Apocalypse Now: Do The Markets Have A Chance To Recover

95129cThere were several pieces of bad news today, but three stand out. This news may have been the primary cause of the market sell-off which took the Dow down 679 points, or 7.3%, to 8,579. The market was above 14,000 less than a year ago.

Every investor and most working men and women have the same questions. What will it take to get the economy back in order? Is the die cast for an awful and prolonged period of financial despair.

The most alarming information came from The Wall Street Journal, In its latest forecast survey from 52 economists, the paper found that the experts expect the GDP to contract in the third and fourth quarters of this year and the first quarter of next.

The paper reports that “If those predictions bear out, it would mark the first time U.S. GDP—the total value of goods and services produced—has contracted for three consecutive quarters in more than a half century.”

Put in stark terms, this would be the worst period in the American economy since the 1930s. Comparing unemployment and bank failures in other deep downturns to those of today, it would be safe to assume that unemployment could hit 12% or 13% and that 1,000 banks could fail.  This number of bank failures could, tax the FDIC beyond its current financial capacity.

The next news came from JD Power, the world’s leading research firm on trends in the auto industry. The head of research at the firm said that “the global market in 2009 may experience an outright collapse.” The auto industry is a reliable indicator for the availability of consumer credit and a measurement for whether people will buy high-end consumer goods. People who are not buying a new car are probably not purchasing anything, from new refrigerators to air conditioners either.

The final piece of news was that the Treasury might buy equity in major US banks to mainline capital onto the balance sheets of these financial firms. This is an unprecedented move.  It is one thing for taxpayers to own toxic assets which might regain their value over time. It is another  for them to own pieces of banks which could fail. The Treasury could have the temptation to throw good money after bad in the hope of keeping large financial firms on life support.

If the federal government really wants to fix the economy, its only option is to push more capital into the economy, probably $3 trillion or $4 trillion. In theory, the Treasury can come up with that money if it continues to collect taxes and sells government-backed bonds, many of which are bought by developing nations like China. China may develop an increase in its appetite for US paper because a collapse of the American economy would bring the finances of the world’s most populated country to a halt.

There is no precedent for how the government would use trillions of dollars to revive a moribund economy. The last huge financial intervention was during The Great Depression. Some economists argue that World War II was actually more instrumental in putting the US back on solid financial footing than any of the FDR programs did.

If we revisit the programs that FDR created, we can examine that grand structure and look for ways to solve the urgent problems of this financial crisis While some people may have called this socialism, the key to the New Deal’s success was essentially that it put people back to work and restored confidence in the banking system. While the FDIC exists today to back-stop bank failures, many people know that it does not have limitless funds.

The first move the Treasury needs to make is to take significant stakes in the nation’s money center banks. Citigroup (C) has a market cap of $50 billion. As absurd as it may appear at first, the government might have to match that sum with its own investment. It would have to do the same with JP Morgan (JPM), Bank of America (BAC), Wells Fargo (WFC), and several other large financial firms. The investment would have to come with a stipulation. Half of the money could go into reserves. The other half would have to be loaned out within a brief period of time, no longer than a year. One of the limitations of the way that the Fed is passing out money to banks now is that it exercises no authority in how this capital is used. The money has simply been hoarded by the banks. New investments from the Treasury would have to reverse that practice.

The Treasury would also have to set up a national home loan association. This is not entirely unlike the Agricultural Adjustment Act of 1933 which was created to save farms. Agriculture was a much greater part of the GDP then, so bolstering the value of farms and allowing them to remain productive, even in a devastated economy was essential to Roosevelt’s plans.One criticism of mortgage assistance programs is that they may not differentiate between people who have genuine need and those who bought property as speculators. In an economic panic the government will not have the chance to separate the wheat from the chaff. The goals of a home loan association would be simple. People would stay in their houses. Interest rates would be reduced. Monthly payments would be reset based on mortgage size or income.

The most difficult program for most Americans to accept would be one that would give most able-bodied people a job. The federal government would need to set up something similar to the Work Projects Administration which was created in 1935. The purpose of the WPA was to give the unemployed jobs which helped rebuild the nation’s infrastructure.  In addition that program became involved in the distribution of food housing, and other essentials. By 1938, the WPA employed 3.3 million people. Based on today’s population, that number would be closer to eight million.

Only extremists believe that the economy is headed toward a depression with a 25% unemployment rate and thousand of bank failures. But, a new CNNMoney poll shows that 60% of those surveyed viewed a depression as “likely”. It is astonishing to think that so many people believe that things have gotten that bad so quickly.

Those who believe in capitalism in its most pure form would argue that the economy should be allowed to fail to the extent that it cannot be saved by private enterprise and the current federal structure which supports banking and lending. That philosophy says that getting out in front of economic problems reflects a level of manipulation which is not allowed under the current structure of American laws and regulations. It is, in many ways, the position that most business leaders and members of Congress took in the late 1920s and early 1930s.

How much force needs to be brought to bear to build a safety net under the failing economy is unknown. It is also an admission that intervening in any meaningful way to save jobs and the value of real estate and financial assets will drive the federal government into the deepest deficit in its history.

But, not getting out in front of the problem could costs millions of jobs and drive down the value of stocks, homes, and other critical asset by another 50%. In California, some home values are already down by half.

If the government does not move to protect employment, real estate, personal and business assets before the end of the year, immeasurable devastation is all but certain.

Douglas A. McIntyre