This credit crisis is a big deal and we will ultimately get it right. Let’s take a look at some necessary requirements to get past the credit crisis and start dealing simply with a severe recession.

Homebuilders wisely took any and all losses possible last year in order to receive checks from the federal government. They had to show losses to benefit from rebates of taxes paid during better times. This was a gift from the 2008 stimulus bill. It is even rumored that many sold land holdings at losses with agreements to repurchase the same property in the future in order to obtain these lucrative rebates. No need for me to pontificate here on the tax payer fleecing. My job is to look for investment opportunities.

Economic Data

Trust preferreds are basically junior debt and are senior to perpetual preferreds in the capital structure. All indications are that these types of securities are not going to be wiped out in bailout or rescue situations the way Fannie Mae (FNM) and Freddie Mac (FRE) preferred securities were wiped out last year. Let’s assume for a moment that a few are wiped out. Yesterday’s market price on PFF still would imply virtually all the straight preferreds will be nearly wiped out.

Last week's rout was multi pronged:

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We are rightly concerned with the last $350 Billion of TARP and with the mockery that is this “stimulus package”. However, we must not ignore the substantive gains achieved by the Federal Reserve, nor should investors forget the propensity of markets to discount recovery and move higher while GDP and employment numbers remain weak.

Like all reasonable economic liberals (aka free market thinkers), I sincerely wish success to President Obama and his team. I am predisposed to believe they are honest and capable men and women. In contrast to President Bush’s team, they also have the luxury of the support of the electorate.

FEAR

During the course of the second quarter, first quarter GDP was revised upward twice to leave us with final growth of 1%.  The surprising growth in the economy has been driven by surging exports.  Goods sold to foreign buyers have been turbo-charged by the declining dollar and strong economic growth throughout the world.  Real income increased in the second quarter as did the all important consumer and service sectors of the economy.  Unfortunately for investors, markets don’t trade so much on what has happened as what is expected to happen.  The parabolic rise in oil and other commodity prices coupled with devastation in the banking, brokerage, and housing sectors have sent confused investors to the sidelines.  With little visibility about the ultimate macro-economic consequence of the financial and energy crisis on the economy, buyers have gone on strike.

Of course for now, we must contend with the fact that markets are being driven by the twin fears of inflation (oil topped $100 and gold closed at an all time high last week) and recession. Despite the plethora of bad news to start the New Year there are reasons to be optimistic.

In the absence of our aforementioned confrere, markets in general and debt markets in particular had priced themselves for perfection. The elimination of risk premium in certain mortgage related debt led ultimately to the sub-prime related re-pricing of risk that has occurred over the past six weeks. Fortunately for investors, this crisis has been contained because of strong global economic growth, pristine corporate balance sheets, and an accommodative Federal Reserve Board. At this writing, volatility has returned to more historical norms and risk has been more efficiently priced into the market.

Traditionally, corrections after hockey stick run ups are considered healthy and somewhat expected. We rang in the new year at Dow 12,463, touched 14,000 on July 19th and have since retreated a mere 5.2% to settle at 13,270 today. Taken in perspective stocks as measured by the Dow are up 6.47% this year. Not being one to ignore the bull in the china shop however, we must consider whether or not there is decidedly more to this sub prime issue than meets the eye.

Sub prime mortgages are nothing new; lenders have made high risk mortgages on Real Estate nearly forever. Today, most mortgages are sold to Wall Street firms who package them into Collateralized Mortgage Obligations (CMOs). The CMOs pool the mortgages and further cut the portfolio into traunches. Each traunche owns similar pieces of each mortgage but are pre-assigned various levels of defaults. The vast majority of defaults are assigned to the last traunche commonly referred to as the equity traunche.

Investors reacted with a slight anxiety attack and sold off bonds of longer maturities when Merrill’s David Rosenberg decided his early prediction, that a 90% chance of Fed Easing should be replaced with a 4% probability. Following right along Mr. Rosenberg’s call was Goldman’s team of Ed McElvey and Jan Hatzius, who opined that “we abandoned expectation of Fed Easing and we no longer anticipate any Fed rates cuts between now and the end of 2008”.

Yesterday, REIT ETFs soared in anticipation of the next buyout deal. ICF closed up 3.82% on the day, while Vanguard’s REIT Index ETF (VNQ) followed right along giving investors 3.57% between 9:00 AM and 4:00 PM eastern time. There is a certain willing suspension of reason at market tops that is only fully recognized during the hangover period that inevitably follows. My suspicion is that we are nearing this point with REITs.

What remains to be seen is how this Fed defines “inflation”. Is this a Fed that defines inflation by relying heavily on analyses of core CPI and PPI data? Or does this Fed approach the issue in a more forward looking way?

Just a few short weeks ago people had written off the ski season in the Western Sierras, citing snow fall significantly below the traditional numbers. Unsurprisingly, the “weather market” has corrected the fat tail performance abruptly dumping multiple feet of sweet powder on the slopes over a few short days.

The stock market loves earnings and sound currency above all else. The Fed has been adamant that it is a provider of the latter. (As opposed to a social engineering type of Fed). This commitment to fighting inflation provides good currency visibility to the stock market. Earnings however, are going to experience a deceleration in growth over the short term. Current low interest rates justify stock multiples and the prospects of still lower interest rates around the corner provide visibility to support those higher multiples. Lower interest rates will stimulate investment and a rebound in the housing sector.

For some product manufacturers the decision to create a new ETF seems to be based purely on what will sell, rather than on what will succeed as an investment. A new private equity ETF may sound sexy, but the opportunity to build a portfolio remotely close to 100% private equity is non existent. Barron’s correctly pointed to some suspicious activity in a single country ETF over the weekend, and I have been critical of funds launched that have a very low likelihood of ever tracking their target index.