What Will Happen If A New Plan Is Passed?

The Senate has passed a slightly altered Plan tonight and perhaps the House will move in the same direction as it meets tomorrow. I continue to believe that the plan might not have the best structure (See my alternative plan) but some Bill will be better than no Bill. Let's assume a Bailout Plan passes, what can we expect to happen in the economy and the markets? The Government will now proceed to buy distressed assets from the balance sheets of financial institutions with the intention of freeing up capital. The goal would be to improve lending and strenghthen the credit markets. It sounds good but first many of these financial institutions will need an injection of fresh capital. Why does Warren Buffett want the plan to succeeed? Many new opportunities to provide attractive equity capital will become available to him. Hence, the plan will allow for more dilution of current shareholders and perhaps lower stock prices.

Does the Bailout improve all the credit markets? Absolutely not. The worst is yet to come. We should expect to read alot about auto loans, credit cards, home equity loans, construction loans, and corporate loans. What we will hear and read about is Default, Default, Default. The consumer is tapped out as his/her home value has declined and his/her ability to borrow against it has disappeared. Instead of consolidating debt through a home equity line, credit cards will be used. The problem is that banks are tightening those credit lines also. It won't be so easy to get a new credit card with stricter credit standards being imposed. The consumer will feel pinched and may not be able to pay off those auto loans or home equity lines. How can this happen all at once? Well, the economy is clearly heading toward a severe recession and the unemployment rate will rise. Fewer jobs and lower incomes mean a weakened consumer.

The new Bill proposes to alleviate the homebuilding industry by removing the bad mortgages off the books of banks but if home prices continue to fall, it may be awhile before homeowners can sell their current homes to buy new ones; and it may cause new potential buyers to delay their home purchases. The Bill doesn't seem to focus on commercial real estate but that problem is brewing. The retail industry is suffering and bankruptcy's have begun. This will start to put some stress on shopping centers. During the past decade, commercial real estate also boomed. Leverage was easy and rents were rising. As businesses fail, rents will fall, competition for new tenants will rise, vacancies will be bountiful, and leverage will be a huge problem. We should expect to see cracks in the commercial real estate market. Furthermore, construction lending was another large profit center for banks, both large and small, but a weakened corporate environment will result in defaults on many of those loans also.

What is amazing during the past year is the strength of corporations. The LBO Boom created the greatest opportunity to add leverage to balance sheets while requiring only a sliver of equity. It was great for a while as private equity firms reaped huge profits after reselling selling those companies or recapitalizing them with huge dividends to themselves. However, the musical chair game is about to be over and not everyone will have a seat when the music stops. We should expect to see a plethora of corporate bankruptcies as the economy weakens, revenues decline, cash flow disappears, and the banks balk at providing new loans. Leverage is great when business is strong but it will kill a company on the way down. Many of the leverage buyouts have capital structures which could delay bankruptcies as the terms of the bank loans will forestall defaults but they won't prevent many forced restructurings. The domino effect could potentially negatively impact suppliers, competitors, and customers of these failed corporations.

Unfortunately, many of these issues won't only affect the United States. These will be global problems and will create a global recession. Buckle up and hold on tight. Invest in only high quality stocks where leverage won't be an issue and free cash flow is available.