Congress fails to pass the Treasury Auction Rescue Plan (TARP)

We want to try to separate fact from emotion surrounding today’s vote in the House of Representatives which failed to approve the plan proposed by Secretary Hank Paulson and Chairman Ben Bernanke. We would characterize the failure to pass this bill as worrisome, but not disastrous.

If a plan is not passed soon, the implications for the stock market and the economy will be very negative. However, there will be time to figure out the appropriate investment strategy. For today, investors should not over-react to the news that the bill did not pass.

The short-term reaction of the stock market was very negative with the Dow Jones Industrial Average falling by about 7%; however, investors should understand that the economy will not implode today, tomorrow or even next week – just because Congress failed to act.

The critical factor that will affect the economy is the commercial paper market. (Commercial paper are the short-term borrowings of corporations that are usually purchased by money market funds and other institutional investors.) If otherwise sound businesses cannot roll over their short-term borrowings, it could set off a negative feedback loop that would have extremely bad implications for the economy and by extension the stock market.

Healthy businesses routinely issues short-term notes called “commercial paper” for their day-to-day cash needs. These notes typically come due every 30 to 90 days and the borrowers simply roll them over by issuing new notes. This is similar to what many people do with their credit card balances.

For many reasons, it has become increasingly difficult for corporations to find buyers for these routine refinancing. If healthy businesses could not refinance these notes, some would have trouble coming up with enough cash for day-to-day operations. That could lead to companies cutting expenses include laying off employees. In extreme cases, it could lead entire companies to shut down and ultimately push the economy toward a Japanese-style deflation.

We think that Congress will ultimately act responsibly. Nobody knows for certain when, or even if, the credit markets will completely freeze but they are not functioning very well now. If credit conditions freeze, it could set off a series of negative economic shocks.

Congress still has time to act but if the worst should happen, long-term treasury bonds will be the asset of choice. In the near-term, there is enough negative sentiment and panic in the stock market that we would advise against making drastic sales to investment portfolios.