Economic Outlook...Dim Government's Response....Worse

American's seem to have an amazingly tiny attention span. When the "subprime" mortgage problems began to bubble up people were worried. Now? Most people don't seem to care. That's unfortunate because the hammer hasn't fallen yet. It takes time but it will trickle down. Buckle up.
Merrill Lynch - $8 billion in write offs for bad debt. They went from a profit of $3 billion to a net loss of $2.3 billion.

Bank of America - 32% drop in 2007 Q3 profits. Net income fell 1.72 billion dollars.

Bear Stearns - 61% drop in 2007 Q3 profits. Total revenue fell 38%.

Countrywide Financial - 37% drop in Q1 2007 profits. Net income fell 249.5 million.

Citigroup - 57% drop in Q3 2007 profits. $6.5 billion in pretax losses and write downs.

I could go on, but these are the best examples. The bigger question is what does this mean? The drop in profits alone is irrelevant for the wider economy. What is relevant is how these loses have tightened equity markets. Less capital leads to less investment which leads to fewer jobs. It is a very simple equation. The fed has bailed out the banks with bundles of cheap cash (notice the dollar's value falling hourly?), but banks will still tighten their lending practices.

What is the government proposing to do? Exacerbate the problem of course. Congressman Barney Frank is proposing to...

"require all mortgage originators to present consumers with loan products appropriate to their current circumstances, ban prepayment penalties for sub-prime mortgages and forbid incentive payments to lenders who steer borrowers into higher-cost loans" (from The Hill)

Imagine if we instituted such rules for restaurants. What would happen? The menu would change for most people depending on who decides the definition of "appropriate", the restaurant wouldn't be able to punish you if you walked out on your check, and waiters would not be allowed to encourage you to buy the extras (desserts, appetizers, drinks). Does not sound like a desirable economic situation for either the buyer or the seller. Essentially the same will happen in the real estate market. There will be a capital crunch.

I'm no historian but this is eerily similar to what happened in the great depression.

Economic Pain Forthcoming

I am now completely divested from the stock market and I advise you to do the same if possible. Usually I don't make predictions because of the high probability of looking silly, but a downturn seems imminent.

Why? Because there isn't enough liquidity in the market. From the NYT...

"The pain for hedge funds and banks has been broad, starting in the mortgage market, spreading to the wider credit markets and ultimately the stock market.
The problems have been worsened by the debt that hedge funds have taken on and used to invest to amplify gains.
Now hedge funds are quickly taking off that leverage, responding to tighter lending standards from banks or redemptions from anxious investors.
The casualties have included investment banks like Bear Stearns, which witnessed the collapse of two hedge funds that were invested in mortgage-backed securities, and blue-chip quantitative funds, whose computer-driven trading models did not anticipate recent market movements.
Now the ripples have spread to Goldman, whose stellar results have made it the firm to beat on Wall Street in recent years."

The cheap cash the Fed was showering on us through low rates led to a predictable overextension. People bought houses they couldn't afford while businesses received loans they didn't deserve. If millions of people begin defaulting on their homes (Jim Cramer predicts 7 million possibly) and investment firms don't have money to invest there will be tough economic times ahead.

The saving grace may be that many good companies are sitting on large cash positions. Many corporations learned their lesson from the dotcom market bubble burst and began stockpiling cash. But there is no reason to predict that they would begin investing it if the entire credit market begins to implode. Instead, they may decide that the prudent move is to continue sitting on all the cash. Central banks around the world including in the U.S. have been fighting the situation by pumping cash into the system at an incredible pace (here).

I am not knowledgeable enough to break down the entire situation. I am knowledgeable enough to know that when central banks have to pump billions of dollars into the system to keep the credit market alive that it is time to get on the stock market sidelines. Sell and live to tell.