What does the $700 billion bailout mean to you?

Now that Congress has passed and the President has signed the $700 billion bailout package, let's take a moment to examine how we got into this, exactly what this is, what we can expect and what we should do.

As I was discussing the markets with a colleague last week, he alluded to a stock market "crash." I thought to myself that this was an extreme description. However in my reading over the past few days, I have learned that my colleague was spot on in his description as a crash is defined by a drop in the Dow Jones Industrial Average of 20 percent or greater over the course of one trading session or several. The Dow is down over 20 percent in the last eight trading sessions ended Friday October 10, 2008 and has retreated by almost 40 percent from its October 2007 high. 

Tightened Liquidity Markets

Stocks are down but the biggest issue menacing Wall Street at the moment is the lack of liquidity that exists in the financial markets. Every day large corporations such as American Express, Procter & Gamble, Boeing and ExxonMobil seek access to the commercial paper markets in order to meet their short-term funding needs. In this case, short-term is anything 270 days or less. 

These companies, and companies like them, use the short-term borrowings to do such things as fund weekly payroll and pay other bills as they come due. When the term on the commercial paper ends, the companies repay the loans, often by re-borrowing from the same markets. The process works as follows:  (1) a company will decide that it needs a certain amount of money, say $500 million for 30 days; (2) the company will contact an investment bank such as Goldman Sachs with a request for such an amount for the particular period; (3) Goldman Sachs will then contact potential investors in such short-term paper such as commercial banks, money market funds, pension funds and others; (4) those investors lend the money to the companies with Goldman Sachs acting as broker. The companies receive the money they need to meet to their immediate and near immediate financial obligations, the money market and pension funds put their money to work for short periods of time and collect the interest as their return, and Goldman Sachs collects a fee for brokering the transaction. The companies get what they need and the other parties get paid for providing it to them. 

A Crisis of Confidence

This is what happens in the ordinary course of business when the companies who have money to lend feel comfortable that the companies who are borrowing will have the money at the end of the term to repay the loan. In the last few weeks, there has been both a crisis of confidence in the ability of the corporations to repay the loans and a shortage of available cash to lend. This lack of confidence is a direct result of the failure of companies such as Lehman Brothers, AIG and Fannie Mae. In addition, the shortage of available funds results from people removing their funds from banks, and money markets as they have lost trust in the financial markets and the institutions which serve them.

When companies cannot borrow as easily as they used to, they must pay more for access to the funds they need to run their daily business operations. The increase in the cost of funds decreases corporate profitability, and, in turn increases the potential that the corporations will not be able to repay the interest and the principal when due. The other risk is that corporations will not be able to borrow at all and will cease to be able to meet their short-term obligations. This makes suppliers less willing to give payment terms, which decreases cash, which increases the need for cash in a cash-starved system.  And so the cycle goes.

The $700 billion is supposed to allow the government to purchase some of the "bad" investments on the books of corporations, which government officials hope will increase confidence that there are no surprises waiting on the balance sheets of corporations which will lead to an unforeseen failure of the corporation. This renewed confidence in the solvency of corporations, the government hopes, will increase the willingness of companies to lend to one another and open up the credit markets again.

Which reminds me, how did we get into this thing in the first place?

The crisis in confidence stems from the failure of huge financial institutions such as Lehman Brothers, Bear Stearns and AIG who faced issues of illiquidity when lenders became concerned about their solvency. In many cases, the assets on the books of these companies that were used to determine their solvency were derivatives tied to residential mortgages. As the market for those instruments dried up, they became more difficult to value and subsequently created issues for potential lenders.

Lehman's bankruptcy filing sent chills through the credit markets and rendered most reluctant to lend to other institutions because of an inability to accurately assess risk and the realization that the U.S. government would not bail out all institutions. In addition, as potential lending institutions correctly assessed the tightening credit environment, they began to hoard cash as liquidity insurance. 

What To Do Today?

So here we stand a year after the October 2007 highs of the Dow over 14,000. The markets have tanked almost 40 percent with more than 20 percent of that decline coming last week. You have been watching your 401K dwindle after each discouraging session of the Dow. In addition, you are worried about your savings and your personal self-managed portfolio. And you are wondering what to do now.

I am not a licensed certified financial planner but I do offer the following advice. What you should do next, depends upon your time horizon of when you need the invested funds. 

More than 10 Years

If you have more than 10 years and especially if you are saving in a tax deferred 401K, you should remain invested if you have not moved to cash. Selling now would only solidify your losses. We know that over the long-term, stocks have returned 8 percent annually on average.  In some of those years stocks returned more than 8 percent.  In other years stocks have returned less.  If you have the time to wait on the equity markets to recover, you would do well to stand pat and participate in the upswing.

If you are contributing to your 401K, you should continue to do so at least up to the matching percentage and potentially above.  Now that stocks are low, the buying power of your contribution has significantly increased.  For the same contribution you can purchase approximately 40 percent more shares of the Dow index, which means that your gains in the recovery will be 40 percent greater than they ordinarily would have been.  Stocks are cheaper than they have been in 5 years.  The market is trading lower everyday not based on fundamentals in most cases but on fear and pessimism. This is the other side of irrational exuberance. 

Less than 10 Years

If you do not have the luxury of time and think you will need your money in less than 10 years, you should be in relatively liquid and safe assets: corporate bonds, treasuries, money markets. The name of the game is capital preservation because you do no have time to wait 10 or 12 years for the markets to come back. The last bear market lasted 14 years from 1966 to 1982.  While relatively cheap valuations seem like a bargain, the market could and probably will go lower. So, if you need the money soon, keep the investments safe.

How Low Can You Go?

Which begs the question, "When will this all be over?"  While no one can know for certain, it is not difficult to imagine the Dow retreating another 10 percent or so to settle in at 7,500 or 7,600 before marking market lows. Here's why: Until now, many of the losses in the Dow have been based on fear and not fundamentals. However, we are in a recession and consumers will cut back on spending. That reduced spending will impact corporate earnings. When those lower corporate earnings are announced, those stocks will lose value. We will likely not find a market bottom until we work through the cycle of reduced corporate earnings. 

Let's hope that we work through that cycle sooner rather than later.  Otherwise, the long cold winter could stretch into spring summer and fall.