The Curve in the Road






10/4/2008 1

The Curve in the Road

Necessary but Not Sufficient

Why the Government Had to Step In

All the King’s Horses

How Can I Be 59?

By John Mauldin

The “Bailout Plan” was passed. Will it work? The answer depends on what your

definition of “work” is. If by work you mean no more government intervention and no

further costly programs and a functioning market, then the answer is no. But there are

things it will do. This week I try to help you see what might lie ahead around the Curve in

the Road. We look at how the rescue plan will function, see what is happening in the

economy, and finally muse as to whether Muddle Through is really in our future. It will

make for an interesting, if not very upbeat, letter, so strap in. I would like your promise to

not shoot the messenger. I am just trying to give you some of my thoughts as to what may

lie in our future. And remember, as you read this, we will get through it. There are better

days “a’coming.”

But first, a few housekeeping items. Let me welcome some 200,000 new readers

from EQUITIES Magazine. I have recently joined EQUITIES Magazine as a regular

contributing editor. My column, Back to the Frontline, is featured in both their print

publication and at I am excited to be associated with this

esteemed magazine with a rich history covering the global markets for over 57 years.

They’ve once again agreed to offer any reader of mine a free subscription to

EQUITIES Magazine. For those who did not take advantage of the free subscription the

first time, here is your chance. You can go to

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The Curve in the Road

10/4/2008 2

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(In this regard I am president and a registered representative of Millennium Wave

Securities, LLC, member FINRA. And please read all the risk disclosures.) And now,

let’s jump in to the letter.

The Curve in the Road

When you are out driving on a strange new road, you can’t see around the curve

ahead. But you can read the warning signs to get an idea of what might be coming. And

while we can’t really know how the developments in the economic world will actually

unfold, there are some signs we can point to that might give us a few ideas.

First, let’s look at the “rescue plan” as passed by Congress. As I pointed out last

week, this is a bad bill. But it was necessary to pass something, and soon. Earlier this

week I sent out a report that reviewed a study of 42 major baking crises. The conclusion:

navigating them successfully depended upon quick action.

As everyone should know, the credit markets are almost completely frozen.

LIBOR is bid only, no offers. Commercial paper markets are imploding. And what is

trading is often at rates that are much higher than they were a few months ago.

Corporations are being strangled on high rates. Corporations have little or no access to

normal credit markets, and they will face massive problems when it comes time for them

to roll over short-term debt.

LIBOR has gone crazy. This is not an orderly market.

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10/4/2008 3

Look at the following chart from friend Greg Weldon. For most readers, the

commercial paper market is something you don’t think about. But it is the lifeblood of

business. We have seen this market drop by almost 30% in a year and by 10% in just the

last three weeks! I simply cannot overstate how serious this is. Left unchecked, business

activity in the US would soon slow enough to bring thoughts of the Great Depression. It

will not be left unchecked.

The credit crisis is not simply a Wall Street issue. It has fast become a Main Street

issue. And Main Street is where jobs are created and maintained.

As I have said repeatedly for months, the problem is that financial institutions are

having to deleverage. They have massive losses and simply have to raise capital in order

to survive. If you can’t raise equity capital (and most can’t), one of the ways you do that

The Curve in the Road

10/4/2008 4

is to make fewer loans and to take less risk. You also charge more for the loans you do


Larger institutions cannot raise capital on competitive terms. GE is an AAA-rated

company. Yet they had to pay Warren Buffett 10% to get $5 billion, plus in-the-money

warrants worth at least another 10%. Buffett is likely to double his money on this deal

over 4-5 years. A short while ago, GE could get short-term commercial paper for a few

percentage points. That difference is going to significantly impact GE’s bottom line. But

they had no real choice. They took the money.

As did Goldman Sachs. Yet another Buffett $5 billion preferred-share purchase

(with more warrants) at a rate that even Goldman will find it hard to make money on. But

they had to raise capital quickly, and they had little choice.

I had lunch with Michael Lewitt and Joe Harch yesterday. They were in town to

meet with a client, and we took the opportunity to get together and share notes. They run

(among other things) a collateralized loan obligation fund. They buy bank and corporate

debt. They now have the opportunity buy well-collateralized loans from rated companies

at prices well below par. They related story after story of debt from quality, highly rated

companies selling below $.90 on the dollar, and some much lower.

If GE and Goldman are paying 10%, what do you think it costs a firm with “only”

a B rating? 15%? More? Junk bond yields have simply gone ballistic. Firms which used

the credit market to access capital now are simply shut out. If they are a small public

company, they can go to what are known as PIPE hedge funds (Private Investment in

Public Equity) and sell equity at usurious rates (which is what Buffett does but on a larger

scale). But a small or medium-sized private company? It is a hard time to go looking for


Left alone for the markets to work out, the economy of the US and the world

would be in a depression within two quarters and would need years to recover. Think


Necessary but Not Sufficient

Now for the bad news. The Rescue Plan was necessary but not sufficient to fix the

crisis. There is going to have to be more heavy lifting, I am afraid. Let me offer a few

ideas about what possible actions might be taken in the future. I am not advocating these

actions, I am simply telling you what might happen. These are possible, because

authorities will do whatever they deem necessary to avoid a systemic economic

meltdown and a potential depression.

If you are a large investor or sovereign wealth fund which put money into banks

last year, you are down anywhere from 35-50% (unless you invested in Washington

Mutual, and then you are down 100%). You are unlikely to invest more in any financial

institution without some very real understanding of what is on the balance sheet of the

The Curve in the Road

10/4/2008 5

bank that is asking for your money. What the Paulson plan potentially does do is remove

the questionable debt. The bank may have to write down assets in order to sell the debt to

the government, but they end up with a transparent balance sheet with hopefully known

risks. Then they can go to the market and try and raise capital. Shareholders will get

diluted. Such is the way of the world.

Sidebar: taxpayers really must demand that someone like Bill Gross of PIMCO

and/or other savvy market specialists run this new government operation. He offered to

do it, and I think we should take him up on his offer. Taxpayer losses should be kept to a

minimum, and I believe someone like Gross would do his best to see that would be the

case. The point of this exercise is to restart the frozen credit markets, NOT to bail out

banks. Some banks may get bailed out in the process, but it should be at a cost to their

shareholders and management, not to the taxpayer.

I am asked, why can’t private money solve the problem? Because there is simply

not enough private money. Buffett offered to take 1% of the new government pool. If that

is all the largest pile of free money in the world can take, why does anyone think there is

enough private capital to take the other 99%? Insuring the mortgage bonds is not

sufficient, because there is not enough money to buy them in this market. When things

have sorted themselves out in a few years, I think the bonds can be insured and sold, and

likely at a profit if bought correctly. But we do not have the luxury of waiting a few


Between the relaxation of the mark-to-market rules and removing ambiguously

priced loans from financial institutions at prices which allow the government pool to

make a small profit, if held for five years, that part (the lack of a known price) of the

problem can be solved. Banks can hopefully buy themselves time in which to work their

way out of the problems they created.

It is much like 1982, when every major US bank thought it was a good idea to

loan lots of money to Latin American countries. It was a most profitable business, right

up until the countries decided to default. Then every US bank was more than just

technically bankrupt. In a mark-to-market world, every large US bank would have

collapsed. It would have been the end of the world as we knew it.

What did they do? The Fed let the banks keep the loans on their books at face

value. Over time, they worked their way through the debt, making enough money to be

able to write down the loans. That was done simply to give the banks the ability to buy


We are in a very similar situation. We have to buy some time in order for

financial institutions to heal.

Why the Government Had to Step In

The Curve in the Road

10/4/2008 6

I had a lot of readers write me very nice letters this week, starting out with how

much they like my letter, my insights, etc. Then they (mostly – but not all – and politely)

launched on me for backing the rescue plan. Many of you had much better ideas than

what was passed by Congress, which is not surprising.

I really do hate the idea of having to support a rescue plan. It goes against my

every instinct. But I also know that doing nothing would result in an economy which

would blow right through 10% unemployment within a few quarters, and take years to

recover. The stock markets and the savings of millions of retirees would be wiped out.

Home values would really go into a tailspin. Being right in theory is not worth seeing that

kind of devastation.

Herbert Hoover sat by and decided to let the market solve the problems of 1929.

He decided to run budget surpluses and ignore collapsing institutions. Combined with

disastrous Federal Reserve policy (raising rates in a recession) and Smoot Hawley (which

caused major trade wars and a slowdown in global trade), what should have been a

serious recession turned into the Great Depression and resulted in the conditions for

World War II.

The rescue plan does not address the need for the increased levels of capital

needed by banks. As noted above, it simply creates the conditions under which capital

might be raised. Banks have already raised $440 billion. They have written down $590

billion. Losses are estimated from a mere $1 trillion to as much as $2 trillion. About half

of those losses would be in banking institutions worldwide. That means anywhere from

$200 to $400 billion more must be raised in order for banks to get back to capital

adequacy. It is probably closer to the latter number.

Until banks are adequately capitalized, they are not going to be able to do normal

business lending. Further, large deposits are fleeing banks. Even with the new level of

$250,000 of FDIC insurance, there is $1.9 trillion in uninsured deposits. These are mostly

deposits of small to large businesses and financial institutions, which can leave a bank at

the push of a button.

Nouriel Roubini tells us that there are 800 billion dollars deposited in US banks

by foreign counterparties. Up until this week, if you were a foreign operation, would you

rather be in large money-center US banks or European banks? Tough choice, but on

balance you would pick the US. Then this week Ireland decided to simply insure every

deposit in Irish banks, no matter the size. Predictably, money started flowing from all

over Europe into Ireland. National banks and finance ministers are furious with Ireland.

However, Ireland may have no choice but to backstop its own depository

institutions to keep them from losing deposits and becoming insolvent from a bank run by

corporations acting in their own best interests. Belgium, The Netherlands, and

Luxembourg each took 49% of their respective parts of Fortis Bank in return for a

massive injection of capital, declaring the bank too big to fail – also wiping out a lot of

already diminished shareholder equity. Europe has its own quite serious problems.

The Curve in the Road

10/4/2008 7

But what if the various countries, one by one, decide to guarantee deposits in

order to protect their own banks? If you are an international corporation, especially if you

are outside the US, do you want your $10 million in Europe or the US if Europe

guarantees your deposits with no limit? Could we see silent runs on US banks?

I think it is about an even chance that the government will have to guarantee for a

period of time (say 6 months to a year) every bank deposit, regardless of size, in the US.

That is a staggering thought. The potential will be large for almost-insolvent

banks to pursue risky behavior to try and work their way through problems. If such a

policy is pursued, tight controls must be administered so risky banks do not offer high

CD rates in order to garner assets. The FDIC must closely monitor such activity. Perhaps

such guarantees should be for existing depositors and not new customers. Insolvent banks

and those on the edge must be shut down quickly in such an event, to prevent risky


Unthinkable? I bet you there is a working committee of government and Fed

officials thinking about just that very thing and how to do it. It would be even more scary

if there is not one. We are in completely uncharted waters, and every contingency needs

to be thought through well in advance. We simply don’t need more last-minute Paulson


In the next few weeks and months, I think you can count on more extraordinary

actions by the Fed and Treasury to try and jump-start the credit markets. Actions which

were highly improbable a few months ago will be on the table. Will the Fed open its

balance sheet to non-banks? Possibly. If they can guarantee money markets, will there be

a scheme to insure commercial paper at some price? Not out of the question. Will

European governments take more equity in large European banks? Very likely. Will the

Fed and/or the Treasury invest even more capital in larger financial institutions? Given

that We the People now own 80% of AIG and 100% of Fannie and Freddie, it is certainly

within the realm of possibility that we will be the proud owners of even more private


Again, this is not just a US issue. We will likely see similar actions in Europe and

some of the developing world. This is a worldwide crisis, and the response will be from

central banks all over the world.

Understand, I am not advocating these actions. I am simply trying to help you

understand what actions might be put into place by the various government of the world

in an effort to avoid systemic economic collapse.

All The King’s Horses

The reality is that the rescue plan does not fundamentally alter the US economic

landscape. There can be no doubt we are in a recession. I think it will be dated from the

The Curve in the Road

10/4/2008 8

beginning of the year, notwithstanding the odd 2



quarter growth. The manufacturing

ISM was a dismal 43.5 (under 50 means a contracting US manufacturing industry). Such

a level is typically associated with recessions, as the chart below shows. Given the

financial crisis and the freefall in auto sales, this index is likely to fall further.

The “good news” is that the service portion of the economy is right at 50, which

means that at least that important area is not contracting.

Unemployment rose by 159,000, with nearly every sector affected. Almost

1,000,000 jobs have disappeared over the last 12 months, and it is likely that we will lose

another 1,000,000 jobs in the coming year. Since December, the ranks of the unemployed

have grown by 1.8 million, and those not in the labor force but wanting a job by 370,000.

Almost 3/4 of the increase in the unemployed have been job losers, with half the increase

from permanent job losers (not temporary layoffs). (The Liscio Report)

Next week we will explore the economic landscape in detail, but let me provide a

few thoughts. As I have said for a long time, we will be talking about deflation this time

next year. Recessions are by definition deflationary events. Given that we have had two

bubbles burst (housing and credit), there is even more potential for deflationary pressures.

Add into the mix the deleveraging process, which will take years to finally abate, and the

recent bout of price inflation caused by energy and food will pass, as demand destruction

for oil will hold oil prices in check.

As I have said for a long time, the next move of the Fed is likely to be a cut. We

are now close to such an action. A 1% Fed funds rate is again a real possibility. I am not

The Curve in the Road

10/4/2008 9

sure it will help as much as some market participants think, but I think it likely the Fed

will move before the end of the year, if not much sooner.

Europe and Japan are also probably in recession, and it is likely we are going to

see a worldwide global slowdown. It would be nice if the European Central Bank, the

Bank of England, and the Fed could coordinate a joint rate cut to signal that they are

working together on the problems. I would not want to be short the markets that day.

At the beginning of the year, I was predicting a small recession with a lengthy and

slow recovery period. I now think that the recession could be deeper than a 1%

contraction. I think we could see a rather lengthy recession. Quite simply, the credit crisis

has been allowed to spin out of control. That Congress almost failed to act is beyond

belief. Given the above circumstances, it is not out of the realm of possibility that a

recession lasts through the middle of 2009. As recessions go, that is a long time. But trust

me on this, it will pass. The recovery will be a slow Muddle Through affair, though. It

will be a few years before we are growing at a sustained 3%. Over the next few weeks,

we will look at what that means for earnings and the stock markets. Investors who utilize

a traditional 60% stocks, 40% bonds portfolio are not going to be pleased. We will look

at alternatives.

Stay tuned.

How Can I Be 59?

This has been a particularly hard letter to write, as I know it is rather gloomy, and

I wish had more encouraging news. I have been writing this letter for over eight years.

Every letter since the beginning of 2001 is in the archives, so my record is open for

inspection. I have no particular axe to grind. Since I basically help investors (in

conjunction with my partners) find investment managers and funds, we can adjust the

choice of funds and management ideas to suit the times, and frequently do make changes

in the mix. My goal in this letter is to help us all think about the economy and our

investments and to be as “right” as I possibly can. Sometimes, like today, that means not

being very upbeat. But it also means looking for ways to go with the tide rather than

against it. I actually hope I am wrong and the bulls are right. But that is not the way I see

it tonight.

Tomorrow is my birthday. The years seem to roll by at an ever accelerating pace.

(I had the reason this happens explained to me once. When you are 10, a year is 10% of

your life. When you are (sigh) 59, it is 1.6% of your life. It makes some sense.) It is hard

to believe I am 59. Maybe it is because I am around my kids so much, but I don’t feel that

old. Seven kids from 31 to 14 (plus assorted spouses and their friends) can do that. And

they are all coming to town to celebrate next weekend, so tomorrow will be a quiet day.

And Tiffani is already planning for a serious 60



birthday weekend next year.

Life has been good to me, for all its ups and downs. And I firmly believe that my

best years are ahead of me. I am simply having more fun than at any time in my life, with

The Curve in the Road

10/4/2008 10

more opportunities than I know what to do with. I am blessed with great business

partners. I have the best readers of any analyst anywhere. One million closest friends. I

am truly one of the world’s wealthiest men when it comes to friends and family, and at

the end of the day that is what counts.

Thanks for being part of my life. I plan on writing for a long time, so take care of

yourself so you can keep reading. And have a great week!

Your actually optimistic analyst,

John Mauldin


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