Getting Beyond the Fear Itself

Perhaps Roosevelt’s most famous phrase is, "We have nothing to fear but fear itself."  Today, we largely find ourselves in much the same situation. 

That does not mean however that fear is not something to be afraid of.  Fear means a loss of confidence.  People will only trade with each other, or give each other money if they have confidence that the other person will hold up their end of the bargain and/or be able to return the money.  Think about it for a minute -- the root word for "credit" is the same as the root for "credibility." 

Given that the financial instruments of today are so opaque and hard to understand, as we go through this deleveraging most institutions have lost faith in other institutions.  They simply don’t know exactly what the other guy has on his books and if it is going to blow up on him tomorrow, or next week or a month from now.  Thus everyone is trying to hoard their cash. 

Confidence is absolutely essential to markets, but most of the time we don’t have to think about it, because it is there in normal times.  It’s sort of like air.  When was the last time you thought about the ability to breathe?  However, take away the air for just one minute and it is all you will be able to think about. 

The bailout bill is first and foremost about trying to restore confidence in the system.  It is not a perfectly devised plan -- far from it.  The latest version is in many respects a worse bill than the one that went down to defeat last Monday.  It has a ton of extraneous stuff in it that has little to nothing to do with rescuing the financial system before it turns blue. 

Some of the measures have merit on their own, but are completely besides the point.  My "favorite" of these is a $200,000 a year tax break for the manufacturers of wooden toy arrows. But there are two features in the new version that do have a bearing on the crisis: one good and one bad.  The good one is the increase in the FDIC insurance limit to $250,000.  This will stop "walks on the bank" where people have been withdrawing everything they have over the current $100,000 limit.  Those "walks" at least contributed to the timing of the demise of Washington Mutual and Wachovia.  The increase in the limit will only catch things up for inflation since it was last raised in the early 1980s. 

The second provision is the relaxation of the "mark-to-market" rules.  This is an AWFUL idea, in that it just tries to sweep the problems under the rug and hide them.  It makes it more difficult for institutions to know what is on the other guy's books.  It makes the system even more opaque.  Allowing you to pretend that the stock you bought at $100 and is currently trading at $50 is still worth $85 or $90 does not make it so.  If you presented a statement to your bank putting those shares up as collateral at a value of $85 it would simply be fraud. 

That is what this proposal is all about -- legitimizing a form of securities fraud.  Yes, it will help preserve the published capital ratios, but it will all be "make-believe." No one will trust the numbers, nor should you.  The book values will belong on the fiction shelf.  Japan tried this approach when it had its banking crisis in the early 1990s.  The result was a full decade of economic stagnation with a bunch of "zombie banks" -- dead but still walking.

Keep one thing in mind, though. Passing the rescue bill does not mean smooth sailing for the economy.  We are still going to face a very nasty recession.  The parade of data coming out on the real economy is just one harsh bit of news followed by another.  However, if nothing is done, we will turn a nasty recession into an absolute catastrophe.  This nation has survived many nasty recessions.  They hurt, but we come out the other side in very good shape.  That is not necessarily going to be true if we do nothing and fiddle while the financial markets burn to the ground.

There are plenty of companies with strong balance sheets and free cash flows that do not need to access the credit markets anytime soon, and that do not depend on customers that need to access them.  The major oil companies like Exxon (XOM) and Conoco (COP) fall into that category.  Healthcare names like Johnson & Johnson (JNJ) and Abbott Labs (ABT) fit the bill.  So do some Consumer Staples names like Procter & Gamble (PG) and Kraft (KFT).  Use big sell-off days to accumulate solid companies like these.  A year from now you will be glad you did.

Written by Dirk van Dijk, CFA

Comments

[woodsey:]

Deliver us from fraud. LHR

2008 Oct 07 01:41 PM

[Wadhamite:]

Yes, there is plenty to be said for good old-fashioned thrift. Not everyone is a credit junkie. It is good to be reminded of some sound companies that are doing fine and will continue to do so.

2008 Oct 07 03:56 PM

[kurt walter:]

Buy RSU .. average in over the next few months.

2008 Oct 07 04:23 PM