Breaking Commentary: It Passed! Now What?
By Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
October 3, 2008
In a 263-171 vote, Congress passed the Emergency Economic Stabilization Act of 2008
in the hopes of unfreezing the credit markets. It will also hopefully reverse the panic that
erupted after the plan failed to pass the House on Monday. As most of you know, the
legislation authorizes the government to buy troubled assets from financial institutions.
The bill had $149 billion in tax breaks added to it since Monday’s no-vote, some of
which were ridiculous earmarks as I touched on earlier this week. As unfortunate as this
situation is – with the largest government intervention since FDR’s New Deal – passing
this bill was absolutely the right thing in our opinion. We needed to stop the panic.
No, the plan’s not perfect. But the problem was that if we waited to act until a new,
better version of the plan was constructed, a complete financial system breakdown was
all-but inevitable. Anecdotal evidence of just how dire the situation had become
probably swayed some votes into the yes camp. Even well-qualified borrowers being
shut out of credit; small companies are finding they no longer have ANY access to their
existing credit lines; and the market for commercial paper – short-term borrowing by
businesses – suffered the biggest one-week drop on record. Businesses cannot function
without access to credit, and the majority of the House finally came around to this
Terrible “marketing” job
Part of the problem getting a majority of politicians and the public to rally around this
plan was its poor “marketing” by the media and politicians themselves. The fact that the
term “bail-out” has been used so ubiquitously is a frustration. No one is being bailed out
and it’s not going to “cost” the taxpayer $700 billion. The U.S. government (taxpayers)
is not handing the money to financial institutions … it is buying distressed assets with the
money, and if structured properly the government (taxpayers) stands to ultimately benefit
from the deal. That’s why Warren Buffett himself has said he’d like to get in on the deal
with a 1% stake.
The government plans to hire five to 10 asset management firms as Paulson establishes
the government’s new office for handling the financial relief plan. The department will
also add about two dozen new employees; a mix of bankers, lawyers, accountants and
others according to Bloomberg News. The Treasury’s first attempt to hold an auction to
buy troubled assets from financial firms will take at least four weeks to set up.
Market down … what gives?
So, why did the market sink on the news of the bill’s passage? As we’ve been saying, we
think passage was a necessity to avoid a full spiral out of control in the credit markets,
but it is certainly not in and of itself a cure for what ails us. This may have been
investors doing their classic thing—buying on the rumor, selling on the news. A ninth
consecutive month of payroll losses certainly didn’t help either. With every hurdle the
market jumps, there’s another one waiting a short distance away.
Governator asks for help
Also probably swaying some lawmakers was the letter yesterday from the State of
California to Secretary Paulson regarding the ability of the state to pay for “teachers’
salaries, nursing homes, law enforcement, and every other state-funded service.” Adding
fuel to the fire, the California State Treasurer was quoted as saying that the state “has
been locked out of the credit market for the past 10 days.”
Given these powerful statements it isn’t surprising that investors who currently own CA
bonds might be experiencing some angst as to the ability of the state to make coupon
payments on bonds and to return principal. We think these fears are overblown. It is true
that California is not in the top-tier in terms of credit quality, but we do not believe this
event is indicative of some imminent problem with California state debt.
To explain why let’s take a step back and quickly explain how state governments fund
their operations. States spend money all year long on a variety of things, but the tax
money to pay for those activities is lumpy. Much of it arrives in the spring when
individuals file their tax returns.
To manage that seasonal variation, California typically issues revenue anticipation notes
(RANs) sometime after the state budget is enacted. With the current year’s budget
enacted so late, California’s estimated $7 billion RAN sale is also occurring about a
month later than usual, and is now coinciding with the locked-up credit market.
To put it more simply, three events are converging that make it hard for California to
borrow right now:
1. California’s spending needs are huge,
2. California does not have pristine credit quality, and
3. Frozen credit markets reduce the ability of the market to absorb new
borrowings—particularly from borrowers with lower credit quality.
This does not suggest that current holders of California state bonds are at greater risk of
not receiving their interest and principal payments. In fact, with today’s bill passage we
would expect the credit markets to thaw somewhat. If they remain frozen then California
could resort to asset sales to make payments to bond holders, a remote possibility at this
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