Black Monday, 2008

By Kurt Cagle
September 29, 2008

This morning I watched the final votes for the Bailout bill in the House of Representatives and the stock market simultaneously. The Emergency Economic Stabilization Act (EESA) failed by sixteen votes, 202-218. As it became obvious that the vote was going down, the Dow Jones Industrial Average fell more than 700 points before profit taking caused a bounce back into the -500 point range. Other indices were similarly hit, the S&P and NASDAQ both falling more than 8% before recovering, then falling again as it became obvious that no immediate revote would occur.

At one point, the fall was so rapid that several financial sites web service update servers were overwhelmed and crashed as people refreshed their browsers second by second to watch the carnage. At the end of the day, the damage was significant - the Dow down 777 points (7%), the S&P down 98 points (8.1%) and the NASDAQ down a staggering 200 points (more than 9.1%).

The bailout plan had morphed fairly dramatically from its initial draft to the plan worked out Sunday afternoon in Congress, with changes including a staggered approach to refunding the banks, much more extensive Congressional oversight of the process, repatriation of assets purchased from the banks to the taxpayers upon sale of these assets, caps on "golden parachutes" and other CEO compensation as well as the creation of an insurance fund introduced as part of later Republican additions to what had been an initially Democratic bill.

However, the bill also faced intense opposition all across the political spectrum, with progressives contending that it didn't do enough to curb the practices that led to the bailout in the first place and that its effects on future taxes were unknown and potentially devastating, and conservatives arguing that the bill represented the largest move towards socialization that the country had ever seen (not quite true, but this is an election year).

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Given this opposition, it was perhaps not surprising that the vote materialized the way that it did, though at the same time it was instructive to note that many more Democrats voted against it than expected (about 1 in 3) while more Republicans voted for it (about 1 in 3 as well) than expected. It was, in fact, a surprisingly bipartisan decision, and it places House leaders in a serious quandary concerning what to do next.

One of the key purposes of the EESA was to provide stability to the market, encouraging banks that there was some form of backstop that would handle the acquisition of the currently unmarketable resources clogging banks' books, in effect keeping them from having to actually set a value on these assets and wipe out their reserves in the process. With the nature of the vote, I have to suspect moving forward that this Congress (which should already have adjourned by now) will be unable to come up with a solution that is mutually palatable to their respective constituencies, which means that it's now unlikely that any type of congressional plan will take place within the next three months.

This is a message that's likely beginning to sink into people now that the initial shock has passed - and this will be a week of hard choices for a lot of people as a consequence. One thing that has already begun has been the drying up of lines of credit, which will have the most immediate effects. During the last couple of decades, most businesses have moved to a model where monthly costs, such as facilities leasing, payroll, utilities and so forth are actually handled via a commercial line of credit (CLOC). This line of credit means that the company has a guaranteed minimum in the bank each month, such that when the company receives income, it can apply part of that against the CLOC, and either bank, reinvest into the business, or pay dividends with the remainder.

Unfortunately, a CLOC is a form of loan, and as such is subject to the availability of credit to loan in turn to the business. The largest banks right now, including Bank of America and CitiGroup, are now in a situation where their available capital is being applied in order to absorb the failing investment banks while dealing with their own marked-to-market problems. This means that the amount of credit they can extend to businesses is very limited. It has been rumored that Bank of America in particular is planning on closing down lines of credit for those below a certain credit rating, and most banks are also failing to renew lines of credit when they expire (since such CLOC in particular are usually on short term - 6 month, annual or biannual terms, this means that a large number of such lines of credit will be negatively impacted just within the next couple of weeks).

The effect of this should be obvious. Within the next couple of weeks, businesses will need to start relying on their underlying capital in order to pay for facilities and payroll. For businesses with a healthy cash flow (or those that have been banking income), the disruption will likely be mild.

However, many businesses are reliant upon lines of credit because their income sources are much more bursty, with large payments received at end and midpoints in projects (this is especially true of software and other services companies). If these companies have not built commercial reserves (and given the uncertain economy of the last year, many companies were already using those commercial reserves to handle shortfalls that the CLOCs didn't cover) this means that they may be unable to cover payroll within a month, and be unable to cover leasing within two to three months.

The result of this will be unpaid holidays - people are going to be idled until such time as alternative funding can be arranged ... and if such funding can't be arranged quickly enough, they will be pink-slipped, likely with comparatively little in the way of severance packages.

For those who remember the Tech Recession, what's coming soon differs in one crucial aspect. In 2001-2004, the principal problem was a fairly typical overshoot of supply (technical capacity) compared to demand. Now, demand is there (though it's weak and declining) but the money to run the businesses in the short term isn't. This means that simply working through the overproduced simply will not by itself is not enough.

In essence, the economy has just had a heart attack. The banks have seized up, because no one is sure what the assets that the banks have are really worth. Moreover, this has been compounded by the huge tower of derivatives that are all going sour, and those who made the bets (investors and speculators with the largest investment banks) are now in a position where they all have to pay up at once. Since many had made the bets assuming that they would never need to pay off more than a small number of them at any given time, this has forced any company dealing with such derivatives - investment banks, hedge funds, insurance companies - all now essentially collapsing at once.

It is debatable whether EESA would in fact have stopped this process, though it likely would have had the effect of slowing it enough that more potent (and longer term) legislation could be brought to bear upon it. That is moot now - the issue has become politically charged at the height of a presidential election, and the likelihood of any new legislation arriving is slim until either the political landscape changes or a significant breakdown in the economy actually takes place, at which point, like that heart attack, the damage will have become irreversible.

Kurt Cagle is Online Editor for O'Reilly Media. Feel free to subscribe to his blogfeed, as well as his personal website, Metaphorical Web.

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