Market Update — Emergency Economic Stabilization Act of 2008 approved — the pain continues

William F. (Ted) Truscott, Chief Investment Officer
Oct. 6, 2008

A brutal week of political negotiation and stomach-churning losses ended with the passage of the Emergency Economic Stabilization Act of 2008 (aka the "Bailout Bill"). President Bush signed the bill into law quickly after it reached his desk. The politics of this package were star-crossed from the beginning. The sobriquet of "bailout" and the size ($700 billion) suggested that the bill was designed to dig rich people on Wall Street out of the mess they had created. Angry constituencies telephoned Congressmen and Senators and demanded a vote against the bill. However, the calls began flowing the other way as credit markets froze and even creditworthy borrowers such as AT&T could not borrow short-term debt on acceptable terms for more than one night. Ordinary citizens began to realize that restrictions on credit and declining 401(k) balances could hurt them too.

The original bill was quickly expanded from 100 pages to more than 400 with the addition of tax breaks and other features designed to make it easier to pass. The substance of the bill makes it clear the bill is not really a bailout, but is actually designed to give the government the ability to buy distressed mortgages and certain other troubled financial instruments from a variety of financial institutions. How the program works is largely left up to the U.S. Treasury, which has 45 days to draw up their plan.

Ben Bernanke, the Chairman of the Federal Reserve, has been described as one of the foremost authorities on the Great Depression. I decided to read one of his most famous papers to see if I could decipher how his past work may be motivating the current efforts of both the Federal Reserve and the Treasury in trying to stem the ongoing crisis. The paper is entitled "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression."

Bernanke's central thesis, which is supported both by logical argument and a series of equations and regression analyses, is that there is more behind the lasting effects of the Great Depression than the loss of shareholder wealth and a rapid decline in the money supply, as other academics have documented. In seeking to explain this, Bernanke introduces a concept called the Cost of Credit Intermediation (CCI). His point is that the CCI rose during the Depression and that a reasonably efficient system for allocating credit was disrupted for many years. It became harder for banks to distinguish between good and bad credit risks and, therefore, the cost of credit soared leaving many creditworthy customers without any access to bank financing¹. This increase in the CCI was unhealthy and it is reasonable to conclude that Bernanke believes the Fed and government's current role should be to counteract the monetary and nonmonetary effects of our current credit crisis.

As I have said before, credit is the grease of any economic engine. Take away the grease and the economic engine will run less efficiently or fail. As such, the work of the Federal Reserve and U.S. Treasury can be seen as a race against the clock. The longer the credit allocation process is disrupted, the higher the potential costs, including a deeper-than-expected recession. Seen in this light, the bill passed last week is necessary in that it can remove illiquid and distressed assets from the balance sheets of financial institutions. This helps free up these institutions to resume the allocation of credit to the economy.

We are not arguing that we are about to return to the Great Depression. Government involvement in the economy is much deeper than in the 1930s and there are many more tools available to policymakers today than were in place 75 years ago. However, our chief economist, Dan Laufenberg, has forecast a recession in 2009 and I am concerned that the disruption in the credit markets and the massive deleveraging of the financial system could prolong and make the recession deeper than originally thought. To mitigate this risk, policymakers are doing everything they can to return the credit markets to some sense of normality. If unsuccessful, then the CCI will likely rise even though we live in a far more open and resilient financial system than in the days of the Great Depression.

The question that nags everyone at this point is what to do? Last week I argued that there were long lists of stocks and bonds that represented good value in today's market. Many clients and advisors naturally asked — "what's on the list?" While we express this in the stocks and bonds that we purchase for mutual funds and separate accounts, let me give two more specific examples.

Last week, AT&T stock had a dividend yield of 5.77%. AT&T is a solid company with a growing wireless franchise. It's important to acknowledge that we do not know when AT&T stock may rise again, and indeed it may fall further in the weeks and months ahead as it is logical to expect that there will be some slowdown in AT&T's business as a result of a recession. However, as an investor you have an opportunity to earn close to 6% just waiting for things to get better. While there is no guarantee that this dividend will not be cut in the future, the dividend of one of America's strongest companies appears reasonably secure. With ultra-safe Treasury notes yielding a little over 3%, a stock investor is earning almost 3% for the additional risk assumed. The dividend yield plus the fall in AT&T's stock price and its P/E ratio of a little over 12 makes this stock a reasonable value.

Corporate bonds are now yielding almost 5% over comparable ultra-safe Treasury notes. This is the widest "spread" we have seen in modern times. That extra yield again provides a reasonable margin of safety for an investor even if times get tougher in the months ahead. Investor Warren Buffett understands this all too well. In the last two weeks, he has struck deals with Goldman Sachs and General Electric (GE) where his special class of preferred stock pays him 10% to wait for conditions to improve. He also holds options to purchase Goldman and GE stock at very cheap prices. Most of us do not have the bargaining power of Warren Buffett, but GE stock yields over 5% and you can buy the stock today at the same price on which Buffett holds his options.

These are difficult times and people at or close to retirement are feeling the steep slide in the marketplace more deeply than most. The paragraphs above offer a non-emotional way to view the stock and bond market. This may not offer complete comfort, and for that reason, we encourage you to discuss your financial plan with your advisor. In that discussion, be sure to look at the wide range of product solutions offered by Ameriprise Financial and use product diversification as a way to manage the risk in your portfolio.

Some of our product solutions, such as certificates and fixed annuities, offer a fixed return, which may be more suitable during these uncertain times. Other products, such as variable annuities, offer exposure to the market with additional riders that include guarantee features. Finally, our mutual funds are configured to try and take advantage of the values in today's marketplace.

No matter what you do, rational thinking devoid of fear is important in today's environment. We have discussed many times before the importance of staying invested, removing the emotions from your investing decisions and remaining focused on your long-term goals and objectives. Your financial advisor is there to help you focus on these crucial strategies and to assure you that Ameriprise Financial remains a strong and viable company.