When the U.S. Commerce Department on Friday said the U.S. economy contracted at a 1% annual pace in the second quarter, the report was actually seen as good news: It was a slower decline than in each of the two prior quarters, and economists had expected a contraction of 1.5%.

“This is good news,” Nariman Behravesh, an economist with IHS Global Insight Inc. (NYSE: IHS), told The San Francisco Chronicle.

But here’s the wild card: Although government spending did increase during the April-to-June quarter, only about 7.7% – $60.4 billion – of U.S. President Barack Obama’s stimulus package had actually made its way into the U.S. economy by June 30, the quarter’s official conclusion. Of that total, the largest component went to U.S. states to help defray the jump in Medicaid costs, CNNMoney.com reported.

Much of the $43 billion in stimulus tax relief – including the “Making Work Pay” tax credit for individual workers – also took effect during the second quarter, CNNMoney said.

At this point, it’s really difficult to “see how the effect of stimulus has been very large,” Edward Lazear, an economics professor at Stanford’s Graduate School of Business – who served as an advisor to former U.S. President George W. Bush – told CNN. “Very little has gone out.”
And that’s the problem.

In short, it looks like we’re already experiencing an economic rebound – without the Obama stimulus having really even kicked in … yet. In fact, the impatience over the continued U.S. malaise, the slowness of the economic turnaround and the fact that when growth does return we’re almost assured of a “jobless recovery” actually has some Washington legislators already pushing for a second stimulus.

That means the economy will be in rebound mode when nearly three-quarters of a trillion dollars in stimulus money starts to flow in. Dumping all that money into an already-growing economy won’t just serve as a simple tailwind that gives the economy a gentle push; it will be more like the head-snapping start followed by the thunderous charge down the quarter mile that we see from one of the supercharged Top Fuel Funny Cars driven by National Hot Rod Association (NHRA) star John Force. (From a standing start, Top Fuel Funny Cars cover a quarter mile in less than five seconds at speeds well in excess of 325 miles per hour).

And there’s only one outcome from that scenario – rampant inflation. In fact, U.S. consumers are probably headed for the worst bout of inflationsince the 1980s. And that makes the so-called “exit strategy” of U.S. Federal Reserve Chairman Ben S. Bernanke all the more important.
To be sure, the Obama stimulus has given the economy a bit of a boost. So far:

• The states have deployed what stimulus money they have received, which helped fuel the biggest surge in state and local spending since 2007.
• Some early pieces of the stimulus – such as the $25 increase in unemployment benefits – have allowed consumers to spend more.
• And one economist – Economic Policy Institute’s Josh Bivens – said Obama stimulus money may have boosted growth by as much as three percentage points during the second quarter.

But other economists say that – given the environment – the second-quarter GDP numbers were much too strong. After all, business spending dropped 8.9% and hours worked fell 7%. Somehow that doesn’t translate into a mere 1% drop in GDP. That latter figure will most certainly be revised downward in the future.

Unless or until that happens, look for the third quarter GDP statistics to give us a better picture of the U.S. economy’s health. Complaints that the promised stimulus money isn’t getting where it needs to be have Obama’s economic team working overtime to iron out the problems that keep cropping up.

Mark Thoma, an economics professor at the University of Oregon, toldCNNMoney that “the third quarter will be a critical time period for assessing the stimulus package.”

And for assessing the inflation threat – which Money Morning has repeatedly warned is a very real threat. Gold, commodities, and other hard assets will be key holdings. The same is true for dividend-paying stocks. And make sure to go global – the best growth prospects will continue to be overseas.

Market Matters

A report by the New York Attorney General’s Office claims the initial nine institutions that received Troubled Asset Relief Program (TARP) money paid out $33 billion in bonuses in 2008.  Of particular note, Citigroup Inc. (NYSE: C) and Bank of America (NYSE: BAC) rewarded a combined 900 employees (combined) with bonuses of at least $1 million, despite having received $45 billion each in government aid (and that doesn’t count the $3.6 billion Merrill Lynch & Co. Inc. employees received).  Imagine how much they would have made if the companies were actually doing well?

While President Obama continued his road trip across America to promote health care reform, a group of conservative Democrats (Blue Dogs) came up with their version of a bill, but offered no timetable for completion.

Meanwhile, regulators pushed forward with proposed rules aimed at reducing speculation in the marketplace and focused on so-called “naked” short selling and on lpacing strict limits on commodities contracts.

In corporate news, deals were the theme of the week.  Microsoft Corp. (Nasdaq: MSFT) made amends with Yahoo! Inc. (Nasdaq: YHOO) and forged a 10-year partnership to cut into Google Inc.’s (Nasdaq:GOOG) share of the Internet search business. And International Business Machines Inc. (NYSE: IBM) is expanding its software empire with the purchase of SPSS Inc. (Nasdaq: SPSS) for $1.2 billion.

On the earnings front, energy companies highlighted the week’s reports and the results were not pretty (though were expected).  On a positive note, Motorola Inc. (NYSE: MOT) surprised analysts by reporting an unexpected profit, while offering a promising outlook, and Deutsche Bank AG (NYSE: DB) continued the favorable trend among (previously depressed) financials by posting strong earnings on solid investment banking operations.

Investors digested the mixed earnings news and chose to focus more on the positives.  Despite a temporary setback in China (5% index decline before encouraging comments by its central bank), the Dow Jones Industrial Average moved higher late in the week after General Electric Co. (NYSE: GE) was upgraded to a “Buy” by a major analyst, a sign of an improving climate.  The Nasdaq Composite Index even flirted with 2,000 for the first time since October 2008, and theStandard & Poor’s 500 Index edged closer to 1,000, a level not seen since last November.

The Dow ended July with its best monthly performance since October 2002.  Japanese stocks moved to their highest levels in about 10 months and European equities soared to nine-month highs.  Bond investors breathed sighs of relief as a record $115 billion Treasury auctions came to a close and foreign bankers emerged as buyers on the final day.

Economically Speaking

Has Fed Chairman Bernanke suddenly become Mr. Optimist these days? Early in the week, he proclaimed that the financial debacle ultimately would produce favorable results as “not only will we will be back on track, but the economy will be stronger than it had been before this started.”  He also urged Congress to move forward with a regulatory reform package to ensure that such dire times will not be repeated.

The Fed’s Beige Book showed that the economy remained weak, though signs of stabilization and improvements in manufacturing, housing, and even labor are occurring across several regions of the country.  Some districts reported enhanced corporate hiring, particularly within the healthcare and technology sectors.

The afore-mentioned second-quarter GDP report was better than expected, giving yet another indication that the recession is drawing closer to an end.

Still, it’s a much deeper recession than most realized: For the first time since records have been kept (1947), economic activity has declined for four consecutive quarters.  New homes sales skyrocketed in June by 11%, the fourth increase in the last six months, and home prices even climbed on a month-over-month basis for the first time since July 2006 according to the S&P Case-Shiller index.

Durable good orders fell in June, though once the volatile transportation category was removed from the statistic, orders actually increased.  Consumer confidence fell in June, as ongoing pressures on the labor markets brought continued concerns and many Americans are refraining from major purchases (now and for the foreseeable future).

On the other hand, jobless claims rose in the most recent week, though analysts pointed to discrepancies from the auto industry.   Looking at the four-week moving average as a better gauge, claims for unemployment benefits actually fell to the lowest level since January and continuous claims unexpectedly declined, as well.

Weekly Economic Calendar

Source: Why the Obama Stimulus Has Us on a Collision Course with Inflation

The largest of the U.S. Big Three automakers yesterday (Wednesday) announced that it failed to persuade the required 90% of its bondholders to swap $27 billion in debt for stock, pushing the venerable GM several steps closer to a bankruptcy filing.

The rejection by bondholders is the latest chapter in the ongoing saga of GM’s desperate attempts to reorganize as it faces a government-imposed Monday (June 1) deadline to restructure or file for bankruptcy.

In recent days, the company struck a deal with its United Auto Workers (UAW) union on payment terms for $20 billion of debt in a retiree healthcare trust, and it successfully convinced the union to take a reduced stake of common stock in the new company.

GM also is still in negotiations to sell its European Opel and Vauxhall units to a consortium of bidders. Those talks were scheduled to continue in Berlin last night, as German and U.S. government officials met with representatives from three prospective new owners.

Still, the odds now favor what would be one of the biggest Chapter 11 cases in history, as the global auto giant that has been an icon of American culture since the early 1900s will likely follow Chrysler LLC into bankruptcy court.

Last Hope Bond Offer Fails

In what was seen as GM’s last best hope to cut debt outside of a government-financed bankruptcy, bondholders rejected the company’s offer of 225 shares in a restructured GM for each $1,000 of principal – the equivalent of 10% of the new company for their $27 billion in debt.

The principal amount of notes tendered was “substantially less than the amount required by GM” and, as a result, “the exchange offers will not be consummated,” the company said in a statement.

The news was no surprise to many analysts.

Bankruptcy is “imminent,” Pete Hastings, a fixed-income analyst at Morgan Keegan & Co. in Memphis, Tenn., told Bloomberg News.

“It’s no surprise at all that a deal that was as unattractive as this one would be soundly rejected,” said Hastings, who had recommended that his clients refuse the exchange offer.

Some analysts blamed the offer’s failure on the unyielding stance of U.S. President Barack Obama’s auto task force, which had a hand in deciding the terms of any deal made with the debt holders.

“I think the task force made that hurdle so high, they wanted them to go into bankruptcy, they see that as the solution,” independent auto industry analyst Erich Merkle told Reuters.

Others saw GM’s long history of mismanagement and failure to respond to market conditions as the primary culprits.

“I think the exchange offer was really a transparent attempt to blame bondholders for the bankruptcy rather than to accept responsibility for years of mismanagement and failure to anticipate things that should have been understood,” Richard N. Tilton, a restructuring analyst at Covenant Review LLC, told Reuters.

The New “Good” and “Bad” GM

A GM bankruptcy is likely to involve so-called “debtor-in-possession” financing so it can continue daily operations as it is divided into a “good” and “bad” company by the bankruptcy court.

The “good” GM would include the company’s most successful operations, including the Chevrolet and Cadillac brands, and within months would exit bankruptcy in sound financial health. The “bad” GM would be left with such laggard brands as Pontiac, Hummer and Saturn, and other liabilities that would be divested in a lengthier court-supervised reorganization.

The U.S. government is expected to increase its ownership stake in GM from its current 50% to as much as 70% in order to slash debt and will lend the new company almost $30 billion, The Washington Post reported last week, citing sources familiar with the matter. That’s in addition to the $19.4 billion the United States has already invested. Canada is expected to lend GM an additional $9 billion for a smaller ownership stake in the company, sources familiar with the talks told The Post.

When all these financial packages are included, the GM bailout will have a sticker price of about $60 billion, making it one of the largest – and most costly – rescue and reorganizations in corporate history. When it’s finalized, the United States and Canada would own almost three-fourths of GM, the newspaper said.
Despite the vote, bondholders would be left with a 10% equity stake in the reorganized company and current shareholders would own about 1%. As much as 20% could go to the health-care trust fund for union retirees.

Chrysler Bankruptcy Paves the Way

Ironically, Chrysler’s swift journey through the bankruptcy process may be a major factor in inducing GM to steer its way into Chapter 11.

Chrysler appears to have made great strides towards a successful restructuring and may be ready to emerge from bankruptcy as early as next week, Bloomberg reported, citing an anonymous source.  That would be well in advance of the 60-day upper limit announced at the time of the filing on April 30.

Chrysler has asked a bankruptcy judge to let it sell most of its assets to Italy’s Fiat SpA (ADR OTC: FIATY) in order to avoid liquidation.  Up until now, the judge in the Chrysler case has signed off on all elements of the company’s simplified bankruptcy process that calls for Fiat to take a major equity stake. The deal is still opposed, however, by some of the automaker’s dealers, bondholders, and former employees.

But consumers apparently are buying into President Obama’s pledge to keep Chrysler alive, as the automaker’s sales in May were about even with those from April. That could mean shoppers remain optimistic about the viability of factory warranties and dealer services if GM enters the same process.

“The government has showed that it’s going to put its muscle behind this,” George Magliano, director of automotive research for IHS Global Insight Inc. (NYSE: IHS) in New York, said in a Bloomberg Television interview. “They don’t want a long bankruptcy. They want to get it in, get it out to minimize the impact of a long bankruptcy.”

Jeremy Anwyl, chief executive of automotive research firm Edmunds.com, told Reuters that “a few months ago, the idea of putting a major automaker into bankruptcy raised fears of things spiraling out of control, but the Chrysler bankruptcy seems to be going well, so right now the idea of bankruptcy seems a lot less frightening.”

GM Bankruptcy More Complex and Risky Than Chrysler’s

A GM filing would be far bigger and more complex than what Chrysler is attempting.

For one thing, GM’s bankruptcy would take longer than Chrysler’s, simply because it is a larger company. GM employees 244,500 people, compared with 54,000 at Chrysler. It also boasts a network of dealers that outnumbers Chrysler by almost two-to-one, with about twice as many brands.

And even though the automaker put 1,100 of its 6,000 dealers on notice that they will have their contracts terminated next year, they are shielded by a labyrinth of state franchise laws.

GM also has publicly traded equity and debt, complimented by international operations in Europe, Asia and Latin America.

Those factors contribute to a large web of complications that could hinder the bankruptcy process and present other, more serious risks, David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich., told MSNBC.

“If you look at the complexity of the company infrastructure and the number of players involved here – the union, the creditors, the dealers, the suppliers and the government – it’s an unholy cast of characters,” said Cole. “Any one of them could cause a problem, and bankruptcy laws are not well designed to deal with institutions of this complexity.”

Cole also said if a “quick-rinse” GM bankruptcy predicted by the administration fails, it could present more far-reaching and serious implications for the overall U.S. economy.

If the planned bankruptcy process “blows up,” he says, it could lead to a “cascading failure,” shoving auto suppliers into insolvency and forcing other automakers into bankruptcy, according to MSNBC.

“We are talking about the potential for a rapid collapse – it could trigger a national depression,” he said. “The automotive supply structure is in pretty serious trouble now… so if we were to see a cascading failure it could quickly spread to the rest of the economy. That’s the scale of this industry.”

Source: Collapse of Bond Deal Steers GM Toward ‘Imminent’ Bankruptcy Filing and Majority Government Ownership

This from Money Morning:

The U.S. housing market is already being pounded by the “perfect storm.” And the outlook for the New Year is for the stormy weather to continue – and probably to get worse.

As if a locked-up credit market and tidal waves of foreclosures weren’t already enough, we’re now watching unemployment climb and consumer confidence plunge.

But even when the housing market is taking on water, there are ways to stay afloat. Indeed, investors nimble enough to maneuver can even make money.

The watchword on this market, though, is caution.  If an investor decides to test the waters, beware of the extraordinary financial undertow.

Here’s a look at what’s happening now, and what the implications there are for investors in the New Year.

Rising Unemployment Feeds into Sinking Demand

The grim reality is that skyrocketing unemployment is a major threat to the recovery of the U.S. housing market.  And consumers shackled with record levels of debt are unlikely to ride to the rescue this time.

Since this recession is expected to be long and deep, economists are projecting high rates of unemployment. And the latest statistics released by the U.S. Labor Department show the crucial jobs market deteriorating at an alarmingly rapid pace.

The U.S. unemployment rate jumped to a 14-year high of 6.5% in October as another 240,000 jobs were cut – an uptick from 6.1% in September and the 10th month in a row the jobless rate has risen. Most forecasts are calling for unemployment to spike as high as 8.5%, which would be the worst showing since 1980.

So far this year, a staggering 1.2 million jobs have disappeared. More than half the decrease occurred in the past three months alone, Money Morning reported in its “Outlook 2009” series economic forecast story. Even worse: A year ago, job cuts were concentrated in the financial-services and homebuilding sectors. Now they’re rising across the board; virtually every part of the economy is feeling the squeeze.

For instance:

• U.S. automaker Chrysler Corp., one of Detroit’s wheezing “Big Three,” is laying off 25% of its white-collar work force of 18,500.
• Appliance maker Whirlpool Corp. (WHR) recently announced it would cut 5,000 jobs to cope with declining sales.
• Worldwide shipping giant DHL, a subsidiary of Deutsche Post AG, is laying off 9,500 people, and threatening to close its U.S. distribution center.
• Onetime Internet search giant Yahoo! Inc. (YHOO) plans to let 1,100 workers go – on top of the 1,000 already jettisoned in January – the result of several botched merger attempts.
• Ailing banking giant Citigroup Inc. (C) heaped more bad news on the financial sector, announcing whopping 50,000 layoffs in the next 12 months.

Layoffs of this magnitude are more than a mere shot across the bow of the housing market – they’re actually a direct hit amid ship. People who are unemployed cannot buy homes. Period. But even consumers who are afraid that they might be joining the jobless ranks are loath to take on the added risk – making them unlikely candidates to buy a new home.

Foreclosures Still Rising

As unemployment climbs, foreclosures will continue to multiply. That only exacerbates an already unappealing combination – more houses being dumped onto the market even as the pool of potential buyers grows increasingly smaller.

RealtyTrac Inc. reported that more than 81,000 homes were foreclosed on in September – 71% increase from the same period just a year ago. For 2008, foreclosures rose to a record 765,558.

“I wouldn’t be surprised to see foreclosures increase as the economy slows down,” said Rick Sharga, RealtyTrac’s vice president of marketing. “The people living paycheck to paycheck are at risk if they lose their jobs. It will cause more people to lose their homes.”

And while foreclosure volumes are outpacing projections, the cumulative losses by banks on bad mortgages may have yet to hit their books.  Since loan losses don’t get recorded until the property is sold, it’s likely there’s a lot of bank-owned inventory that hasn’t been unloaded – meaning there may be more foreclosures out there investors don’t yet know about.

“We are in uncharted waters,” said Brian Bethune, an economist at research firm Global Insight (IHS).

Making the waters even rougher was the decision by Standard & Poor’s Inc. (MHP) to cut the ratings on $34.1 billion of “Alt-A” residential loan packages that had been issued in 2006 and 2007.  Alt-A mortgages are those written with little or no documentation, i.e., without proof of income or assets. Even worse, S&P put an additional $351.7 billion of Alt-A securities up for possible review reflecting the rating company’s “belief that further declines in home sales will depress prices further and push loss severities higher than we had previously assumed.”

On top of all that, record numbers of borrowers are already “underwater,” or “upside down” on their mortgages, making it more attractive for them to default by simply walking away, than to hang around and drown.

About 18% of homes nationwide are now “upside down,” according to a report from First American CoreLogic.  Almost two-thirds of those homes are in just seven states: Arizona, California, Florida, Georgia, Michigan, Nevada and Ohio. In Mountain House, Calif., an unincorporated planned housing community located in the foothills of the Diablo mountain range, the housing crisis right now has nearly 90% of the homeowners owing more on their houses than they are worth – the highest percentage in the country, The New York Times reported on Nov. 10. The average homeowner is underwater by $122,000, the newspaper said.

Other areas are suffering almost as much: In Nevada, alone, borrowers owed a whopping 89% of the value of their homes.

Despite such dramatic anecdotes, this housing slump is nationwide in nature. It’s more severe than any other such downturn since World War II, mostly because of the risky lending practices that inflated the real-estate bubble in the first place.

The Downdraft in Housing Prices

Meanwhile, while unemployment rises, the downward spiral in housing prices is gaining momentum.

“The No.1 thing that drives housing values is incomes,” said Todd Sinai, an associate professor of real estate at the Wharton School at the University of Pennsylvania. “When incomes fall, demand for housing falls.”

The S&P/Case-Shiller Index of home prices plunged 16.6% in August from the year before, following a 16.3% drop in July. The index has fallen every month since January 2007 (See accompanying chart, “Plummeting Prices.”).

Prices were lower in all 20 of the major cities the index covers, with Phoenix and Las Vegas down nearly 31% from last year.

Nationwide home prices have fallen 20.3% since peaking in June 2006.

And the skid isn’t over.

According to Fitch Ratings Inc., U.S. home prices will fall another 8% to 10% before they show signs of stabilizing.  According to a Fitch forecast, the peak-to-trough price decline will be 30%.
And still one other reliable indicator of housing prices seems to confirm that, in many cities, home prices still have further to fall.

According to analysis by Moody’s Investors Service (MCO), Miami houses are right now priced at about 22 times annual rental income – versus an average of just 15 over the past two decades. This suggests that a home currently priced at $350,000 is actually worth only $238,600 – meaning the price would have to drop 32% to reach the fair-value point.

Congressional Missteps

In an effort to help more than 400,000 homeowners avoid foreclosure, Congress came up with the “Hope for Homeowners” program.  Unfortunately, in their infinite wisdom, federal lawmakers designed a program that is almost certain to fail.

The program supposedly makes as much as $300 billion available to at-risk borrowers, enabling them to refinance into a 30-year, fixed-rate loan insured by the Federal Housing Administration (FHA).

The biggest mistake Congress made was to make this program strictly voluntary for participating banks, experts say.

Just as bad: In an effort to make the program more affordable for beleaguered homeowners, it also requires the lenders to write the value of the home down to 90% of its current market value. So in a downtrodden market like Phoenix, if a lender holds a $400,000 mortgage on a home currently appraised at $300,000, the bank would have to settle for a new mortgage worth only $270,000.

Needless to say, the response has been underwhelming.  After four weeks, a whopping 79 people had applied for the program.

Not to be deterred, the Federal Deposit Insurance Corp. (FDIC) is proposing another package, which would extend the terms of at-risk loans from 30 years to 40 years, with interest rates as low as 3.0%.  Housing payments for delinquent borrowers could not exceed 38% of gross monthly income.

In order to sweeten the pot for lenders, the government would share as much as 50% of the losses if a borrower ended up in default anyway.  In addition, the FDIC would pay servicers who process these new mortgages a fee of $1,000 for each re-worked loan.

FDIC officials estimate that this anti-foreclosure program would cost $24.4 billion, and would prevent 1.5 million of the 2.2 million at-risk homes from falling into foreclosure.

But that also means the taxpayer will be on the hook for half the value of 700,000 mortgages that do fail.

Can you say “fuzzy math?”

Homebuilders on the Ropes

You can probably guess where this leaves the nation’s homebuilders – gasping for air.

D.R. Horton Inc. (DHI), one of the nation’s biggest homebuilders, just wrote down $1.1 billion in land, deposits and inventory in the third quarter, as sales fell by half. The Ft. Worth, Tex.-based company expects to post a fourth-quarter net loss of between $800 million and $900 million, 18 times more than it lost in the fourth quarter a year ago.

Other builders are in similar shape. Pulte Homes Inc. (PHM) and The Ryland Group Inc. (RYL) just reported quarterly losses of $280.4 million and $65.7 million, respectively.

Even Toll Bros. Inc. (TOL), which caters to the high-end buyer, said fourth-quarter revenue fell 41% from the same period last year.

The Forecast for 2009: More Pain Before Any Gain

No matter what happens in the U.S. housing market, until a large inventory reduction takes place, housing prices will not stabilize.

In a recent Forbes magazine column, A. Gary Shilling, president of an economic consulting firm of the same name, said the worst is yet to come. Says Schilling: “Excess inventory, the mortal enemy of prices, now amounts to 1.8 million homes, which is a huge number relative to the net demand (new families minus departures due to deaths and moves to nursing homes) which is only 1.5 million a year.”

And one of the architects of the U.S. housing debacle – former U.S. Federal Reserve Chairman Alan Greenspan – is also downbeat: “At a minimum, stabilization of home prices is still many months in the future,” Greenspan said in an October speech.

The question that needs to be answered, then, is this: In the current atmosphere, does anyone believe we actually need homebuilders to add even one new home to the market?

Some pundits claim this may be a golden opportunity to short U.S. homebuilders. Even though they’re already down 80% from their highs, the deadly combination of skyrocketing unemployment, deflating prices and tight credit continue to spell further pain for the industry.

Short sellers would obviously look at any of the companies mentioned above. They might also consider iShares US Home Construction (ITB), the prominent exchange traded fund (ETF) for the group. However, any such move would have to be made with extreme caution.

The reason: All bets are off if the new Barack Obama Administration implements a moratorium on mortgage foreclosures. There’s also the possibility that Obama will be able to shepherd through any one or more of the proposed mortgage guarantee programs now on the table.

Those kinds of moves could provide a boost to homebuilders and leave short sellers in the grips of an uncomfortable squeeze – just like the millions of homeowners saddled with mortgages they can no longer pay.

Source: New Year U.S. Housing Market Forecast: No Gain, More Pain