The Big Bank Bailout: Are You Next?

They’ve saved the bankers, but what about the butchers, the bakers, the autoworkers and their dented 401(k) savings? Who’s going to bail out the retailers, restaurants and manufacturers small and large? The government has committed $250 billion to rehydrate the balance sheets of the nation’s leading banks and get lending flowing again. But if you’re not exactly feeling reassured, there’s good reason. With the global financial system wobbling, policymakers don’t have many ways to stop the rest of the economy from heading for a recession. The challenge now is to try to contain it.

As banks have slammed on the lending brakes because they have lost so much money on subprime mortgages and securities tied to real estate, the entire $14 trillion U.S. economy is piling up behind them. Tighter lending means fewer firms can expand their business; cities can’t sell bonds to build schools and sewer systems.

And regular investors–long advised to buy stocks, diversify and stay patient–are taking the beating. Anna Weiss, 67, of Houston embodies the anxiety now taking hold across the country. “I saved for 30 years. I have saved and saved and saved so that I could afford some of the nice things that I never allowed myself when I was young,” says the retired retail manager. “Now I find because of other people’s stupidity that the money I have saved has shrunk.”

Why Paulson Changed Plans

The damage had been mounting so swiftly that in the midst of a global stock-market rout that ate 18% of the Dow, Treasury Secretary Hank Paulson was forced to import a plan he once considered practically un-American. Paralleling a program authored by U.K. Prime Minister Gordon Brown, it called for the U.S. government to take partial ownership of nine leading banks and offer to buy pieces of hundreds of others. On Oct. 13, the nine bank bosses, assembled in the Treasury’s imposing boardroom, were each handed a piece of paper with the terms: $25 billion of preferred shares each from Citigroup, JPMorgan Chase, Wells Fargo and Bank of America. In return for the capital, the U.S. would collect a 5% dividend in the first five years. Although Wells Fargo chairman Richard Kovacevich resisted, Paulson gave the bankers no choice. It’s partial nationalization, although in announcing the bailout Oct. 14, Paulson deliberately avoided using that term. “Today’s actions are not what we ever wanted to do, but today’s actions are what we must do to restore confidence in our financial system,” he said.

For weeks, Paulson had held off on direct investment, preferring instead to use the $700 billion Troubled Asset Relief Program (TARP), passed by Congress on its second go-round, to buy toxic mortgage-related assets from the banks. The bank bailout will be funded out of that budget, and the Treasury still plans to start buying troubled assets in the next month or so. But that wasn’t soon enough for worried investors or for Fed Chairman Ben Bernanke, who according to inside reports had been advocating for a recapitalization for months. Money flowed out of the stock market, including that of many large hedge funds. Some $2 trillion in market value disappeared in a week. “It was tunnel vision,” says Republican Congressman Spencer Bachus, ranking member of the House Committee on Financial Services. At a meeting at the White House on Sept. 25, Bachus says, he and others brought up the need for alternative approaches. “The President said, ‘Paulson wants to do it. He’s the guy. Whatever he says, we do.'”

So what finally forced Paulson’s hand? Pressure mounted from abroad when Ireland, the U.K., France and Germany moved almost sequentially to insure deposits and recapitalize banks–nearly $3 trillion worth. For the Treasury to fail to match that offer would have risked a capital flight by institutional depositors that could have started emptying U.S. banks.

The move to recapitalize the banks got an endorsement in global stock markets, which momentarily roared back, in many cases with record one-day gains. “[They] have headed off a full-blown collapse of the economy,” says Anil Kashyap, an economist at the University of Chicago Graduate School of Business. “There’s a 0% chance of 1930s-type depression.”

The new government guarantees should insure that interbank loan rates retreat to the point where money is moving again. With the first capital injections a few days away, loans should begin flowing easily in a matter of weeks, says Scott Talbott, chief lobbyist for Financial Services Roundtable, representing major U.S. banks. “This will open up credit immediately, and the benefit will begin to flow to small businesses shortly thereafter,” he says. Every $1 of equity creates $10 in lending power. Half of the $250 billion set aside for capitalization is targeted at smaller banks. Some banks are wary of the strings attached–including a halt to dividend increases–but they may have no choice.

The Demand-Side Problem

While the banking bailout may address the supply side of credit, it doesn’t necessarily stimulate the demand side–where we all live. Across America, there is growing evidence that demand for credit–and everything else–is shrinking, with recessionary consequences. Two days after the Washington drama, the Fed’s Beige Book report revealed that business was weakening everywhere, prompting the Dow to regurgitate 700 points. GM is shutting plants earlier than anticipated, idling 2,800 workers; PepsiCo, which reported falling sales in the U.S., is chopping 3,300 jobs worldwide. Demand for Samsung’s DRAM chips is dropping. The retailer Linens’n Things is closing its remaining 371 stores, eliminating 17,000 jobs. The NBA is laying off 80 people, citing slower ticket sales.

Dan Danner, executive vice president of the National Federation of Independent Business, says most of his 350,000 members are “some combination of nervous, scared, in the trenches. At the moment, credit is not a problem only because they’re in survivor mode, waiting to see if they’re going to have customers tomorrow.” David Guernsey, who owns an office-products firm in Chantilly, Va., knows the feeling. While less expensive items are selling, purchases of office furniture that are normally bank-financed are lagging. Customers are telling his sales staff, “We just need to circle the wagons and wait this thing out,” Guernsey says. That’s true among large corporations too. “People are putting projects on the shelf because the uncertainty came in so fast,” a FORTUNE 100 CEO tells TIME. “Everybody in the boardroom is questioning, You want to reinvest now?” And if businesses stop spending, the pain will be felt in industries from steel to construction to carpets.

Resetting the Economy

So does anyone want to invest now? For many people opening their third-quarter brokerage statements, the news is grim. “Our call volumes are up 100%. We are just on fire here,” says Gary Bhojwani, CEO of Allianz Life Insurance in Minneapolis, which sells annuities–insurance products that trade off risk and the potentially higher returns that stocks or bonds offer in exchange for a guaranteed payback. (Most annuities are guaranteed by state insurance regulators.) Investors who wouldn’t know an annuity from a pineapple are asking one question: Is my money safe?

If you’re thinking for the long term, it still is. To stock watchers, the flight to safety–capitulation, in other words–is a good thing, signaling that a market bottom is near. More important, though, says Tom McManus, chief investment officer at Wachovia Securities, is your own comfort level: “If you can’t sleep, you have to sell down to the sleeping level–a mode where you are comfortable opening the statement and discussing it with your adviser or a family member.”

Once you are well rested, then you can understand your risk tolerance and restate your goals, your investment horizon and your expectations. The standard advice is to continue to buy on a regular basis into a declining market because your average cost of buying shares declines.

Still, a lot of people are going to have to rebalance their portfolios to remain properly diversified and in line with their goals. “You can have an extremely negative view of the economy and use that to say, ‘I am not going to go anywhere close to consumer discretionary stocks,'” says McManus. He’d opt for consumer staples instead, as well as health care, utilities and perhaps some beaten-down market sectors such as energy.

Certainly some stocks have been getting cheap. McManus points out that last Friday the dividend yield reached 3.3%, which was higher than the expected inflation rate. The last time this happened was during the 2002 sell-off, which presaged 26% market growth the next year.

One possible benefit of turmoil: the bear market of 2008 may have ended the spendthrift ways of the 80 million–strong boomer generation, which is now heading rapidly toward retirement, and refocused them on saving. “We must have a reset on consumer spending; frankly, it is out of control,” says Daniel J. Houston, president of retirement investor services at Principal Financial Group in Des Moines, Iowa. The average contribution to a 401(k) plan is 7% of salary, yet the average person may need to save 13% to 15% of his salary to maintain his standard of living in retirement. For people 10 years from retirement, “this might be the best wake-up call we ever got,” says Houston.

If we are forced to increase savings, then spending has to drop, and that has ramifications for the stock market and the economy, because it implies we’ll buy fewer computers and take fewer trips. With consumers hard-pressed, it is the government that will have to do the spending, says McManus. “Now is the time for us to spend, spend, spend, to make sure people are employed and have money on the table.” Both presidential candidates have proposed economic-stimulus packages on top of the $168 billion stimulus Congress passed in early February. At some point, of course, the next President will have to either rein in that spending or raise taxes–or risk a historic budget deficit.

As for the stock market, you have to think of it as a forecaster. The market looked into the future and saw a horizon darkened by a complete collapse of lending and the prospect of a long, deep recession. So Paulson and Bernanke changed course, as have some investors. “We can always adjust our retirement plan by a couple of years just to ride this out,” says Linda Gallegos, 54, of Golden, Colo. She and her husband Gary have two 401(k)s. “I’ve been thinking, Oh, my God, this could be bad. But I feel pretty powerless to do anything. I figure, what goes down will come back up. Maybe we’ve seen the worst of it.” Maybe. The fate of the economy could depend on how many Americans are willing to bet on it.