Where do we go from here?

WEST COVINA, California -As all of you who are paying attention probably already know, the US House of Representatives has voted down a bill to authorize as much as $700 billion for the purchase of the so-called “toxic” mortgages. As a result, major US equity market indices were down between 7-9% today.

It is easy to stop there and not look at the root of this slide. But I won’t.

The root cause of market volatility is uncertainty. Markets hate uncertainty because it does not allow for the formulation of reasonable assumptions to try to justify asset prices. This is where we find ourselves in – a situation where no one knows what the end game is.

So, where do we go from here?

Two possible directions would be (1) an alternative bail-out bill is crafted and rushed to Congress for approval and (2) the markets are allowed to sort out this mess.

The first option is the more likely direction of the two that I mention. I just can’t see Congress not doing anything to try to hammer out another compromise bill. Voters may not have liked the first bail-out bill but they will probably like less the idea of their elected representatives leaving everything to the markets. As this bill is negotiated, the markets will remain volatile throughout this period. It will remain so until the specifics of this new package are nailed down and people will have a chance to assess the likelihood of its success in resolving the current mess.

The second option will see more financial institution failures, personal and corporate bankruptcies, the continued rise of unemployment and a decline in consumer spending. The Fed, in concert with the rest of the world’s Central Banks, will try to mitigate and stem the effects of these events by infusing even more money into the markets but these efforts will be overwhelmed by negative sentiment from everything else that will likely happen.

Regardless of which path we eventually take, it is important to note that the markets, at some point, will come to a reasonable estimation as to the degree of damage these “toxic” mortgages will have. This point will come sooner than when the actual losses are written off, before all of the institutional failures end and before we actually see all the negative effects of this crisis. At that point, markets will likely enter a period of even more weakness before stabilizing and beginning the long road to recovery.

This point will come before the actual recovery of the general economy, probably 12-18 months before. So if we are looking at maybe 3 years before all of these consequences plays out, we may be looking at least another year before we see some kind of relative market stability, not to mention recovery. There will be plenty of opportunities to find value in the markets before that but be prepared for what should turn out to be a very interesting (to put it mildly) ride.

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The Financial Storm of the Century

CHINO HILLS, California – Who would have thought that two of the most venerable names on Wall Street would announce their demise (at least as to their previous state) within hours of each other? If you haven’t already heard, Merrill Lynch, Wall Street’s third largest firm, will be acquired by Bank of America. Lehman Brothers, the Street’s fourth largest firm has filed for bankruptcy protection.

Alan Greenspan, in an interview over the weekend, called the current turmoil surrounding the financial markets as “…a once-in-a-half-century, probably once-in-a-century type of event…”

One of my clients sent me a link to an interview given by Prof. Nouriel Roubini of NYU’s Stern School. Prof. Roubini has always been someone whose opinions I have learned to take seriously. He has, at times, been a lone wolf in commenting on the seriousness of the current credit crisis that we find ourselves in. Thus, it is with some concern that I listened to this interview.

Prof. Roubini essentially says that we are not out of the woods as far as this crisis is concerned. He says there may be more bank failures in the horizon. He even suggests that our bank deposits may be in trouble given that the FDIC has only $50 billion in reserves to protect $1 trillion in deposits. He recommends “people with accounts exceeding $100,000 in value should spread their money – and the risk – among different firms.”

No doubt, such a call from a respected economist like Prof. Roubini is bound to create some panic and maybe even spur some minor “runs” on the bank. It is unfortunate that in many cases, bank failures are caused not by the actual financial standing of the bank but by a mad rush of withdrawals brought on by a “better safe than sorry” mentality. No bank no matter how big can withstand a sustained “run” many of which are driven by rumor and innuendo. Nevertheless, you cannot entirely blame the masses who may just be out to protect the totality of their life’s savings.

So what are we to do? If you do not have over $100,000 in one bank, you may not have that much to worry in terms of losing your money. You may have to deal with long lines, if worse comes to worst and you actually would have to take your money out from a failed bank.

If you do have more than $100,000, I will not be a proponent of strictly following the advice of Prof. Roubini without doing some other remedial action. The $100,000 FDIC limit has some wrinkles to it that actually allow you to keep more than $100,000 in one institution and still have all of it insured. The trick is in divvying up your money among different accounts. For more of how this works, go to the FDIC website. There is also this guide from the FDIC.

It is very easy to get lost among the trees in the forest especially during times like this when we are deluged by this torrent of terrible news. I have always been one who never panics when events and periods like this happen. Granted, this weekend has been worse than most. Nevertheless, if you step back and delve more into what Dr. Greenspan and Prof. Roubini ultimately say you may find some comfort in the fact that all those “Armageddon-like” prognostications are more fiction than fact.

Note the following:

“…a once-in-a-half-century, probably once-in-a-century type of event…”

– Dr. Greenspan

“Question: Truly long-term, are you still optimistic?

Prof. Roubini: yes.”

As Dr. Greenspan and Prof. Roubini say, there will be a time when all these challenges will be sorted out. When that time comes, a typical person will never know until they are well into that recovery. We will likely be through a period where the recession will be twice as long as normal (at least 2 years?) and where such a recession will be twice as severe as the last one.

Financial markets have a way of punishing the excesses of its participants. This is what is happening now. Left unfettered, markets will continue to exhibit “boom and bust” characteristics. If government has a role, in these markets, it would ideally be to exercise better regulatory oversight to limit these excesses and, in so doing, soften market volatility. I understand why government is acting the way they are acting right now (i.e. bailing out Bear Stearns, Freddie Mac, Fannie Mae, etc.). It may be easy to “Monday Morning Quarterback” this thing but I sincerely believe that we would not have gotten this far had government done their job properly in terms of their oversight functions. Now it’s causing more grief and costing taxpayers more money.

This is not to excuse the private sector’s getting away with the poor judgment that they have exercised. It is just that markets will eventually find a way to punish these recalcitrant market participants. But by then it will probably be too late, as it is in this case, for Main Street denizens who have or will lose their jobs, their homes and, God forbid, their hopes and dreams.

I try not to end my notes in a depressing manner so if I were to hazard a silver lining to all these it would be these. I hope that the failure of Lehman is a sign that the powers that be have finally come to the realization that failure in the markets is okay. That letting Lehman fail will serve as a warning that irresponsible behavior will have dire consequences. I hope that the removal of the “too big too fail” safety net (at least for now) will begin to weed out these irresponsible market participants. I hope that, when we look back at this day in 3, 5, 10 years, we can say that this was the beginning of an economic renaissance. For now, I can only hope. But I choose to hope for without hope what else is there to look forward to.