressed more directly, and I'm glad to see Europe finally step up to the plate and recognize their own messes and be willing to coordinate.

Europe left its rates way too high for way too long. They faced many of the same systemic risks as the U.S. financials did -- and in some cases, worse -- and all they succeeded in doing is making the Euro too strong, tanking the dollar and more quickly sinking their economy.

Even in the face of an obvious global slowdown, Europe didn't move.

 

[audreyh1]

Fortunately it looks like that stubborn streak is finally over!

Audrey

 

[Gone4Good]

Finally - some credit relief directed to Main Street!

I want to say that after the move by the Fed yesterday to start providing some short term relief to companies by getting involved in the commercial paper market, and the globally coordinated interest rate cuts today, I feel that the Main Street issues are finally being addressed more directly, and I'm glad to see Europe finally step up to the plate and recognize their own messes and be willing to coordinate.

Much to the chagrin of Socca and Independence it seems as if we've side stepped a Great Depression.

With governments around the world throwing everything (including the kitchen sink) at the problem, the worst is likely avoided. We will all live to fight another day.

 

[audreyh1]

OK! Today's move by the Fed (as uncapitalistic as it seems to be) was probably the last major step needed to protect Main Street, so I'm breathing a lot easier.

Ironically, the US finally "had to do it" because Europe did it. Pretty good cover for US Policymakers.

Short term LIBOR rates cut in half - that's terrific. Flight to treasuries is starting to reverse. Maybe we'll see our commercial paper markets start to function again.

Hey - it took less than 20% of the bail-out package!

Audrey

 

[FinanceDude]

OK! Today's move by the Fed (as uncapitalistic as it seems to be) was probably the last major step needed to protect Main Street, so I'm breathing a lot easier.

Ironically, the US finally "had to do it" because Europe did it. Pretty good cover for US Policymakers.

Short term LIBOR rates cut in half - that's terrific. Flight to treasuries is starting to reverse. Maybe we'll see our commercial paper markets start to function again.

Hey - it took less than 20% of the bail-out package!

Audrey

probably the best use of taxpayer money in many years. I am NOT a bailout guy, but this appears to have some merit. The US is a nation of credit, and if the credit markets are frozen, that is a big problem......

 

[audreyh1]

Hey - it took less than 20% of the bail-out package!

Audrey

Whoops! Looks like Paulson made the banks take $250B, not $125B as I had read last night.

Make that less than 40% of the bail-out package. Not quite so cheap.

Audrey

 

[audreyh1]

probably the best use of taxpayer money in many years. I am NOT a bailout guy, but this appears to have some merit. The US is a nation of credit, and if the credit markets are frozen, that is a big problem......

Absolutely! What is the point of leaving the credit markets frozen and destroying our economy?

Audrey

 

[FinanceDude]

Absolutely! What is the point of leaving the credit markets frozen and destroying our economy?Audrey

Hey, now the bank lobbyists have a LOT less power. Even though the Govt gets non-voting stock, I think they will have a LOT of influence on the operations going forward.

I am somewhat worried about the socialistic way in which we are moving, with the federal government owning the credit markets, hopefully there's a timeline and an exit strategy........

 

[Independent]

Much to the chagrin of Socca and Independence it seems as if we've side stepped a Great Depression.

With governments around the world throwing everything (including the kitchen sink) at the problem, the worst is likely avoided. We will all live to fight another day.

If I'm the "Independence" you're referencing, I'm quite sure I wasn't predicting a depression, nor was I hoping for one. And I'm also sure I said I'd rather have a recession than promote the idea that the gov't can bail out everyone all the time.

For example, it seemed to me that people who invest in money market mutual funds instead of FDIC insured bank accounts should recognize that they don't have a gov't guarantee. The same goes for the companies that were funding on-going operations with CP instead of equity or long term loans. Both of them were taking risks. Are they going to modify their future behavior based on the past couple weeks? or will we be building the same house of cards all over again?

 

[audreyh1]

Independent, I think the disagreement is on degree.

The Fed/Treasury didn't do this to avoid a recession. They did it to avoid a depression. I know plenty of folks don't believe we were ever at risk of a depression. If a certain outcome is avoided people can argue endlessly about whether or not it would have occurred.

We're going to have a recession anyway. Now that credit is starting to thaw, maybe we can avoid a really, really bad recession. But it won't be a light recession either. Too much damage has already been done. Too much deleveraging and falling housing prices and contraction of credit has occurred. Yes, it is good that a lot of this has happened, but the pendulum has swung the other way and now the question is how far?

We will all be swallowing a lot of bad medicine these next couple of years - the "innocents" along with the "guilty". Unfortunately we are all in this boat together, and if it capsizes we all risk drowning. Maybe in the future we can police things much better so that those with the power to capsize the boat are forced to limit their risk taking.

Audrey

 

[audreyh1]

For example, it seemed to me that people who invest in money market mutual funds instead of FDIC insured bank accounts should recognize that they don't have a gov't guarantee. The same goes for the companies that were funding on-going operations with CP instead of equity or long term loans. Both of them were taking risks. Are they going to modify their future behavior based on the past couple weeks? or will we be building the same house of cards all over again?

Why are bank deposits any more sacred than money market mutual funds? Why should one have a federally backed insurance program (paid for by depositors), but not the other? The commercial paper markets are critical to the smooth functioning of US corporations, so why shouldn't they have some protection? I would state that this is more like the Fed realizing and correcting an oversight of many decades. There were no shenanigans in the commercial paper (at least not on the scale of investment banks and mortgage backed securities), just regular credit-worthy companies going about their business. Why should money market funds be penalized instead of the banks?

FDIC was put in place when the US realized that without it, they could never have a stable financial system. I think they have just now realized the same is true for the commercial paper market.

Audrey

 

[Freeatlast47]

New Bank?

www.prosper.com

Has anyone tried this? Looks like the rate of return is much better than my local bank of course it is not FDIC insured.

 

[REWahoo]

Has anyone tried this? Looks like the rate of return is much better than my local bank of course it is not FDIC insured.

See these threads:

http://www.early-retirement.org/forums/f27/prosper-com-25470.html
Individual-to-Individual Loans as Investment?

 

[Gone4Good]

The Fed/Treasury didn't do this to avoid a recession. They did it to avoid a depression.

Exactly right.

 

[Independent]

Audrey, this makes sense to me:

Independent, I think the disagreement is on degree.

The Fed/Treasury didn't do this to avoid a recession. They did it to avoid a depression. I know plenty of folks don't believe we were ever at risk of a depression. If a certain outcome is avoided people can argue endlessly about whether or not it would have occurred.

We're going to have a recession anyway. Now that credit is starting to thaw, maybe we can avoid a really, really bad recession. But it won't be a light recession either. Too much damage has already been done. Too much deleveraging and falling housing prices and contraction of credit has occurred. Yes, it is good that a lot of this has happened, but the pendulum has swung the other way and now the question is how far?

We will all be swallowing a lot of bad medicine these next couple of years - the "innocents" along with the "guilty". Unfortunately we are all in this boat together, and if it capsizes we all risk drowning. Maybe in the future we can police things much better so that those with the power to capsize the boat are forced to limit their risk taking.

Audrey

I understand that Berneke/Paulson are trying to walk a fine line between too little intervention leading to a depression and too much intervention leading to a continuation of the moral risk that got us into this. I don't know exactly where that line is. B&P know a lot more than I do, but I'm concerned they will veer too far to one side.

I see this an instance of the "expert" problem with public policy. For example, only civil engineers know enough details about our physical infrastructure to evaluate the risks of not investing money to improve it. But, I wouldn't give them a blank check and say "do whatever you want". I'm afraid they'll do too much. They have too much vested interest in physical infrastructure and too little understanding of other public goals.

In this case, only specialists in the credit market really understand the details, but I'm still worried that if we give them a blank check they will spend too much money to maintaining their system and leave us too little to spend elsewhere. I'm particularly worried because they haven't shown themselves to be very concerned about the public good in recent years.

I'm old enough to remember the S&L meltdown and the LTCM fiasco. I agree with the "Maybe in the future we can police things much better..." sentence. It's just that I give the "Maybe" a very low probability. I think the boat is at risk of capsizing because some people built the upper decks higher and higher just to give themselves a better view. So if we work real hard to keep it upright today, who is going to tear down the upper decks so this doesn't happen again?

 

[audreyh1]

I am more positive about the "Maybe in the future we can police things much better..." because I think the US did this in the 1930s, and we managed to significantly reduce the excessive financial volatility that had characterized decades and centuries prior through the 1930s. That was a very successful 75 year run. IMO 73-74, 1987, the S&L meltdown and the LCTM fiasco were small storms compared to what we face this year.

Ironically, several of the key regulations that were put into place in the 1930s to avoid financial instability and held as sacred cows during most of the decades following were taken off the books during the past decade. Some of them just last year. And what do we get? A global financial blowup. It didn't take long at all.

So, I think we've done it before, and I think we can do it again. And maybe we have to relearn these lessons every 3rd generation - who knows!

Audrey