Buy, Sell or Hold Insight: GM Remains a High Risk Profit Play – Even as it Files its Turnaround Plan Today

With America’s “Big Three” automakers all due to submit turnaround plans to Congress today (Tuesday) – a requirement if General Motor Corp. (GM), Ford Motor Co. (F), and Chrysler Corp., are to receive $25 billion in government loans – I couldn’t help but recall the moment eight years ago when I realized the U.S. auto industry was skidding toward a financial collapse.

I’ve been thinking about that market call of mine a lot of late, particularly after recently reading that JP Morgan Chase & Co. (JPM) credit analysts had rated GM’s distressed debt as a “Buy,” noting that the company was likely going to survive.

It was October 2000, and I’d just joined a multi-billion-dollar asset management organization as its head of credit. While most of my experience before this was with very risky and fast-moving emerging markets, this new position was focused on the top tier of the investment market, since the group I was joining had a marked risk aversion and was managed with capital preservation as its main mantra.

“Piece of cake,” I thought to myself.  After decades of deciphering volatile emerging economies, I had “graduated” to analyzing strong companies in the top economies in the world. These credits were all rated “A” or better. And the proportion of our holdings that were not rated “AAA” was a rounding error.

WorldCom Inc., Enron Corp., and the U.S. “Big Three” carmakers were among the companies I had to analyze, as well as some 208 structured investment vehicles (SIVs).  The curious asymmetry was that while companies like Enron and WorldCom were rated “A,” and had tremendous – yet officially unrecognized – risks to the downside, their commercial paper was rated “A1” and “P1,” the highest possible rating offered by leading rating agencies.

The SIVs, Enron, and WorldCom did not resist even minimal analysis. I axed the two companies, as well as the SIVs that did not offer a full guarantee from the sponsor. [For additional insights on the SIV debacle, check out Part I of the Money Morning special investment research report, The Dumbest Money in the World. The report is free of charge.]

So I ended up starting with the corporate bonds, by first addressing the largest exposures we had.

A Debt-Focused Tour of America’s “Big Three”

Since the three U.S. carmakers – all carrying “A” ratings on their bonds, and “A1” to “P1” on their commercial paper – accounted for about one-third of all investment-grade paper outstanding, I analyzed them first.  I had a large advantage over my peers in the investment grade industry:  Since emerging-market credits – both sovereign and corporate – were overwhelmingly in junk bond territory, I had seen over years how late the rating agencies were in adjusting their ratings to the credit reality of the issuers in general. 

The foregone conclusion in “junk land” was that the rating agencies provided lagging indicators of credit risk.  In addition, having analyzed credits in Argentina with 1% inflation a day, as well as massive, surprising devaluations, I knew how distorted financial statements can become and was highly skeptical.  

When I downloaded the balance sheet for General Motor back in the third quarter of 2000, I was stunned. Something just wasn’t right. These numbers I saw just couldn’t be correct.

 “Surely I had made a mistake and downloaded the wrong one,” I thought to myself.  “I must have downloaded a subsidiary’s or maybe the parent company’s unconsolidated balance sheet.

I checked and re-checked.  I had the right one.  The company’s equity-to-assets ratio was only about 2%  – and that was before counting its under-funded pension liabilities.  With that deficit factored in, GM had negative equity.

In other words, the leading U.S. carmaker was technically bankrupt.

Now, I wouldn’t even lend money to a bank with such high leverage. And a bank diversifies the risks in its lending portfolio, is highly regulated, and secures a huge amount of its lending with hard assets. 

But an industrial company sitting on hoards of car inventories and loans backed by used cars … that nobody particularly liked?  Not a chance.

With such low levels of equity, the ability of a company to withstand an economic shock is almost nonexistent.  So, I searched around for any possible redeeming qualities that I could be missing.  But after a very thorough review, I concluded that we had to drop all three of the U.S. carmakers – GM, Ford and Chrysler.

When I brought my decision to the firm’s chief investment officer, a portfolio manager with years of experience in the investment-grade debt market, and a person I’d known back during my days at Merrill Lynch & Co. Inc. (MER), he was unnerved.  He trusted my judgment, but he, like the rest of the market, was confident that each of the Big Three was “too big to fail.” 

Nevertheless, with our firm’s overarching commitment to capital preservation, we negotiated a fast wind-down of exposures: We would sell all the long-term exposure immediately, freeze any new exposure and we would not roll over the commercial paper – most of which was due to mature within a couple of weeks.  In this way, all of our Big Three exposure would be gone within weeks, and we were confident each of the three had the cash and near-term liquidity to pay us back.

A couple of weeks later, at a charity function, I happened to bump into the former head of one of the premier asset management organizations in the world.  In a short conversation, I mentioned my private concerns. The gentleman draped an arm across my shoulders and essentially told me that “the Big Three are not going to go bankrupt.”  That was it.  Another too-big-to-fail advocate.

The Too-Big-to-Fail Myth

Evidently, there were reasons beyond mere creditworthiness that led this very smart man – and others – to keep ignoring the fact that the automotive emperor had no clothes.  The pre-eminent one is the “too-big-to-fail argument,” and those who make that argument are trafficking in the moral hazard trade.  Yet, even today, GM on its website ardently contends that it is indispensable to the U.S. economy, hoping to persuade U.S. taxpayers to throw good money after bad.

(We’ll find out how Congress feels about that argument after GM, Ford and Chrysler submit their plans today. It certainly won’t help that today we’ll also likely find that November sales from the major automakers show only a limited bounce from 25-year lows.)

The other argument is that the auto industry is “strategic” to national interests.  That is to say: How can a country defend itself if it produces no vehicles?  And what about advanced transportation and classified technologies research?

But that argument does not hold up under scrutiny, either.

As eminent economist Martin Feldstein has reminded us, giving the Big Three $25 billion will last less than a year. The reason: They are burning through about $7 billion each a quarter.

Clearly, forcing the three carmakers to restructure will be in everybody’s interest. 

Through bankruptcy – with some, minimal government intervention – we should force the inevitable restructuring to take place. As a result of that restructuring, worker compensation levels will be brought into line, employee and retiree health benefits will be reduced to lower-but-still-competitive levels, any dividends will be eliminated, and executive payouts and perks will be capped. How far must this go?

That’s easy – keep cutting until the companies are restored to health and, most important of all, to a state of long-term viability.

This does not mean that the Big Three will disappear. What will disappear is corporate waste. The companies will restructure/continuing profitable activities and liberating resources from unprofitable ones to expand future development.  This has been done successfully – and en masse – in many “strategic” industries, such as the steel business in the United States, and telephony, utilities, energy, aerospace, and many others that were restructured in the 1990s in Argentina, Brazil and South Korea.

There is no reason why each of the Big Three – each currently the laughingstock of the global auto industry – should not regain their leadership positions, as measured by profitability and technological prowess. In this way, GM, Ford or Chrysler – or even all three – can create good, secure jobs and contribute to the U.S. economy, rather than detracting from it.

To be fair to GM and the others, they all have attempted to restructure. They’ve secured agreements with the United Auto Workers union that were designed to control costs. And they’ve tried to launch newer, better vehicles.  But those agreements are too little/too late, and the sands have run out of the hourglass.

Union leaders from GM, Ford and Chrysler have now scheduled an emergency session for tomorrow (Wednesday) in Detroit as the companies plan to seek concessions from the United Auto Workers to help land those win $25 billion in government loans, Bloomberg News reported yesterday (Monday). Participants will be asked to reopen a 2007 labor agreement to consider concessions. GM, which has said it may run out of cash to meet its obligations, wants to stop paying union workers when plants are closed and there isn’t any other work for them to do. Now Ford and Chrysler are expected to ask the UAW for similar concessions as part of their bid for the government aid package, Bloomberg said.

All three of the American carmakers were technically bankrupt since at least the time of my first analysis near the end of 2000, and the union agreements still did not bring compensation down to levels comparable to that of their competitors. Now the U.S. automakers are on life support.  There is no time left for gradualism.  They missed that window long ago and the costs imposed on all U.S. taxpayers figure to be huge.

The current predicament in which GM, Ford and Chrysler now find themselves is not only their own fault, as we’ve now already been subsidizing the unions for far too long.

Are Unions to Blame?

One of the biggest reasons Detroit’s Big Three have run out of capital is the extraordinary compensation that has been paid out to unionized workers in the United States.

Even in the last reported quarter, when the economies of Europe and Asia had slowed dramatically, GM was almost breakeven in those two regions and actually had 10% profit growth in Latin America, Africa and the Middle East, where GM also has unionized work forces. But the company is losing money in the United States.

That’s because the GM pays about $75 per hour – $156,000 a year – to its assembly line employees.

And because of that, the Big Three are lagging far behind in technology investment. That has not only damaged the auto-related technology industry, but has decreased productivity and innovation, delaying the shift to more fuel-efficient technologies.  And because they have jointly held the market leadership, they set prices high, allowing foreign competitors to undercut them.

These phenomena have increased the costs of transportation for all Americans for decades.  Americans have overwhelmingly voted with their dollars by buying foreign brands, which has contributed to our growing trade deficit.

Ultimately, inefficiencies in the auto industry have imposed huge costs on the rest of the economy, putting the Big Three at a competitive disadvantage that has hurt profits, cost the economy jobs, and opened the door to foreign companies to export U.S. dollars back to Germany and Japan (and now South Korea and China).

GM lost $21.3 billion in the third quarter and burned through about $7 billion in cash.  It has only about $16 billion in cash left, and already its liabilities are $60 billion larger than its assets, which means that GM has negative equity

And the current quarter will be worse.

The bottom line is that GM is essentially bankrupt – and has been for years.

At this point, GM should – like so many companies before – have to restructure its costs to a point that allows it to be competitive before receiving a single taxpayer dollar.  Otherwise, we are just throwing good money after bad and it won’t be long before GM comes crawling back for more.

I just hope that the politicians and government officials in Washington are wise and determined enough to control the situation, and force the bitter medicine down the company’s throat.

To Buy, or Not to Buy

In this environment of high uncertainty, I would not go near any GM securities. 

However, highly sophisticated players may consider making a very small bet, in one of several ways. With GM’s bonds and credit default swaps trading at near-bankruptcy levels (15 cents on the dollar), it may be attractive (albeit highly speculative) to buy GM’s bonds, in the hope of converting these debt securities into the debt-and-equity of a newly restructured General Motors. Over the course of a couple of years, this could turn out to be extremely profitable, but only if GM’s work-force wage-and-benefits costs are brought into line with the company’s global rivals – and if the U.S. economy recovers. Among the many financial scenarios under review, GM’s board of directors is reportedly considering an option that would grant current bondholders equity in a restructured company in return for maneuvering room, according to media reports.

Reuters reported that GM’s bonds fell nearly 12% early yesterday (Monday) as investors waited for the automaker to submit a new turnaround plan that might actually have a chance of winning lawmaker support. GM's 7.125% notes due in 2013 fell to 23 cents on the dollar, down from 26 cents on Friday, according to MarketAxess. As we noted earlier, GM is due to submit that plan by today.

When JP Morgan’s credit analysts made their market call last month, GM's benchmark 8.375% bond due 2033 has dropped to 25.75 cents on the dollar, which was down from 36.5 cents at the end of October, MarketAxess said. The bonds had traded at more than 80 cents on the dollar at the beginning of the year and currently yield 32.5%.

In the case of selling credit default swaps, an investor would get paid some 80% to 85% of the value they are “insuring” up front. If GM gets bailed out, which is an increasingly likely scenario, that investor would keep the full premium and walk away.  And in the case of default, that investor would have to pay the buyer 100%, therefore losing some 15% to 20% after the default, but getting the bonds he is insuring in exchange for that loss.  We would then take the bonds into the restructuring as noted above.

I would not buy the actual GM shares, even though I have friends in high places in finance that still believe in the too-big-to-fail theory. My concern with GM’s stock is that there would be a very strong chance the company’s equity gets totally wiped out in a bankruptcy, or at least heavily diluted as a result of any government infusion the company receives.

GM’s shares closed yesterday at $4.59 each, down 65 cents each, or 12.4%. They have traded as high as $29.95 in the past 12 months. The company right now has a market value of only $2.8 billion.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Money Moves Alert” service. To find out more, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as PepsiCo Inc. (NYSE: PEP), Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE). One recent recommendation, the iShares MSCI Brazil Index (EWZ), an exchange-traded fund (ETF) that invests in Brazil, actually rose 42% in the first six days after Marquez rated it as a “Buy.”]

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