Please excuse my hubris if you are not really interested in my opinions, but sometimes one needs to say their peace. Take it for what you think it is worth.
First understand the issue at hand is a Balance Sheet problem and not an Income Statement problem. Companies are not bleeding cash. The problem is not that companies are losing money from operations, it is that they are losing money from asset write-downs. Why are they losing money from asset write-downs? Because they are being forced to because of mark-to-market provisions in GAAP rules. So the result is that the losses that will eventuate from mortgage backed securities, collateralized commercial paper, credit default swaps, and various and sundry credit derivatives, and being forced to be absorbed NOW, and all at once. This is coming in the form of asset write-downs. Many of these securities have real value of maybe $0.85-$0.90 on the dollar if held to maturity, but companies are being forced to value them at maybe $0.20 to $0.50 on the dollar now, because that is what the "market" is, even though they will hold them to maturity and earn $0.85-$0.90.
What is the result of taking these write-downs now? Apart from the loss on the income statement (while EBITDA is good) is that companies are now in violation of lending provisions. Many of the people who have bought these securities have done so on margin. When you, because of mark-to-market requirements, are forced to write-down your assets (because someone else sold the same security at $0.75 on the dollar), your debt to equity ratio is now changed radically. In most cases you are now no longer in compliance with your borrowing covenants.
When that happens, your lender will demand that you get back into compliance, or they will institute a margin call, forcing you to liquidate. So the response of the borrower is to sell assets, and in doing so, they use the proceeds to reduce debt, which if done on a dollar-for-dollar basis will get you back to being in compliance. Unfortunately what happens is you must sell at $0.50 on the dollar, which forces you to unwind faster than you want to. At the same time as you sell these securities at you must further write-down your asset portfolio to $0.50 to the dollar, because you must mark-to-market, which leads to a further unwinding, and if left unchecked a melt-down.
The problem is that there is no market for these securities, because risk is being over-priced, because of concerns of what may happen in a further mark-to-market write-down. Just like in 2003-2006 risk was greatly under-priced, it is now excessively over-priced. The spread between corporate bonds and TBills has ballooned. The cost of a credit default swap is now huge. AIG has to borrow short-term at LIBOR plus 8%, because of an almost irrational fear of risk. When risk is priced so high no one is willing to become the buyer of last resort, at any price. When there is no longer a buyer of last resort, there is no effective and functioning "market", yet you are being required to mark to this "market" which is based almost totally on risk avoidance. If you could take the loss on only those assets where you actually took a loss, then your balance sheet wouldn't be out of compliance. The loss is still there, and at some point you will need to take the loss, but if you can spread that loss out of years, instead of now, then you are not hit with a liquidity crunch. If everyone in the world is in the same situation as you, then you compound the problem onto an almost unimaginable scale.
Now look at our present circumstance and the Great Depression. The GD started with the stock market crash, stocks were highly overvalued, and being driven up by heavy use of margin (housing crash, homes overpriced, excessive debt today). The market crashes, and lenders start making margin calls, because borrowers are out of compliance. This leads to a liquidity crunch, and in the 1930's the Fed reduced liquidity, and that lead to a system wide unwinding, and the GD. There was no buyer of last resort, and no money available even if there was one. As one company goes under, because they cannot find a buyer for their assets, they leave a wake of default in their wake, which begins to stress the balance sheet of banks. When the second company goes under it happens again, and before you know it banks begin to lose their asset base and then you have bank failures, unless they can get short term financing to bridge the gap. If they can't they go under, which causes a run on that bank and other banks. As you get a run on banks, then credit is further shrunk, and liquidity further tightened. This leads eventually a total collapse.
That is the same situation as we have today, except that Fed is not tightening liquidity it is expanding liquidity, and now the US Treasury is stepping in to be the buyer of last resort. Once you have a buyer of last resort, then the market will begin to function. You want to sell a security, but you could not find a market, but now you have a buyer, the US Treasury. They may only pay $0.20 but they will at least buy the security. Once a buyer is in place then the rest of the market sees a bottom, and once you see a bottom, and you recognize what the cost is then trading will resume again. You see that the Fed is buying at $0.20, but you believe it is worth more than that, so you offer $0.25, and you buy. Others see what you paid, so they set their prices targets accordingly, and in time the market begins to function. Once the market begins to functions credit spreads shrink, and risk begins to be priced more appropriately.
This situation is the same as what happened to Long Term Capital Management in 1998. They had developed formulas that determined appropriate risk based upon credit spreads for a number of fixed income securities. The formulas were spectacularly accurate, and LTCM increased their net worth by 160 times in period of only 4 years. They bet on credit spreads, and did so using large amounts of margin, but their formulas were incredibly precise. Then credit spreads began to widen even more, because of the Russian debt default and the Asian currency crisis. Their formulas told them to buy, so they bought, and there were lots of willing sellers who were looking to avoid and eliminate risk. As they bought more, then more sellers offered, at ever widening spreads, meaning that according to the LTCM formulas they should buy even more, because the margins were so great, which lead to even more selling and even more LTCM buying. At some point though it stopped, as LTCM began to absorb losses, because the credit spreads their formulas said were to large (causing their earlier bets to lose), got larger and larger, and the contracts they had bought got further and further underwater. The greater the spread, the greater the loss they experienced now on the bets they already made, but also the greater the potential gain for the new purchases when the market turned.
The problem was that the LTCM formulas worked well in a well functioning market, but the formulas could not ever measure the reactions in a badly functioning market, where risk avoidance had become the objective. Think of this in terms of a distribution curve. The LTCM formulas measured to an accuracy of +/- 10 standard deviations (or even more accurately). Unfortunately they were not in a circumstance like that any longer, they were way out on the edge of the distribution curve. This is like the event horizon on a black hole, all the physical laws of gravity, magnetism etc no longer apply. All the laws that apply to a well functioning market no longer apply, it is chaos, and no formula can accurately predict what may happen. In 30 days equity in LTCM over 99%, with potential losses potentially exceeding $1 trillion, because of the use of margin, and the volume of credit derivatives they bought and sold.
LTCM was purchased by their lenders for virtually nothing. In many cases their lenders were the ones who were driving the credits spreads that took LTCM under. Once LTCM was bought and money came back into the market the buyers of LTCM made a huge profit on many of the trades LTCM bought. LTCM was right, but they could not last long enough to actually execute the trade. All the losses happened NOW, and they could not deal with it. In a more sober time frame the trades were good trades, and the trades ended up being in the money.
There is lots of talk now about new regulations to keep these things from happening again. The key to government regulation is to make sure that the regulation doesn't exacerbate the problem it is trying to solve. Mark-to-market provisions are in place partly as a response to Enron etc. People did not know exactly how much bad debt they had, so they bought with bad information. Mark-to-market is a designed to let investors know just where they stand and it has a great benefit in that regard.
Mark-to-market is a great thing in an up market, but it is horrible in a down market. The mark-to-market regulations have taken a bad situation and made it far worse. In regulation you want to avoid these outcomes. The suspension on short selling can be another. You have rules against naked short selling, but they are not being enforced. You now have a ban on shorting certain financial stocks. Why not set up a mechanism that makes it harder, but doesn't make it illegal? It is the same thing with credit derivatives. They are a huge market, and it is completely unregulated, and the potential risks do not show on the firms balance sheets. If you force them to be regulated then you can dry up a huge and highly effective insurance market, for risk mitigation. That is what derivatives do. If you regulate them then they become much less effective at what they are designed to do. If you force them onto your balance sheet, then with mark-to-market you can lead to incredible increases and decreases in asset value, especially in markets like this. This can make bubbles bigger and crashes deeper and the opposite of what you are trying to avoid with regulation. I am not saying regulation is bad, but it can be just as dangerous as no regulation, and regulation is not a panacea.
What inevitably happens with regulation is the same thing as what happens with the LTCM formulas. Regulations are put into place to handle normally functioning markets. When you have a chaotic market, then the formulas and regulations to not operate effectively, and often make a bad situation far worse. Mark-to-market is just one such example. I fear greatly that the Feds will set up a much more onerous regulatory environment that will make the economy much less efficient, and will not help in these periods of correction. The reason they won't work is that because people see and understand what the rules are, they respond accordingly. If the rules make their situation worse, then when things begin to unwind, then they pursue another path that is not regulated, but which accomplishes what they want. In other words you cannot regulate your way out of these situations.
I think it is important for people to fully understand that the terms being thrown around in the media are not entirely accurate. Sometimes it is great to use big numbers to make a story big, or more earth shaking etc, but it is not always what it seems to be. First all this talk about bailing out Bear Stearns, AIG, Fannie & Freddie. Let be clear, that the shareholders of these companies are not being made whole, and nor should they be. In most case the shareholders are getting nothing or nearly nothing. Recognize also that the debt holders are not necessarily being made whole, they will suffer losses, and well they should. The talk of the potential losses to US taxpayers of trillions, while technically true, is functionally apocryphal. If all this is bought at par, or all debts and potential debts are covered at par, then yes the debts could be that high. In reality nothing will be done at anywhere close to par. The Feds have a great opportunity to have a return like the shareholders of LTCM had. They will be the buyer of last resort, and they will be in a situation where they do not have to buy. Just because the seller wants $0.75, doesn't mean they will get it. The fed is the buyer of last resort in a buyers market..
So to the US economy in general. The US economy is in OK shape. We are not in a growth recession, as we experiencing good but some what overstated growth (at least as measured by the typical GDP measures). What we have is a mild jobs recession, as unemployment is rising but it is still low in historical terms. We have a housing depression, but housing makes up only 4% of the US economy. We are in the midst of a severe recession in the financial sector. We are in the midst of boom in exports, and that boom will continue for a number of years regardless of what happens to the US$. We are in a boom in commodities and agriculture, with very high prices, even after the corrections in the last 30-45 days. High tech is strong, health care is strong, energy is strong, autos and transports are bad. In other words it is a mixed bag, but it is not the end of the world. You need to evaluate the US$ in 2 ways, an absolute value and a relative value. It's value in absolute terms is best measured by gold, which will go higher for a while, how much higher I haven't the foggiest. In relative terms the $ will probably lose a little value against other currencies, but as soon as the financial market situation is better understood, then it will begin to appreciate. Most of the rest of the world is in the same situation regarding mortgages we are, but we are 6-18 months ahead of most other countries.
I read this recently and I thought it was apropos. We all know what a bubble is. We can see it, and touch it, and understand its physical properties. What is the opposite of a bubble? Can you describe it, see it, touch it, or understand it's physical properties? Ok think of the financial markets. We all saw the bubble forming in Tech in the late 90's and we all saw the housing bubble happening. Perhaps we didn't respond to it like we should have, nor did we all fully understand just how big the bubble had become, but we saw it. Well now we are in the opposite situation. We are right now in the opposite of a bubble. We cannot see how big (or deep) it is, and we cannot see just how stressed it is, but at some point it will begin to re-inflate. When it does those who bought distressed paper at huge discount will make a huge amount of money.
