This column was written by Michael Kao, CEO and portfolio manager of Akanthos Capital Management, a hedge fund specializing in convertible, capital structure and event-driven arbitrage strategies.
As I watch the surreal economic tableau unfolding, I recognize more and more that one of the key impediments to efforts to stabilize our economy and markets is that many people don't appreciate the umbilical cord that exists between the Wall Street economy and the "real" Main Street economy.
While Treasury Secretary Paulson and Fed Chairman Bernanke have repeatedly sought to find the right salve for the economy, they have thus far diluted their own efforts by trying to punishing the "bad guys" on Wall Street. The farcical showdown in Congress regarding the passage of the TARP again revolved mainly around the need for immediate action versus the need to assuage the moral hazard hawks.
While there is no doubt that there were "bad apples" on Wall Street who exacerbated the current crisis and that the moral hazard issues ought to be resolved over time, the fact remains that while the house is burning down, there really isn't time to discuss what kind of fire hose to use. People need to understand that, like it or not, our real economy
on the viability of the financial system. Availability of credit and proper functioning of capital markets are crucial lubricants to the engine that is our economy.
One of my biggest frustrations in watching the debate in Congress over TARP was that too much of the discussion revolved around "credit freeze-ups" and "elevated LIBOR" and other arcane-sounding "Wall Street" lingo that the layperson on Main Street might not understand. No wonder that the politicians had overwhelming pressure by their constituents to vote "Nay." That the press kept labeling it a "$700 billion bailout bill" also further extended the mislabeling.
Make no mistake -- Wall Street and Main Street are joined inextricably at the hip. The heart of this crisis stemmed from falling real estate prices due to subprime borrowers' inability to continue mortgage payments once resets started hitting.
The resultant foreclosures and tightening of credit has spread this contagion far beyond the bailiwick of the original "bad apples." The freezing up of the credit markets is now damaging the businesses of even "good banks," making it impossible for them to extend credit to even "good borrowers," whether they are individuals or businesses in need of financing.
As a result, not only are financial equities plunging, but the overall market is plunging due to "good companies'" inability to roll debt and finance working capital. This will inevitably result in more and more bankruptcies in all sectors, causing rapidly rising unemployment.
Main Street America has yet to fully grasp the ramifications of a frozen banking system, and falling real estate prices are just the beginning. When banks are too scared to even lend to each other (as evidenced by the freeze-up in commercial paper and highly elevated LIBOR levels), why would they extend mortgage financing to anyone but the super-qualified?
And even then, because there is no other game in town, why shouldn't those rates be exorbitantly high? This means that even "innocent bystanders" will be hard-pressed to purchase and hold onto properties. At a time when home ownership is at an all-time high in America, the average person on Main Street in dangerously close to lose most if not all of his/her net worth.
The inability to obtain financing is affecting
kinds of consumers and businesses -- it is cutting deep into the muscle and bone of our economy. Auto leasing companies can no longer make leases viable, so the typical consumer who cannot afford to pay all cash for a car has to resort to loans; again, if banks are reticent to lend against real estate, what makes them likely to make attractive auto loans?
Similarly, if a credit card issuer cannot securitize its receivables because asset-backed markets are freezing up and decides to either shut down accounts to dramatically raise interest rates, what will happen to Joe Consumer who relies on this last resort financing to pay the bills? What happens to students who cannot afford college educations without loans? What happens to the small business owner (or for that matter the big business owner) who can no longer get business loans or credit facilities renewed that are required for basic working capital needs?
Vendor financing is drying up as suppliers themselves are unable to get credit. Accounts payable terms inevitable shorten, while accounts receivable become questionable. Countless businesses across all sectors, including manufacturers of widgets to retailers, are already feeling this pinch and are forced to fund working capital needs out of cash or, if they lack cash, by fire-selling assets like inventory and property, plant and equipment -- again cutting into the muscle and bone of the business.
Besides borrowing, where else can an individual or corporation get money for all of these needs? Savings, of course! Wait, let's look at what happened to those savings. Even for those lucky enough to not have been hit by collapsing real estate prices, most people in working America have 401(k) plans and IRAs and pensions and life insurance policies. Based on the asset allocation recommendations of most financial planners, stocks have been marketed as a great long-term investment (long-term as in 30 or 40 years), thereby commanding as high as 50% to 70% of investors' retirement vehicles.
While some might argue that it's ok that global equity prices have plummeted 40% to50% (60% to70% in some cases) this year because they are long-term investments, what happens if people need access to these vehicles because they cannot get credit? Worse, what happens when the very custodians of these assets, whether they are the Morgan Stanley's or the AIG's of the world, are on the brink themselves?
OK, so what if Main Street can't borrow or has no savings to tap -- at least people still have their jobs. Or do they? When businesses can't roll credit lines they can't meet working capital needs. When working capital has to be reduced, revenues are sure to fall -- and that's even before talking about weakening demand for its goods/services in a Depression economy. When revenues fall, fixed costs have to be reduced. Unfortunately for our hapless Main Streeter, one of the easiest costs to shed is personnel costs. While raising taxes on corporations and cutting taxes on the middle class sounds very enticing to Main Street, the law of unintended consequences may once again strike here. This very path was followed by Herbert Hoover in 1932 following the 1929 market crash; the end result was the Great Depression, and unemployment far exceeded 20%. Main Street America won't benefit from tax cuts when there is no income to tax.
Our government leaders must understand the symbiosis between Main Street and Wall Street. Without the lubricant of credit availability that comes from Wall Street, Main Street will suffer irreparable damage, turning any hope of a "U-shaped recovery" (no one is banking on a "V") into a Great Depression style "L-shaped recovery." The "bad guys" on Wall Street have arguably already gone over the precipice. Like Inspector Javert in Les Miserables, the moral hazard hawks' endless zeal to punish the so-called perpetrators is about to lead the rest of America over the precipice as well.