the bailout and the stock market.....

This is a special single idea post. Today's regular post is below.

Casey asked me to put in plain English what the $700 billion bailout was supposed to do. I think many people are confused by this bailout, and what it actually does, or is supposed to do. Also, many thought after being signed on Friday, things would automatically get better. The public did not expect to see a stock market drop of almost 1000 points these last three sessions. Well, the stock market and the credit market (which the bailout is supposed to fix) are two separate entities, and while the credit market is not effected by the stock market's ups and downs, the stock market can be effected by the credit market, if the credit market is slowed or "squeezed".

This mess has never been explained to the public in terms that "normal" people can understand. I will try to do so here, in the same way I was explaining it to Morgan earlier today. This is a very crude example, but I think it works.

Imagine that ABC Bank loans money to people and businesses. Under normal conditions, ABC makes loans to Mr. Smith and John Doe Company, along with many other people and businesses. Mr. Smith uses the money to buy a house or car, while John Doe Company uses its money to purchase equipment, inventory, and hire workers. All keeps the economy moving along.

Also a company, let's say Mike Jones, Inc., may even borrow money from ABC Bank in the form of a line of credit to pay some bills until income or cash flow arrives. All part of normal business. This is a little different though, because Mike Jones, Inc. has a line of credit, they don't actually have the money in hand, but know it is there if they need it.

***In real life, DEF Investment Bank might purchase the loans from ABC Bank, and then GHI Big Shot Firm might buy from DEF what it just bought from ABC. You don't see any of this, but this was how "Wall Street" got involved, because it turned those purchased mortgages into investment vehicles***

When payments are made, ABC can lend out more money, including the interest it makes on the loans. This "in and out" of money is what keeps cash flowing and our economy churning.

Well in the last few years, the Mr. Smiths of the world, have not been paying back their loans. On top of that, the houses that were to be used as collateral against the loans, are down in value as compared to when the loan was originated, plus nobody wants to buy the house. So, ABC has lots of pieces of paper, and no money. With no money, they can't lend money to businesses, so businesses can't expand, or possibly pay some of its bills. If they can't pay their bills, because people are not buying their goods, they may need to lay people off.

This is the credit crunch people have been talking about. There may be money out there in the system, but not in the amounts that there was before, so it is hard to get, and if you want it, you must pay higher interest rates to get it.

***A real life example of this was Caterpillar last week. They went to get some short term loans to pay some normal operating bills, and paid almost double their normal interest rate***

***As my "real life" example before. Because Mr. Smith is not paying back their loans, it not only effects ABC, but DEF, and GHI. So, because of the way these loans were handled as future investment instruments, Mr. Smith's loan being "purchased" up the chain, when not paid back, effects many different entities.***

OK, so the bailout. Well the bailout is really a "government will purchase those bad loans" agreement. What is supposed to happen is that the government will purchase the bad Mr. Smith loan (wherever it is in the system), in hopes that it will be paid back, or the collateral can be sold to offset the loan amount. By purchasing the loan from ABC Bank, the federal government is putting the money back into the system. With the money back into the system, it means that these ABC Bank can start making loans again, and at normal interest rates to people and businesses.

In essence it sounds good, but because we are in a bad economic cycle, companies are not looking to expand, just survive at this point. While this "bailout" will put the money back into the system, until people start spending money (which will only happen if jobs are created, housing values start rising, etc.) companies will just be "getting by".

This in a very raw and crude way is what the bailout is supposed to be about. I am not going to assign blame here, as I have done it in different posts, but let's say that home buyers, mortgage lenders, and firms looking to profit on those mortgages, are all to take a portion of the blame.

Now, what everybody is seeing, and somewhat understanding, is that the stock market is tanking, and with that, people can "see" their investments (usually retirement portfolios) shrinking. What needs to be understood is that the stock market is a reflection of how much money people are spending, or going to be spending, in the outside world. Right now, people are holding onto their money and not making many purchases outside the necessities. Investors expect people to be frugal for a while, so with that stocks are going down. The same with oil. Because investors think people will be driving and traveling less, oil went below $88 a barrel today.

***A little real life example for the stocks and your portfolio. I have purchased Apple stock. I have it for almost a year or so, and I paid $124 a share. Now Apple is iPods, iPhones, Macs, etc. A good solid company, and not going anywhere. At a time this summer those shares were close to $200 a share. Today, they dropped to less than $90 a share. Same great company, same great products, but investors think people will be holding their money and not purchasing as many iPods, iPhones, etc., so the stock falls.

Now if Apple was your 401K, you are thinking it is tanking, so you better leave it. First, you purchased at $124, so it really only lost $34 a share, as when it was at $200, that was "paper profit", so while it has gone down, it is not as far as it seems, because much of the loss was "paper profits".

Well, unless you think Apple is going to close its doors, and you think Americans will never buy "gadgets" again, Apple will rise again. It may take a while, but it will. The iPod is not going anywhere.***

So, unless you are completely pessimistic about the US economy over a long time (10 to 20 years), it is just a matter of patience.

The government did a terrible job explaining to average Americans what this all meant, and that it would not have an instant effect on the economy (and many think it will have no effect).

The economy goes in cycles, up and down. What has happened here is the "perfect storm". Besides an economic slowdown, housing values started declining and people in terrible loans found themselves "upside down", with no way to pay them back. Add to that the costs of items (food & energy) going up when oil rose to $150 a barrel, and it was/is a recipe for disaster.

Hopefully, I was able to explain in plain English, what is going on, and why things were done the way they were, and why things are happening now. It is a tough and confusing time, but this is America, and I believe we will get through this, but it is going to be a bit of a rough ride in getting there.

Until the next time.....