(UNEDITED)

February auto sales fell 7% from last years pace to 15.4 million units as increased incentives failed to drive sales. It is becoming very apparent that sales were pulled forward during the incentive induced buying frenzy over the past year and the industry is entering the period which sales were pulled from. February marked only the third month in over four years that total vehicle sales were below an annualized 16 million units. All three of these low points have occurred during the past nine months. This is especially unwelcoming since incentives actually increased 10% on a month-over-month basis, and 33% year-over-year. The two previous months that saw sales dip below the 16 million vehicle rate was not accompanied by a large boost in incentives and followed a spike in sales. December was a very good month for sales, 18.3 million unit rate, so it might just be the result of sales being pulled forward during December. If not, and this is the beginning of a downtrend, it will be a very somber year for the automakers. This month will be very important for the industry. There has not been two consecutive months with industry sales below the 16 million annualized rate since the summer of 1998. Addressing the growing inventory situation, both GM and Ford announced that they would cut second quarter production. GM announced that it will cut production by 11% and Ford will reduce production to be "more in line with sales."

Sales were weak throughout the industry with domestic automakers faring toward the bottom of the industry. There were several automakers that increased sales in February, mostly in the luxury sector.

According to CNW Research the average incentive on new vehicles jumped almost 10% to $3,224 per vehicle from January. The average incentives for all three domestic automakers increased in February. GM tops the list of domestic automakers with a lucrative $3,977 per vehicle. Ford's average incentive was $3,543 during February. While DaimlerChrysler's incentives were the lowest of the group at $3,283, it increased the most, 7.4% from January. Unfortunately for the automakers, a dollar decline in selling prices drops down to the bottom line on a dollar for dollar basis.

Part of the boom during the late 90s was caused by an increase in the number of consumers leasing vehicles instead of purchasing. Starting in 2000 the trend reversed sharply. According to the Association of Consumer Vehicle Lessors, leasing activity declined 14.5% in 2002 (end of November data) and is down 50% since 2000. This trend was already underway before the zero-percent financing offers were introduced, but was exacerbated by the cheap financing. Also contributing to the decline in leasing was the decline in residual values for when vehicles are returned to the finance companies. During the late 90s residual values were overestimated when leases were originated. Finance companies found that they could not sell the vehicles for the amount originally forecasted, which resulted in losses by several finance companies. Not only were residual values subsequently adjusted downward, but also several finance companies decided to exit the business. Lower residual values caused monthly lease payments to increase and leasing lost a large portion of its attractiveness, especially when zero-percent financing hit the market.

Residual values have declined even further as the industry started offering huge incentives. Since increased incentives lower the actual cost of a new car, it also lowers the value of used cars. Since used cars compete with new cars, if the new car price declines so does the used car price. According to Automotive Lease Guide, the company sets the residual values that most leasing companies either use or benchmark their internal values against, residual values drop by $435 to $685 per every $1,000 increase in incentives. The incentive induced marketing has caused used car prices to drop.

Through a combination of incentives for new cars and a glut of used cars resulting in consumers trading in to take advantage of the new car incentives, used car prices have plummeted. According to ASESA Analytical Service, used car prices have dropped every month since July 2000. In the previous six years to July 2000 there were only six months that used car prices fell. The price decline has accelerated recently. July and August of 2002 saw declines of over 6%, which had not happened in at least eight years. January 2003 saw a decline of 6.6%, which is the largest decline in at least nine years. As one might expect newer model used cars have suffered the most dramatic price decline, as those are closer substitutes for new cars. Models less than four years old experienced declines of over 7% in January, compared to a decline of 2.4% for those four and five years old.

The decline in leasing activity will also likely lengthen the car buying cycle. The average lessor acquires a new vehicle after 39 months compared to 54 months for those that purchase. Going forward it is very likely that it will lengthen even more. The average loan term has grown to almost 58 months from 50 to 52 months just five years ago. Longer loan terms and declining used car prices means the average car owner is upside-down for a substantial part of their loan.

Lower used car prices can result in lower sales of new autos. If used car prices have dropped enough so that the owner is upside down on his loan (owes more than the car is worth) the likelihood that he will be able to receive favorable loan terms declines. Usually in these cases the difference between the value of the car and the remaining loan amount is added to the new loan. This will however, makes the next loan much more difficult. Since the owner is upside down on the loan before he even starts the car, the amount that he is upside-down grows. This will stretch out the car buying cycle. Obviously it is in the best interest for the automakers to have a shorter buying cycle.

The future looks pretty grim for the auto industry. And this does not even consider the problems Ford and GM face with their pensions and post-retirement benefits. GM has already announced that pension costs will reduce earnings by $1.4 billion, or $2.55 per share. That is a lot of money that is going to employees and ex-employees instead of bondholders and equity holders. Should GM lower its assumed rate of return and increase the expected rate of inflation for future health care cost, these payments will grow.

On Wednesday, Dow Jones reported that Ford bonds were quoted on a dollar basis, a convention typically used for pricing junk issues. Last Wednesday, the spread on Ford's bond maturing March 2013 widened 27 basis points to 431.4 and today widened further to 462.5. Spreads remain much tighter compared to last October when spreads blew out to 668 basis points, but after narrowing since October the trend has definitely reversed.

Ford's position is so dire that Egan-Jones, a credit rating agency, thinks, "If the name weren't Ford, they would have been forced to file bankruptcy already."

With the widening of spreads the bond market might be figuring out that as incentives increase the value of used cars declines. Lower used car prices lowers the value of the collateral securing the enormous debt issued by the automakers. If credit quality continues to decline, bondholders might be shocked to find recovery rates lower than currently anticipated.