WEEKLY ECONOMIC COMMENTARY:  WEEK OF SEPTEMBER 26, 2008

Congress has been busy doing what it does best, creating drama and discord, while failing to do what needs to get done. Nero fiddled while Rome burned. This Congress may be remembered as the Congress that postured while the US economy and financial markets imploded.

The U.S. housing market has been in a downdraft, and the U.S. financial sector has been in the process of imploding for more than a year, risking the prosperity of the entire country. Regretfully, Congress --including some, but not all Congressional leaders-- display a combination of a lack of understanding of the core reasons for the current crisis, as well as the breadth, depth and magnitude of the risks posed by the situation. Let's be clear on this. The Paulson Proposal is a very unpalatable option, but it is the only option available at this late date. Some version of it is the only hope of preventing the unfolding implosion of the financial sector from continuing and exacerbating the ongoing economic deterioration.

Based on news releases as of late yesterday (Thursday) Congress appeared to be moving toward agreement on a version of the Paulson Proposal that had added a variety of Congressional touches. For example, Congress agreed that legislation should include provisions on oversight of the Treasury-run program, limits on executive pay and a section on homeownership preservation, although it was not clear what exactly constituted "homeownership preservation." There was also a phase-in of the asset purchases, with $250 billion being available immediately for asset auctions, which would have prevented the Treasury from implementing its requested "Big Bang" approach to asset purchases ($700 billion) that was hoped would jump-start the process in a meaningful way. While the plan was imperfect, it appeared to be a workable solution that had support on both sides of the aisle.

With perfect timing, a group of House Republicans on Thursday evening snatched defeat from the jaws of victory by refusing to back the plan, putting forward another proposal that derailed the passage of the evolving Paulson Proposal. More troubling is the fact that the House Republican plan reflects a failure to grasp the root cause of the current problems and, consequently, the possible cure. While we concur that the Paulson Proposal is unpalatable medicine, it does address current problems. The broad brush of the House Republican plan is to allow banks to buy insurance for the bad assets that are clogging-up balance sheets. To be blunt, this proposal is inadequate, ill conceived and misdirected. It may be good medicine for another ailment at another time, but it is an aspirin at a time when surgery is required.

At this point, the best-case scenario is that House Republicans are posturing for the voters at home, and will eventually make a very "tormented" capitulation to the Paulson Proposal, thus appearing to be unsuccessful martyrs in the quest for fiscal responsibility. By fighting to the last, it may be their hope that the unpopular price tag that goes along with the Paulson Proposal gets pinned on the Democrats...at least in their districts. We remain hopeful because huffing and puffing and holding its collective breath are among the more widely practiced activities in DC. Congress has played dangerous games of "Chicken" with the budget and the debt ceiling on numerous occasions, causing at least some government operations to shut down at various times in the past. For at least some Congressional members, what happens in government is all they know, so the carnage happening on the streets outside of Capitol Hill is of secondary significance to personal political survival. Hopefully, this will prove to be just another game of "Chicken" deliberately staged ahead of the elections.

At this juncture (Friday), it appears we will not know whether or not this is the case until at least the end of the weekend. In the interim, the markets continue to be buffeted by uncertainty and confusion and the economy is increasingly vulnerable to the financial meltdown that is battering households and businesses. Make no mistake; while the disconnect between Main Street and Wall Street on the issue of bailouts is palpable - and will require a Willie Loman-like selling job on the part of Paulson if a bill finally emerges - the fortunes of John Q Public and lending institutions are inextricably linked. As noted at the outset, it's been more than a year since the subprime catalyst infected the credit markets with its toxic waste, ushering in the housing collapse that has destroyed wealth for millions of households and eviscerated the balance sheets of banks and other institutions holding depreciating mortgage-related securities. Until fairly recently, however, the damage has been relatively contained, with a few sectors - primarily housing and autos - bearing the brunt of the economic slowdown.

For example, in the year through the second quarter, government data show that the 7 percent of the economy represented by housing and autos plunged by a nauseating 16 percent, which is as steep as any nosedive seen in past recessions. However, the remaining 93 percent of the economy held up quite well. Over that same 12-month time span, the far greater slice of economic activity that is not housing and autos had expanded by a robust 3.8 percent, hardly any dropoff from the pace registered over the previous six years of the expansion. Simply put, most of the economy had weathered the housing and credit-related storm in decent shape - at least through the middle of the year.

But that was then. We are now entering the fourth quarter, and the escalation of the credit crisis over the summer has clearly taken a toll on the broader economy. Households, having suffered a drop in net worth for three consecutive quarters through mid-year, are also coping with slowing wage growth linked to the relentless deterioration in the job market. During times of stress, consumers strive to maintain living standards by borrowing against their homes, using credit cards more frequently or dipping into their savings. Those options are virtually closed, for all intents and purposes. Banks have clamped down on home equity lines of credit, credit-card limits have been reduced even as their terms have stiffened and the personal savings rate has been driven down to near zero.

The results of this tightening vise on purchasing power have been predictable. Consumer spending, adjusted for inflation, declined in July and August, and reports from merchants indicate that the usual back-to-school lift that takes place in September has been a no-show this month. If September turns out to be a washout for expenditures, it will be difficult for the economy to squeeze out any growth during the third quarter, putting a stamp on the growing army of economists who believe a recession is underway. To be sure, the plunge in oil and other commodity prices over the past month erases much of the squeeze on discretionary incomes that the spiral in those prices imposed in the spring and summer months. But even that trend has a dark side, as it reflects softer demand associated with a weakening global economy. In time, that will crimp foreign demand for U.S. exports, which has been the key driving force keeping the economy afloat over the past several quarters. Indeed, net exports accounted for all of the 2.8 percent increase in real GDP in the second quarter.

With the export thrust poised to fade and consumers still licking their wounds from mounting strains associated with the loss of housing wealth, high debt burdens and slowing wage growth, the last bastion of strength, business capital spending, could also fall by the wayside. In fact, this week's report of a disturbing 4.5 percent plunge in durable goods orders by manufacturers in August - a much steeper drop than expected - could be a sign that a retrenchment is already underway. Keep in mind that business investment spending is essentially a derived demand, one that derives its strength from sales. If the two most powerful sources of sales - exports and consumer purchases - are perceived to be on a downward trend, companies will understandably cut back on capital spending to prevent a buildup in unwanted productive capacity.

Still, durable goods orders are highly volatile, so a one-month drop following three months of increases may not represent the start of a trend. We'll see. But one thing is sure: businesses large and small - particularly the smaller ones - must borrow to purchase machinery, computers and software, and the credit spigot has been all but turned off for an ever-broadening swath of companies. Not only are banks turning away loan applicants due to a shortage of capital stemming from mortgage-related writedowns, the money markets are also becoming increasingly unreceptive to commercial paper, a major source of funding for corporations. That's because of growing investor fear of defaults, which is driving them into the safest of assets, namely Treasury bills.

Indeed, investors are pulling cash out of money market funds, the biggest holder of commercial paper, at an astonishing rate -- $184 billion over the last two weeks alone - following the report that one major fund "broke the buck", i.e. redeeming 97 cents of each shareholder dollar invested. So far, that's been an isolated incident, reflecting the fund's holding of tainted short-term paper issued by the bankrupt Lehman Brothers. Still, by reminding investors that money market funds are not the same as government-guaranteed deposits, it poses a real threat of massive redemptions, which could shut off short-term funding for all of Corporate America. As it is, the redemptions are having an effect, as commercial paper outstanding plunged by more than $110 billion in the two weeks through September 24 - the steepest decline since the sudden onset of the subprime crisis last August. The point is, the economy is caught in the vise of a strangling credit crunch that will only tighten its grip until confidence and liquidity are restored to the credit markets. That, in turn, will happen when the debilitating housing meltdown is arrested, stemming the free-fall in the value of mortgage securities held by financial institutions. The process will not happen overnight, but the Paulson Proposal now stymied in Congress is a necessary first step that must be implemented to unclog the credit-market's arteries. All eyes will be on Washington this weekend.

Mutual funds involve market risk, including fluctuating returns and possible loss of principal. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.Needless to say, that reversal reflected the growing tumult in the mortgage market stemming from the rising volume of defaults, the spike in foreclosures and the predictable heightened aversion of institutions to extend new mortgage loans that can't be offloaded to a now-moribund secondary market for mortgage securities. The drying up of the secondary market has been magnified by the woes of Fannie Mae and Freddie Mac, whose ability to purchase mortgages has been greatly impaired by its own balance sheet strains, which pushed them to the brink of insolvency. However, with the government bailout of these critical housing agencies last weekend, the capital-raising capacity of Fannie and Freddie took a sudden turn for the better. One result is that mortgage rates on conforming fixed-rate mortgages experienced the biggest weekly drop in more than ten years, plunging 42 basis points to 5.93 percent in the latest week.