The credit crisis is easy to understand if we keep the terms simple and compare it to something as straightforward to understand as consumer credit and debit card use.  Large corporations are not issued credit or debit cards for their daily money needs.  According to a September 26th, 2008 report by CNBC, the commercial credit market in the United States has shrunk from $1.815 trillion to $1.702 trillion in two weeks, a $113 billion dollar decrease.  And according to the volume of commercial paper since the end of 2007 (which shrunk $200 billion from 2006) has shrunk by over $198 billion through September, 2008.  What does this mean for our economy?  

Well, think of commercial paper as the equivalent of our using credit or debit cards.  It is just like a credit card only it is due daily instead of monthly.  (Commercial paper can be anywhere from a day to a few months but for our purposes, we will use daily.)  Normally companies have a clerk to check each day how much money hits their accounts and how much money was paid out.  If the money coming in is less than the money going out, the company has to take another loan usually by selling to a bank or mutual fund.  This is called issuing commercial paper.  If the money coming in is greater than going out, they buy back their commercial paper.  The interest paid is almost negligible and each day paper is either bought or sold. 

Well, we have had a couple of hiccups.  Two money market accounts were unable to pay out a dollar when Lehman Brother's collapsed.  They paid back 97 cents.  That 3 cent difference was catastrophic.  Pension plans, endowment funds and sovereign funds all flush with cash took their $6 trillion dollars in cash and bought US treasuries.  Businesses no longer could receive cash for all of their commercial paper.  It is the equivalent of a bank reducing your credit limit on your credit card or holding back funds on your debit card.  As a result, they went back to operating like we did before credit and debit cards; businesses only incur expenses for the amount of credit they are allowed or their cash on hand.  So, with their access to commercial paper limited, big businesses such as General Electric, Microsoft and Apple Computer begin to cut back on buying to preserve cash.  This means they buy less and wait to build new factories, hire new people and order supplies.  It also means they reduce their customers' lines of credit so they can get cash faster.  Overall, we buy less which means our economy starts to shrink!  This is the credit crunch we are now experiencing and it is not limited to businesses.

Municipal governments and State governments are also required to match expenses to receipts.  It is so bad, that two of our larger and best run states, California and Massachusetts are hurting.  California already laid off 10,000 contract workers to lower their expenses and Massachusetts is asking for loans from the federal government because they can't sell their bonds to meet expenses. 

The ripple effect spreads further though.  People are buying less and companies are producing less, which means they are reducing payrolls.  This explains the 159,000 latest reduction in payrolls this past August and over 600,000 people not working since the beginning of 2008 (US Department of Labor September 26, 2008).  That is almost the equivalent of Alaska's entire population of 670,000 (from the US Census Bureau).  Therefore, there is little doubt our economy is grinding slowly to a halt until we get the credit markets operating properly again, and it was this scenario of a protracted era of shrinking commercial paper use that scared Congress into passing the latest bailout bill. 

Apparently we are following the Japanese playbook in dealing with a liquidity crisis.  Their approach was to deny something was wrong and then to put out each small fire as it came along rather than dealing with the larger problem and creating a systematic fix that would solve the problem nationwide.  Their financial crisis basically started when their bubble economy burst.  When that happened, the Bank of Japan, for a painful seven years, dealt with one crisis after another.  They denied theirs was a systemic problem and refused to close banks, recapitalize their banking system, and change the regulatory crisis.  During that period, the country experienced annual contraction of its economy and a loss of confidence and feeling of well being that has yet to recover to pre-crisis levels.  The government tried to spend its way out of its contraction and all they accomplished was creating a national debt where none existed before.  It was not until 2001 when Koizumi came to power as prime minister that Japan and its economy started to grow again.  He promised to fix the problems on a systemic level and implemented new regulations to prevent the credit excesses that led to the original problem; the government recapitalized the banking system; and allowed deregulation where it would help.

So, unfortunately we believe that the approach that the Bush administration and Congress has currently chosen leads to the following:  A slowly contracting economy with fewer good jobs, low national morale and ever increasing national debt (due to their economic crisis, Japan went from a surplus to an $8 trillion debt) and, unlike the Japanese, we are not starting with a surplus!  As far as I can tell, we have had this crisis unfolding since 2006 when housing prices started their decline, it picked up steam with the sub-prime crisis of 2007, is now working its way through the credit default swap markets, and our next credit crisis will probably be consumer debt (credit cards and home equity loans). 

The singular lack of leadership from our politicians crosses both party lines and is following a pattern we saw in the 1930s and in Japan in the 1990s.  The need right now is for integrity, transparency and bold leadership.  Without those three ingredients, there is no hope that our economy will rise above its current downward spiral during the short term. 

In the long term, 94% of our working population is employed and that is good.  So the fear that has permeated our society may create some fundamental behavior changes that will help us long term.  There are some positive results from this crisis.  Energy and other commodity prices are declining as demand dwindles.  The consumer debt behavior is reversing as people fear for their jobs, future, and economic well being; this should result in an increase in the savings rate, something we as a country need desperately.  Our slowdown in the economy is also helping to slowdown global warming.  People are driving less and using planes less due to economic factors, thus helping the ecology just as we are reaching a tipping point in alternate energy and zero carbon footprint devices and acceptance by the general population.  However, we are paying a high price for these benefits! 

Liquidity is like oxygen, economies choke without it.  However, since it is like oxygen, it is too vital for our politicians to ignore for very long.  Yes, we are in a recession and probably will be for the remainder of 2008 and part of 2009, but the overall economy should function on a more predictable and normal pace than the last few weeks.  The changes we made to your portfolio anticipated a slowing economy and a recession; therefore, with time they too will increase in value.