It's Getting Better All The Time?

Recent comments by some pundits declaring that the recession may have bottomed are unfortunately premature. Most arguing for an impending economic turnaround point to recessions of the recent past which have lasted from 12 to 16 months. Recent data indicating that the recession probably started December 2007 has bolstered this argument. However, I am sorry to say that this is not your father's recession. This promises to be the worst recession of the post World War II era.

The economy is stuck in a negative feedback loop. Weak home sales, scarce credit and financial industry layoffs have causes a slackening of consumer demand. Weaker consumer demand has resulted in job losses in the broader economy which causes more loan and credit card delinquencies which leads to more financial job losses, tighter credit and weaker consumer demand.

Where does this all end? It ends when home prices are permitted to bottom and the sooner the better. If home prices were permitted to bottom sooner, home values may not have fallen as much as they have and how much they are going to fall. Why would letting home prices bottom earlier, rather than attempting the cushion the blow, have resulted in a relatively more modest decline in home prices?

The Fed has the power to make bank borrowing less expensive. It cannot force banks to lower mortgage rates in lock stop (technically it has no power to force banks to lower rates at all) and it has no power to order banks to lower lending standards from their current stringent standards. As credit remains tight it fosters the aforementioned negative feedback loop. As the feedback loop persists (or worsens) and workers lose their jobs, the pool of potential home buyers persists. Demand for homes softens and, quite possibly, many home owners who did not make poor borrowing decisions and who did not purchase too much home begin to go delinquent or default on their mortgages. The result is persistently lower home prices. The recession cannot be reversed until home prices stop falling and job losses are halted.


This brings us to a "chicken and the egg" scenario. Will job losses moderate when home prices stabilize or will home prices stabilize when job losses moderate? The answer is the former. The U.S. economy is consumer driven. Get consumers (home buyers) back in the game and the employment situation will stabilize. Home prices should be permitted to fall to levels which the current pool of qualifying home buyers will enter the market. This had better occur before the pool shrinks further.

Yesterday's Nonfarm Payrolls report indicating a loss of 533,000 jobs (with a significant downward revision to the prior report) may help speed along Detroit Three rescue plans. The Wall Street Journal is reporting that Congress may be close to passing emergency funding to tide the Detroit Three over until January. Although it is possible that the Detroit Three will survive intact until the start of 2009, it is unlikely that they will receive cash to do what they will. Bond holder show=uld beware, but the Detroit Three bonds are not similar situations.

First: Outstanding Chrysler Financial and DaimlerChrysler bonds are obligations of Daimler, not Chrysler. These bonds are not in danger of default. There is one Chrysler 12.25% bond outstanding which is an obligation of Chrysler, but that was a private placement deal, I believe.

2) Ford is not in imminent danger of defaulting in the near future so there is more time to to work out an assistance package.

3) GM needs help NOW!!! GM bond holders are in the most precarious situation. Even with a rescue package, GM bond holders will likely be taken out at yet-to-be-determined cents on the dollar. It is unlikely that GM bond holders will receive par.

Also, bonds of the auto finance companies (Ford Motor Credit and GMAC)are not obligations of Ford and GM. They are obligations of themselves only. This may not mean much for Ford Motor Credit bond holders as Ford is not in immediate danger of halting vehicle production, but GMAC holders have reason to be concerned. If GM would cease production, GMAC would be left without a product which to finance and GMAC could default as well.

GMAC bond holders do have a reason for which to be hopeful. GMAC has applied to be a bank holding company. If GMAC is approved as a bank holding company, it would be eligible for TARP funds and would continue paying its debt. However, it is unlikely that the FDIC would grant bank holding company status until the GM situation is resolved. If GM would implode taking GMAC with it, GMAC would be an FDIC problem The FDIC has enough problems. However, if GM is "rescued" GMAC bonds could pay as expected even if GM bonds are settled at cents on the dollar. It;s up to the boys and girls in DC.

Speaking of DC, there has been a lively debate in preferred trading circles as to whether the non-cumulative preferred stocks are more attractive than their cumulative trust preferred brethren. The argument for preferred stocks is that they are DRD and QDI eligible and that since they are on par with the government's preferreds, they are unlikely to experience a cessation of dividend payments as the government will demand payment of its dividends. I do not agree.

First: QDI is going away by 2011 and taxes are not a primary concern among preferred investors at this time.

Second: Being on par with the government's preferreds is precisely what makes preferred stocks less secure. If the government would tell a bank to halt payments to the government to save cash, preferred stock dividends would have to be suspended as well. The same would be true if the government began administering a bank. Note: in spite of being administered by the government, AIG's AFF and AVF preferreds ae scheduled to pay their dividends as they are trust structures. Had they been tradtional preferred stocks, the dividends would have been wiped out along with the equity dividends. After consulting other preferred market participants and research and strategy experts, the consensus of the more knowledgeable people is that preferred investors should consider trust preferreds over traditional preferreds as the reward of 200 basis points +/- offered by traditional preferreds is not sufficient for the risk encountered.