There’s no doubt about it:  the economy is a mess.   The job rate continues to rise and it seems like just about everyone is asking for support or a handout from the government.  In addition, it seems like 300 and 400 point drops in the Dow are becoming the norm.

It turns out, however, that there is some good news that could end up having a positive implication for the economy at-large:

Ambac (ABK) is a company that insures bonds.  Traditionally, they’ve provided bond insurance to municipalities as a way of guaranteeing high ratings for those bonds.  Over the past few years, they and their largest competitor, MBIA (MBI) began to insure mortgage debt; and when the market began to tank last year, ABK and MBIA were among the stocks that were hit the hardest…due mostly to the mark-to-market write-downs that they have had to take on mortgage-based assets and the expectation that they’ll have to pay out large sums on the mortgage-base securities that they insured.

This caused a huge problem within the municipal bond industry.  Traditionally, the bond insurers have been extremely stable.  But they’ve seen their credit-ratings slashed in concert with their write-downs, meaning that it costs municipalities and other organizations that use bond insurance more to borrow and insure their bonds.

But here’s the good news:  Ambac announced yesterday that they had reached an agreement to cancel some of those mortgage-based liabilities in exchange for a one-time payment. This will allow Ambac to reverse some of their write-downs and in parallel with that, their credit ratings should also improve.  Ultimately, that will have a positive effect on municipalities, as their balance sheets will also strengthen.

And the best part?  It’s expected that this transaction is just the beginning.  Both banks and the insurers have a vested interest in canceling as much of these liabilities as possible.  As this happens, credit markets will improve.

Over the course of the year, analyst’s estimated earnings for the S&P 500 have been dropping steadily.  Back in March, the average forecast called for earnings of $81.52 per share; and as of October 14th, that forecast had dropped by 41.5% to just $48.52.

If you assume for a moment that Bear markets tend to bottom with a PE of about 10, then that would imply that the S&P could see a bottom around 450-500 within the next year or two – assuming that the earnings forecast doesn’t continue to fall.

With the economy heading south and unemployment continuing to rise, consumers have been pulling back on their spending in order to have more money available for day to day necessities.  Certain areas of the economy are more susceptible to the downturn than others; and as spending has dried up, manufacturers and retailers in those segments have started offering big discounts to entice buyers. 

The Bureau of Economic Analysis recently identified a number of different areas where spending has fallen off.  If you’re in the market for goods in one of these areas, you can likely find some pretty good bargains.  They include:

• Autos – Almost all of the automakers are hurting at the moment; and many are offering large incentives in order to move inventory.  A friend of mine recently picked up a $17,000 Ford pickup for just over $10,000.  Not bad.
• Boats – Considered by many to be a leisure expenditure, boat makers are facing not only an economic downturn, but the end of the boating season as well. 
• Furniture – Many people tend to buy new furniture when they move into a new home; and with housing in the dumps, furniture makers are feeling the pain. 
• Appliances – Like furniture, appliance manufacturers aren’t moving as many products due to the slowdown in housing.  In fact, Whirlpool just announced that they plan to layoff 5,000 workers.
• Clothing – Apparel purchases are down close to 12%; and retailers have been running sales like mad to try and make up for the shortfall in revenue.
• Vacations – According to the conference board, the number of families with plans to vacation in the next 6 months has fallen by 10.4%.  As a result, a number of resorts, casinos, and airlines have begun to run promotions.
• Dining – Off by about 4%, dining has not dried up as much as some other sectors of the economy.  However, places like restaurant.com have been offering deeper discounts on a more frequent basis.
• Sporting Equipment – Like boats, sporting equipment is considered by many to be a leisure expenditure.  Spending in this area is off by 6%
• Jewelry – Spending is off by 5.3%.  And with gold prices down and the dollar quickly strengthening against the euro, it may be a great time to buy that fine watch or other jewelry that you’ve had your eye on.

Over the past three and a half months, gas prices have fallen about 35%, giving consumers some much needed relief during the current economic downturn.  While this is good news for many in the short-term, low fuel prices can be troubling in the longer-term.

Just a short time ago, there was a razor-sharp focus on initiatives to fight the high-cost of fuel and energy:  Chevy moved forward with their Volt electric car; and other auto-makers took steps to realign their manufacturing so that they produce fewer trucks and SUVs and more smaller, gas-efficient automobiles.  Likewise, energy producers started a number of alternative energy projects such as wind or solar farms.

However, if prices for energy commodities such as gas and oil remain low, many of these recently announced initiatives are at risk of being scaled back or killed off entirely.  In general, smaller cars are less profitable for auto-makers; and newer technology such as hybrids and electrics are a lot more expensive to manufacture.  Along a similar vein, alternative energy tends to be more expensive as well.  While the return on investment (ROI) for many of these projects looked good when oil was over $100 a barrel and gas was at $4 a gallon, that’s not necessarily the case now.  Ultimately, companies may need up having to take on the expense of “unwinding” these projects and we will continue to be dependent upon foreign countries for much of our energy needs.

For today’s post, I have agreed to join eight other bloggers and provide my thoughts on the following question:

"What is the single most important initiative that the next administration should undertake to improve the economic health of the U.S. middle class?"

At the end of this post, I have listed other sites that are also participating in this, so if this is something that is of interest to you, feel free to visit them for their prespective on this topic.

Introduction

As we saw from the turmoil in the financial markets on Monday, passage of the bailout bill was not enough to fix the crisis at hand.  In order to restore confidence to the credit markets, the bill needs to be implemented; and this work will fall largely on the shoulders of the next administration.

The crisis is largely one of confidence; brought about by the way that the financial markets are set up. And unfortunately, if the government fails to restore this confidence, the potential downside will be felt by almost everyone.  In the remainder of this article, I will provide basic explanations for some of the principle causes and will also discuss the potential risk if confidence is not restored.

The Causes

Leverage:  As a rule of thumb, banks typically lend out about 12 times more than their capital base.  So, for example, if a bank has $100k is assets, it might lend out $1.2 million.  In practice, this works well.  However, if a bank has to write off a bad loan, then leverage works against them.  So a $10,000 write-off means that the bank has to either reduce their loan portfolio by $120k, or raise new capital to cover the loss.  And with many bank stocks floundering at or near 52 week lows, raising new capital can either be expensive or impractical.  As a result, some banks have turned to tightening up lending by canceling lines of credit or making it more difficult and costly to borrow.

Mark-to-Market Accounting: Simply described, this is an accounting rule that says that if you have an asset on your books, it has to be valued at the price that the market will pay for the asset at a given point in time.  Firms can choose whether or not they use mark-to-market for their assets; and many banks chose to do so when housing and similar assets were rising in value, as it allowed them to recognize oversized profits.  However, once a firm chooses to use mark-to-market, they cannot revert to a different method.

Toxic Mortgage Debt:  Banks and other financial firms that are holding mortgages or mortgage related securities are finding they are worth a lot less than they expected, or that the secondary market for buying and selling mortgage-based products has effectively evaporated, because there are few, if any, buyers.  As a result, the market value for these securities is either very low, or zero. 

The combination of bad mortgage debt, along with mark-to-market accounting and leverage has created a perfect storm of sorts, where the losses that banks are being forced to recognize on their books are being amplified into much larger problems in the credit market.

The Risk

Given that our economy is largely driven by credit, the problems in the credit market can readily spillover into other areas of the economy.  Tighter lending means that it can be more difficult and costly for consumers to obtain loans for large-ticket items such as homes and cars.  More importantly, many large organizations depend upon loans of varying types to fund expansion activities, as well as short-term operational needs, such as payroll and inventory purchases.  Already, McDonald’s has reported a delay in its plans to build coffee bars in its restaurants because franchisees were denied financing through Bank of America.  And California is thinking about asking for an emergency loan from the government so it can keep operating.

Simply put, if the next administration fails to instill confidence in the banking system through a successful implementation of the bailout program, we may see a large set of issues pop-up that are all indicative of a worsening economy:  Firms closing and associated job losses because they cannot cover payroll or buy inventory, auto and housing companies facing tough times because of fewer sales, and continued softness in the stock market.  Issues which will hit Americans at every level, regardless of their income.

Other blogs covering this topic include:

Blunt Money at www.BluntMoney.com

Cash Money Life at http://cashmoneylife.com

Clever Dude at www.cleverdude.com

Finance Your Life at www.financeurlife.com

My Dollar Plan at www.mydollarplan.com

My Journey to Millions at www.myjourneytomillions.com

Student Scrooge at www.studentscrooge.com

Tough Money Love at http://toughmoneylove.com

I’ve mentioned Jim Cramer on this blog in the past, both here and here.  And while I’ve always looked at his rants with mild amusement; some of his schizophrenic ramblings leave me perplexed; and I wonder if perhaps he’s doing more harm than good.

On the Today Show this morning, Jim cautioned viewers to take any near-term holdings out of the market. 

"Whatever money you may need for the next five years, please take it out of the stock market right now” he said.

Sure, fine.  Any funds that will be needed on a near-term basis shouldn’t be invested in risky investments anyway.  However, it strikes me as interesting that while Warren Buffett appears to be following the old adages of “Buy low, sell high” and “Buy when there’s blood in the streets” with his investments in Constellation Energy, GE, and others; Cramer has shot into a sheer panic and is running for the hills.

Time will tell who is right; but if it were my money, I would wager on Buffett.

So far this year, the major indices are all down by over 20%.  It’s gotten so bad that a lot of us don’t even open up our retirement statements when they arrive in the mail.  So what’s the smart money doing? 

They’re buying up beaten down stocks.

Following the old adage of “Buy Low and Sell High”, Warren Buffett’s Berkshire Hathaway has recently taken big stakes in Goldman Sachs (GS) and General Electric (GE); and recently agreed to buy Constellation Energy at a fraction of its recent high of over $100 per share.

And he’s not the only one.  Anthony Bolton, described by some as the “British Buffett”, recently purchased shares for the first time in two years because he believes that valuations are among the cheapest he’s seen in years.

There’s been a lot of debate and dissension over the proposed $700 billion bailout package.  It seems that the two main points of contention are around whether the bailout is needed and whether or not the US taxpayer should be left holding the bag.

NPR published a good segment last week that explains why the Fed is so concerned about the potential risks to the credit market (audio).  In a nutshell, the credit markets were (and are) at risk of freezing up; and when they do, it will be very difficult for businesses of all types to obtain the operating capital they need in order to remain in business.  The argument is that without the bailout, the overall economy is at risk of cratering; including the jobs that those businesses support.

But will the bailout work?  If history is any indication, then it’s possible that the plan will not only work, but will end up costing taxpayers well less than $700 billion.  It turns out that Sweden went through a similiar banking crisis back in the 90’s; and the current bailout proposal shares a number of similarities with Sweden’s plan, including the acquisition of equity in any companies that are assisted.  Ultimately, Sweden’s economy recovered; and they were able to realize a return on the assets they acquired.  They estimate that the final cost was close to nothing, or up to half the original cost, depending upon how the rate of return is calculated.

The Motley Fool recently published an article entitled Why Would Warren Buffett Stoop So Low? which points out a potential conflict of interest between Buffett’s recent five billion dollar investment in Goldman Sachs and his recent comments in support of the bailout package.  As the Fool rightly points out:

“By reserving public comment until after he stood to benefit from it, Buffett looks less like an advocate of reason and more like someone out to make a quick buck.”

If this were the first time that such a conflict had occurred, I might see fit to give him the benefit of the doubt, but it isn’t.

Earlier this year, Buffett started the Berkshire Hathaway Assurance Corporation (BHAC) as a provider of municipal bond insurance.  Shortly after starting the company, Moody’s gave BHAC its highest rating.  And it turns out that Berkshire Hathaway owns a good chunk of Moody’s stock, as it represents about 3.6% of Bershire’s holdings.

So here we see a rating company that’s effectively giving one of its largest investors a gold star.  Seems like a clear conflict of interest to me.

• Ali Hale talks about tracking your money with a Spending Log.
• The Huffinging Post explains how the weak economy is speeding the demise of the newspaper.
• Yahoo! provides some tips on 5 Big Bills You Can Cut Fast.
• The Motley Fool explains Why It's A Good Time To Be Greedy.
• CBS Marketwatch mentions that “Out of almost 2,100 diversified retail US stock mutual funds…just 17 have positive returns for both the past 12 months and year-to-date”.  Ouch.