$700 Billion Wise, Several Trillion Foolish

A few republican congressmen are $700 billion wise; several trillion foolish. Voting against the bailout was a sop to the worst brand of envious populism. They didn't know history and now are condemning us to repeat it. They must be hearing the theme to All in the Family in their empty heads: "Mister, we could use a man like Herbert Hoover again."

The question looming large is whether a Great Depression will occur again, especially in light of this recent legislative failure. Obviously, things look scary enough and historical comparisons look stark enough that the question deserves a fair hearing. However, the divide between a severe recession and a depression is vast. It's important to keep the gap of this divide in mind, because an error in the measure of that gap can lead to major mistakes in a long-term investment plan. History shows that a depression is an aberration, not a normal cyclical collapse. We believe that a Great Depression is not in the cards for the following reasons:

FDIC insurance, which did not exist at that time, is preventing deposits from leaving the banking system entirely and seeking haven in a mattress. Instead deposits are shifting from weakly capitalized banks to strongly capitalized banks such as J.P. Morgan Chase. In addition, strong depository institutions are acquiring weaker ones, protecting these deposit bases and sparing the FDIC costly payouts.

The entire social safety net of social security, disability, etc. did not exist during the Great Depression. Most of these important innovations were signed into law by Roosevelt in 1935. The existence of these government programs will cushion the contraction in the economy caused by job losses.

The Fed is heavily biased toward promoting liquidity. Yesterday, the Fed injected $600B to promote interbank lending. Though credit markets remain frozen, liquidity injections, along with a Fed rate cut and various other options, will maintain a bias toward money supply expansion. In the Great Depression, the gold exchange standard prevented this flexibility. The Fed's actions will promote liquidity but with some unwanted consequences: an expansion of the Fed's balance sheet which will eventually lead to much higher interest rates and a debasement of the dollar. Eventually, the Fed will have to intervene quickly to prevent secondary inflation, but we believe there are enough hawkish Fed members to accomplish this.

Global trade is still intact. Though the credit crunch will contract global trade to
recessionary levels, it will not halt it as did Smoot-Hawley protectionism during the Great Depression.

There are many well-capitalized institutions expanding lending, even in this constrained credit environment. J.P. Morgan Chase, Wells Fargo, and Hudson City are just a few of the banks committed to seizing market share through aggressive expansion of their loan books.

The amount of cash on the sidelines is staggering. Even after the exodus from money that occurred before the Federal guarantee program was announced, there's an estimated $3.4 trillion in money market funds. This is an enormous pile of money available for spending, investment, and debt repayment. Though it may remain where it is until some measures of confidence return to the financial system, it is an unprecedented reserve of funds that sits dormant and waiting for deployment.

On the other hand, the stark facts that would incline toward a depression to occur are as follows:

Policy mistakes are the key ingredients of a depression. It takes a series of very poor policy decisions to create a depression. Yesterday's legislative disaster was an example of the type of mistake that can do so. If congress clings to laissez-faire in the face of crisis, this could lead to a set of poor policy decisions.

The credit crunch is very severe. The TED spread, or gap between public and private borrowing costs is steep enough to halt growth. If a revised bailout or Fed intervention fails to unfreeze these rates, a recession could turn into a depression. However, the history of most credit crises (1907, 1982, 1990, and many others) is that reasonably priced lending does resume once intervention stabilizes the system. The thirties was the outlier in this series, not the norm.

The commercial paper market has been somewhat stabilized by the proposed backstopping of money market funds, but many companies will get shut out of this lending market by dint of their poor balance sheets. This will cause major GDP contraction.

Fear and panic can obviously cascade. The media can compound this problem. One example is the media reporting that yesterday's drop was the worst ever for the Dow. It was the largest ever in point terms, but not in percentage terms. And percentage terms are what count. The percentage loss was 8%, but the 1987 crash took the Dow down 22%. We've had many percentage declines of the scale of yesterday's.

It would take a series of continued policy mistakes, not one legislative failure to cause a depression. If government does not show a renewed resolve to intervene and the Fed does not continue to inject liquidity, we would put the odds on a depression rising and that would cause us to slash equity weightings, whatever the valuations. It's important to emphasize that we are not there yet, and not even close. Again, the difference between severe recession and depression is wider than most would realize.

It's important to invest for probabilities, not limited possibilities; that is, for the more probable outcome that the bulk of our country and institutions will survive, not the limited possibility that none will. This is because history is littered with predictions of ends that never came. Thus, logic, as opposed to panic, cannot dictate another approach. Panic and nihilism are not investment plans. The reality is that if collapse occurs on a scale of another great depression, stock prices will be the least of anyone's concerns. However, we are mindful that governments can fail to implement the right policies, so we will follow that closely.

Even after yesterday's collapse, the XLF, the financial index ETF is at $18.57, still significantly above its July 15 low of $16.77, making the financials one of the best-performing sectors since then. Another positive note is that the survivors of this crisis are starting to emerge: J.P. Morgan Chase and Citigroup, by means of their acquisitions of weaker lenders, are likely to come out of this stronger and leaner, with huge market share. Their future returns on equity are likely to enrich those who buy them during the crisis.