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Fallout From Failure

Tuesday, April 11, 2006

Jubak's Journal
Bad for GM, bad for America

General Motors has launched a time bomb that could push the company into Chapter 11 -- and take down the financial markets with it.

By Jim Jubak

Leave it to the guys who are driving General Motors (GM, news, msgs) off a cliff to make things worse. Thanks to their most recent "solution" -- selling off a 51% stake in the company's profitable General Motors Acceptance Corp. financial arm -- CEO Rick Wagoner and his team have actually raised the odds that General Motors will have to seek bankruptcy protection. And made sure, as an added bonus, that they can do nothing to stop what theyve set in motion.

Pretty neat, huh?

But, wait, that isn't all that these guys managed to accomplish last week. Before you relax into some comfortable jeering from the sidelines -- unless you own GM stock or, even worse, work there or at some GM-dependent company -- you should know that last week's GMAC sale has put all of us in range if GM should blow up. Thanks to the way that Wagoner et al, structured the GMAC deal, they've created the possibility of a real blowup in the derivatives market that insures bond holders against default. If that bomb were to go off, every financial market would be in shrapnel range.

Cheap goods
So how does a CEO manage to put his company and the entire financial market at risk with a single deal?

By making it contingent on the whims of the not-so-rational combatants at Delphi (DPHIQ, news, msgs) and the United Auto Workers, who have locked horns over wages and benefits in Delphi's bankruptcy proceedings.

General Motors did this by "selling" 51% of GMAC to a private investment group including Citigroup (C, news, msgs) and headed by hedge fund Cerberus Capital Management for $14 billion. Of course, GM won't get that $14 billion all at once. When the deal closes, Cerberus and its partners will pay General Motors $7.4 billion. GM will collect another $2.7 billion in cash from GMAC as a return of the higher taxes that GM paid on GMAC's income when it owned the financial company. GM will receive another $4 billion over three years from GMAC as income on $20 billion in leases and retail assets that GM will retain after the deal.
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This isn't exactly a great deal for General Motors. GMAC is the company's most profitable unit, earning $2.8 billion in 2005, and GM has been able to tap GMAC for capital during what has become a perennial rough patch. The investor group is paying about five times net income for its 51% stake in GMAC -- and part of that price is cash from GMAC itself. If you look just at actual cash from the investor group and subtract the cash from GMAC, the price is closer to two times income.

But when you've lost $10.6 billion in a year, as General Motors did in 2005, getting a good price takes back seat to getting the deal done at all. Especially when your auto sales are dropping like a rock. GM's U.S. sales dropped 14% in March.

The no-sale sale
But price isn't the real, company-crushing bad news in this sale. I'd save that moniker for this oddity: The sale isn't a sale at all. Cerberus and the rest of the group can walk away from this deal before it closes some time in the fourth quarter of 2006 if the credit rating on General Motor's unsecured long-term sinks to less than a triple-C rating from Standard & Poor's. A rating like that would be two notches deeper into junk-bond territory than General Motors' current rating of single-B. (The deal is also off if GMAC's own credit rating slips below its current double-B rating, just two notches below investment grade.)

What could drive General Motors bond ratings down another two notches just about overnight? A strike set off by supplier Delphis efforts to break its contracts with its unions in bankruptcy court. The company has filed a reorganization plan that includes closing or selling all but eight to 12 of its 33 North American plants and cutting as many as 30,000 jobs. For U.S. workers who keep their jobs, Delphi has proposed an immediate wage cut of $5 an hour (or 18%) to $22 an hour for production workers and another cut to $16.50 an hour -- for a package of cuts totaling $10.50 an hour -- in 2007.

The United Auto Workers, as you might imagine, has branded the proposal unacceptable and threatened a strike. Delphi has responded by asking the bankruptcy judge for a ruling that would allow the company to unilaterally break its union contracts with the company's 34,000 union workers and its 12,000 union retirees. The first hearing in this game of chicken is scheduled in U.S. Bankruptcy Court in New York on May 9-10. A ruling on the labor contract is unlikely until June.

A strike at Delphi would cripple GM by shutting down almost all of the auto giants North American production. General Motors last faced a long strike in 1998, when a 54-day work stoppage closed 95% of its North American operations. Merrill Lynch estimates that a 60-day strike at Delphi would cost General Motors $7 billion to $8 billion in cash. That sum wouldn't just come from lost production. It also comes from swings in the company's cash flow created when hard-pressed suppliers, also shot down by a Delphi strike, increase their demands that GM make prompt payments of existing bills. Payables -- what GM owes suppliers -- stand at $26 billion. And they're paid in cash. That's a significant figure even for a company like GM with $20 billion in cash.

You'd think $20 billion in cash would be enough to reassure the credit-rating agencies who have graded GM's debt "junk" or, to be polite, "below investment grade." But it's not, because there are so many demands on that cash, including the recent early retirement offer to workers at GM and Delphi that could cost GM $2.2 billion in cash, according to estimates by Bernstein Research, and $5.4 billion in pension obligations. And then add in whatever size loss General Motors is likely to show this year on its car-making operations.

All this is bad for General Motors, but why is it bad for the country?

Insurance buyers, in good hands?
The short answer is that bond traders are scared enough about the possibility that General Motors itself could wind up in Chapter 11 bankruptcy that they're buying insurance, but they're not scared enough to worry how good the insurance is.

If they want to insure a debt against default, big investors turn to a kind of derivative called a credit default swap. (Derivatives are securities based on other securities -- derived from them, if you will.) Forget about the details -- they involve an investor who thinks default is relatively likely who then buys what amounts to insurance from another investor who thinks default is less likely. So that, for example, on April 6, a default swap on GMAC to insure $10 million of GMAC debt for five years cost $385,000.

This makes prices in the default swap market a good barometer of how likely investors think a default is. More likely and the price of the insurance goes up. Less likely and it falls. Recently the credit-default-swap market has been pricing in a 50/50 chance that GM will go into bankruptcy some time in the next five years.

The insurance provided by the credit-default-swap market takes some of the worry about of buying GM bonds. Oddly enough, that works to keep yields on those bonds lower than they might be. If you can insure against the bonds going bust, your risk is lower, and the yield should be lower, too. The existence of the derivative market for credit-default swaps -- where recently it cost 18.25% to insure GM bonds against default for five years -- has lowered the yield on the actual GM bond by lowering the risk of default.

On April 7, a General Motors bond due in January 2011 was priced at $73.50 per $100 of face value, a yield of 14.73%. That's a very nice yield but, I'd argue, not what I'd expect for a company with a 50/50 chance of going bust before the bond matures. (The original coupon on this bond when it was issued was 7.2%.) And I'll bet that some of those bonds, thanks to credit-default swaps, have found their way into pretty conservative portfolios.

That would be just about perfect if we could count on the credit-default-swap market to provide perfect insurance. A credit-default swap as insurance is only as good as the money of the investor on the other end of the deal. If that investor pays off in a default, great. If the demand for payment, or the prospective demand for payment, creates a scramble to sell before the insurance bill comes due, then the cost of insurance can skyrocket. That, in turn, would lead some investors to sell any credit-default swap contracts with lower "premiums" (assuming the market would allow this) and would send other investors back into the bond market, where they'd demand higher yields rather than paying higher premiums in the credit-default-swap market. And, if a weak hand fails to pay up on that insurance, then pricing in the whole credit-default-swap market runs amuck, with prices for contracts soaring or with supply collapsing -- or both.

Testing, testing
No one knows, of course. This isn't an old market, and it's not well tested. Moreover, the derivatives market has failed some past tests as weak hands have proved unable to meet commitments.

And the risk in the credit-default-swap market rises as events get more uncertain. More uncertainty brings more investors to the market looking for insurance. And the growing demand increases the odds that one investor or another offering insurance will make a mistake or get overextended. That can lead to exactly the swings in price and supply that could lead to a collapse of liquidity in this market.

We've already seen clues to how volatile this market can be. The most actively traded credit-default swap in March was that of GMAC. In a matter of a few days prices moved from lows of $300,000 for $10 million in insurance to highs of $485,000.

It's about a 62% swing. Without a strike at Delphi or a wildcat strike against GM. Without fears that the Cerberus-GMAC deal might collapse. Without another ratings drop on GM debt.

I don't have much faith in any of the parties to this mess. But I sure do hope they work it out. I can get along without another real-life test of the derivatives market.