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.”

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.

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

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 money.

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 Japan.

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