(Washington, D.C., Right Commentary): Last week, the stock market shredded almost 20% of its value, and briefly looked as if the Dow Jones Industrial Average would march to 7000, a number that would bring the market’s value down to almost 50% from its high a year ago. Panicked investors continue to be frenzied as they worry about the value of their 401K’s, IRA’s, and government savings plans, selling in droves and fleeing for the safety of US Treasury Bonds; bonds which are almost worthless in their yields at the moment as demand for bonds far outstrips supply. In the time of market panic - cash is king. Many Americans are asking, however, why this is happening? They were told the Bail Out “rescue” plan would avoid Financial Armageddon! Why then does the market continue to be driven downward, and the credit market continue to be seized?

The reality is, the bail out plan will likely do very little to resolve the current financial crisis and its corollary effects on the equities markets. There was perhaps a time where the intervention would have helped alleviate the pain we are all now experiencing. However, Congress screwed up that opportunity, and the resulting plan that emerged will not result in many banks taking advantage of the government’s “generosity”.

The dropping value of the Dow Jones Industrial Average, and the equities markets more broadly, reflects factors that cannot be fixed by the TARP. These factors are profitability of US companies, the availability to attract expansion capital, and the inter-generational gap between savers and borrowers. Before addressing these factors, however, I want to address two very pervasive myths that people are attributing to the “financial crisis” - the first is the collapse of the international banking system, second, is a belief that the financial markets lack capital.

The first myth is pervasive - it claims that the system of banks is collapsing. That is entirely false - at least in the United States. Despite massive depositor runs on US banks - no bank has failed because of depositor liquidity imbalances. I’ll say that again - no bank has failed because of depositor liquidity imbalances. Washington Mutual’s demise, or IndyMac, or Wachovia, did not result in any losses whatsoever to depositors - including deposits in excess of the FDIC insurance. The only people who really took it on the chin for those banks were subordinated debt holders and investors. They will get virtually nothing back - losses will result in hundreds of millions of dollars. However, the “depositor” who has his/her money in the bank lost nothing.

For a very long time - the reality of US FDIC insurance has meant all money in the bank under deposit is insured. No bank failure since the 1930’s has resulted in depositors losing value because of a lack of insurance. Even during the S&L crisis - depositors were covered against losses from banks - a move that was largely orchestrated by Alan Greenspan to ensure that the overall banking system remained sound. Since that crisis, bank failures have always resulted in investors losing all of their money, but depositors always being covered by the insurance and the guaranty made to the purchasing institution. In modern times, no one has lost a single dollar of deposits.

It may be time to make that promise explicit for awhile… to stop the stupidity of this bank run.

A true story (albeit anecdotal) - last week my wife was attending a function with my daughter’s girl scout troop. One of the mothers told my wife that she was so afraid that the banks wouldn’t have any money that she withdrew ten thousand dollars from the bank - just to be sure. I have also heard others talk about wanting to withdraw cash from the bank - or holding higher than normal cash levels - thinking that cash would be unavailable.

When IndyMac failed - there were nearly riots outside IndyMac’s branches as depositors fought with each other and with police at times - trying to get their money out. There were smaller panics with Washington Mutual and Wachovia as people withdrew their cash as those two banks headed for the rocks.

This belief is absolute lunacy. However, it is driving a massive outdraw of capital from depositor banks in the United States, and did trigger the Chairwoman of the FDIC to order all member banks to withhold additional reserves of cash to ensure depositor liquidity. It also resulted in Federal Reserve banks throughout the United States pumping a considerably higher than average number of greenbacks to member banks to hold as vault cash.

The fact that depositors continue to withdraw cash has forced the FDIC to consider what is perhaps best described as the “nuclear option” for banking - insure it all. The FDIC does have the power to temporarily suspend the limits on deposit institutions and ensure all deposits. This would not mean that all accounts with banks would be FDIC insured (brokerage accounts and non-FDIC money market accounts would still be outside such a deal), but the move would be designed to nuke the continuing bank panic that depositors have by providing full liquidity for all funds held in every US depositor bank.

Why they continue to wait is beyond me. There is no problem with the US banking system other than people who hold their money in US banks are idiots and panicking. The best way to stop the panic is to remove all doubt about safety and solvency. It’s time to ensure all deposits and stop the rush of depositor capital out of the US banking system.

The second myth is that somehow there isn’t enough capital in the capital markets to meed the liquidity requirements. This is completely nonsensical. There is sufficient liquidity in the system - again - there isn’t sufficient confidence.

The reality of the current situation is - if anyone thinks you’re a bad risk as a bank - get a shovel and start digging because your life is over. For example, Lehman Brothers did not need to go bankrupt. Lehman could have financed its way out of the situation it was in if the situation Lehman found itself in was something other than the complete lunacy of “freak out” mode that Wall Street and the US financial market found itself engaged since early August. Lehman’s death was a self-fulfilling prophecy; Wall Street thought it would die, so they killed it. No one wanted to save it. There was no buyer for the assets before bankruptcy (although many came forward afterwards to claim the left overs). AIG followed in another death spiral. Again - AIG could have probably financed itself out of the mess if the mentality of Wall Street was something other than - I’ll eat your remains after you’re dead.

The current market situation is once you get “leprosy” of a tinge of failure - the market swoops in and kills you almost instantly, and eats the remains. Banks are doing this because if they show any weakness at all in their books - they are worried their investors will rush to the door, and they will be next to get a shovel. Instead, they let their brethren die and then scoop up the remaining assets to continue to try and pile on liquidity and reserves.

It is in this market that banks are trying to figure out if they can lend money. As a result, hardly anyone wants to lend anybody any money for fear of not getting the money back - suffering the liquidity crisis - and falling into the instantaneous death spiral. Any weakness - and get a shovel. The sad reality is, it is no longer a case of there not being enough liquidity. The Fed and other central banks have pumped in close to 2 trillion dollars worth of capital, currency swaps, and long-term debt buy-backs. There is plenty of money in the system. It is the fact that in the current environment, banks don’t trust each other enough to loan beyond an overnight period. That means that cash isn’t being circulated through the financial system and banks are relying too heavily on short-term loans, which does little to help pay off looming debts. Weaker banks are living day to day - and when the music stops - not all of them are finding chairs. Bigger banks buy up the carnage and sweep aside the bad debts. Everyone knows this. That is why banks are hoarding cash, both to cover their debts and to improve their year-end books. You either hold on to your cash or you get a shovel.

Until the vicious mentality of kill immediately anyone who might look weak ends on Wall Street and in the global financial system, the capital market will continue to be dysfunctional. The TARP does not address this problem - beyond perhaps giving the Treasury power to buy directly into banks and then provide them a mandate to do long-term bank exchanges with other banks the Treasury buys in to. I don’t forsee this happening any time soon, although, Treasury may wind up saving banks like Morgan Stanley and Goldman Sachs (Paulson’s alma mater) through direct investment via the TARP.

Lunacy of the Financial market starves the US of capital. That makes for a wicked ride in the stock market as companies have literally found themselves with no way to finance operations.

Stocks move up and down  based on their value to investors. Shareholder value is largely determined by profitability of the company underlying the stock. While market panics can lead to wide fluctuations in stock prices - as we saw last Friday where the market swung over 1000 points in one day - long-term downward pressures on stocks would be the result of a failing US economy, and with it, a lack of productivity on behalf of US firms, and lower profitability.

The reality is, recession is almost assured. It will probably be severe. Consumers will have to cut spending to pay down debt and to pay expenses that might have otherwise been financed. Investors know this and are pulling their money out of equities. The long term bear trend, however, cannot be fully explained by weakening economic conditions.

Another story, and again anecdotal, was a long-time friend of mine was telling me how he lost 300K in his retirement account over the past month. He was already in retirement. While I suspect my friend will ultimately be fine - I was shocked to hear how much of his retirement funds were invested. I also suspect that the recent panic of the last two weeks is in part the result of a inter-generational gap between savers and borrowers that has resulted in a fair number of baby-boomers and retirees suddenly pulling out their investments in order to preserve capital. While a crisis is the worst possible time to try and withdraw capital from the market - the sheer volume of trading the last two weeks has led me to conclude that many retirees are freaking out and withdrawing their money. Why it was invested in the first place is somewhat of a mystery to me. However, the market conditions suggest that a fair number of people who thought they were “risk tolerant” in retirement flipped out. There is little other explanation for why the massive outflow of value in the last two weeks occurred. The market imploded but the economy has not. Usually economic conditions occur first - then it shows up in company earnings - then stocks decline. 

I think that as many retirees and those close to retirement watched the market swing - they over-reacted and jumped out. That created a market dynamic where so much money was flowing out - prices had to be in free fall until we hit the floor. The market will take a long time to recover as this money is unlikely to flow back in once things stabilize.

Finally, there is the very real prospect of a recession. It is kind of hard not to think recession is all but assured. In the past month - the US economy shredded close to 3 trillion dollars in investment wealth - or about a quarter of the US GDP. Unemployment continues to climb. Interest rate cuts seem to be doing little to stimulate economic activity. Plop on top of all this the election. Consumers have much to be focused on until November. Whether or not the US economy will “hit bottom” as hard as the stock market did remains to be seen.

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