Credit investors ponder GM-sized hole in universe
Posted by Stuart Staniford on March 29, 2006 - 3:19am
Topic: Economics/Finance
Tags: general motors, peak oil [list all tags]
Like the elephant in the living room, the decline of General Motors is a problem that investors don't want to think about but can't ignore.The world's largest automaker, whose debt is close to the gross domestic product (GDP) of Belgium, lost more than $10 billion last year and is facing a bankruptcy that would reap devastation in the financial markets.
GM's (GM.N: Quote, Profile, Research) share price has halved in the past year, while its $100 billion of bonds have been cut to junk, confronting investors with the prospect of never getting their money back. Others in the highly-leveraged derivatives market face incalculable losses should a bankruptcy occur.
"A GM default would be absolutely huge," said Jonathan Loredo, of credit manager Cairn Capital. "It would be the biggest thing to hit the market in terms of losses and operational stress."
The complex market in CDO squared, or CDOs of CDOs, also faces significant risk following a GM downgrade, one London-based hedge fund manager said.Obviously, few peak-oilers are going to be very bullish on a US car company that has made a central focus of extremely large and fuel-inefficient vehicles. But I'd love to have a better understanding of the credit market implications. The credit markets seem to be to be very important to understanding the whole deflation versus inflation post-peak question, as well as how the relative timing and impact of the housing bubble bursting versus peak oil, which has profound implications for oil prices."To be blunt -- it would be carnage," he said.
But after spending an extended period over at the Wikipedia on Collateralized debt obligation, Credit derivatives etc, I have to confess that I'm not really there yet. I still don't understand why one corporation is so significant to these markets, or what it means.
Anyone out there got a good grip on this and care to explain it to us?
Another point others might be able to enlighten on: is some of the meltdown due to the credit arm of GM taking a bath on some bad loans? It is a rumour I heard.
They had a story on the news this morning about how GM was hoping to spin off about 50% of GMAC, but there were financial irregularities that were recently discovered, and until those are understood nobody is going to touch it.
There is a second question. GMAC is the big money behind Ditech.com - that highly annoying internet home loan thing that is advertised on TV all the time. If the real estate market tanks, it could lead to losses for Ditech and GMAC.
[Incidentally, Auto lease are increasingly complicated as they now include built-in service agreements and other consumer unfriendly provisions that offer substantial margins to the dealer and automaker over-time. Many (most?) lease are underwater for a time with consumers as the vehicle depreciates significantly before payments catch up.]
The Wall Street Journal on Monday (3/27) and Tuesday has had three articles that relate to TOD. One was on GMC, one on tar sands, and one on nuke power plants & France. Someone there is thinking along our lines.
I recall that Warren Buffet of Berkshire Hathaway had a wonderful article explaining derivatives and societal risk. I would look for the specific link, but I am simply bushed and needing shuteye from reading all the previous excellent posts.
Bob Shaw in Phx,AZ Are Humans Smarter than Yeast?
Here's a copy of Buffet's letter on that topic. It helps but the entire derivatives scene is a story of taking risks on someone else's risks which were taken on someone else's risks. He also criticizes the inherent tendency to be optimistic, coupled with derivatives reporting earnings today whose full costs cannot be known until some tomorrow on the horizon.
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2006/03/18/cngm18.xml&menuId=242&sShe et=/money/2006/03/18/ixcitytop.html
(sorry if this was posted previously)
Not only do I agree with the first post in this thread, that a domino effect will occur if GM goes bankrupt.
There's also a fat chance that the emotional and psychological reactions will effect many businesses, not only the ones with ties, directly or indirectly, to GM. GM has a symbolic value which is not to be underestimated.
"What's good for America is good for General Motors, and vice versa."
Then his remarks were twisted for politcal purposes to suggest that what he said was:
"What is good for GM is good for America!"
But he never said that.
Does anyone have access to a transcript of the exact words?
GMAC wants to spin off from GM because, the way it's currently structured, GM's crappy credit rating applies blanket-like to GMAC and that will kill the profitability of that division eventually. So they have to separate to sufficient arm's length that they can command an independent credit rating.
GM is doing some dumb things. You probably remember the Fortune magazine article, almost a year ago, about GM's billion $ investment in hydrogen fuel cells and research. The last line of the article was a rather pessimistic guess that GM was gambling on a very risky adventure and I agree with that assessment. To do the fuel-cell thing (with gov't assistance I'm sure) they and Ford walked away from a program to develop high-MPG car technology. Now their hydrogen / fuel cell gamble is probably $1.5B and it's money down the toilet. The so-called "hydrogen economy" will not happen. Imagine if they had put the same money into hybrids, or even better a super-clean-burning diesel engine technology - which could be combined with hybrid / batteries and get a really attractive fuel-efficient vehicle. Too late now.
That tsunami you see on the horizon right now, looking west from California, is the Chinese auto industry. They are coming, they will be cheap, fuel-efficient, good-looking, and they will put the final nail in GM's coffin.
http://www.financialsense.com/stormwatch/2005/1123.html
They call it a "short story" but it's not that short. But it does have some interesting info on how hedge funds work, and it's more accessible than most of their stuff.
(I posted the link to the last part, because it has links to the previous three parts.)
If FinancialSense.com is not your thing, try Googling Long Term Capital Management (LTCM).
As I understand it, hedge funds have exploded, because they can offer big gains even when the market is in a funk. They do this, in part, with massive leverage. If one of their bets goes bad, the whole thing can go down the tubes very quickly.
GM however, as a car producer for the average customer has made a lot of mistakes. Being dependent on such a volatile number like the oil price is, should result in a more diversified array of products and being enabled to offer cars which can compete with cars from Japan. Are managers really blind not to see the dark clouds on the horizon coming near?
Is GM a victim of the relatively low gas prices in the USA?
BUt it is wrong to think of gm as a victim - the japanese companies have been gobbling up market share in the same environment that us ones are losing share because the former consistently offer better products. Mgmt's biggest concern has been unions demanding overly generous benefits, rather than any real interest in offering better products likely to meet their customer's present and future needs.
However, I suspect that european automakers would do worse against the japanese if it were not for the EU doing what it can to keep japanese cars out of their markets. US cars don't compare well with japanese cars on reliability, but they are significantly better than german luxury sedans - and this is no doubt specifically because the us does allow real competition. I suspect it will be easier for the (remaining) us companies to produce more fuel efficient cars than for the european companies to produce better ones.
Mercedes had a lot of quality problems and hence problems selling enough cars. Now this company wants to reduce bureaucracy. The interesting thing is, there is meanwhile a considerable technology exchange between Chrysler cars and Mercedes cars. As far as I can tell, Chrysler benefits from this.
Porsche has no problems and is very succesful these days. Porsche owners don't need to be concerned about fuel prices.
So it is a matter of size and a matter of the array of products?
I am not a motorist, I cannot evaluate the quality of cars. But I think both are almost the same. There is no difference between a french car, a german one and maybe only a little to japanes ones. American cars almost don't exist on the streets here in Europe. So do - still - chinese ones.
The problem with the derivatives market is that nobody truly understands the financial wizardry involved. What is known is that they are typically highly leverged (not always the case as you may use one derivative here to protect yourself against a leverage exposure there but this creates a financial chain of indeterminate length). As long as the growth spiral is positive all is good. As soon as the growth spiral looks to turn negative the parties begin to unwind their positions, everybody runs for the exits, and the entire house of cards comes tumbling down.
I agree with Stuart that there is reason to be concerned, especially when the following are also taken into account.
The first link is to a Wall St Journal article describing US/China trade relations on a "knife edge."
http://online.wsj.com/public/article/SB114347098996009022-OvMpyiZqlZWNvS3qXzgBYErA7aI_20070328.html? mod=hpp_free_today
The second article describes guidance coming from the Asian Development Bank cautioning its members in regard to a possible meltdown in the US dollar. The problem here is that once the parties begin to contemplate such a meltdown as within the realm of possibility then the reality tends to conform to that view and the meltdown occurs.
http://english.aljazeera.net/NR/exeres/50B0028B-B417-4FDE-866C-842CB3280A4F.htm
From a PO perspective, a decline in the USD would have the effect of raising the cost to America of every bbl of imported energy while decreasing the cost to all nations with a currency appreciating against the dollar. America's foreign military adventures would suddenly become much more expensive, America's trade balance would be increasingly negative (it will not be possible to immediately re-source all the products made overseas; the American factories have been closed and the workers laid off), and America's creditors would be increasingly unlikely to finance America's debt. This would result in a significant jump in US interest rates. Persons living on the margin with large variable rate interest only mortgages would see a rise in all of their costs (transport, shelter, credit, consumer goods). The housing market would flatten, if not collapse completely from peak, mortgage loans would be greater than home equity, and the mortgage lenders may encounter severe financial problems. All of that is the good news.
The truly bad news is that America's creditor nations may seek to impose stringent terms and conditions on America if they are to assist with the reflation of the American economy. This would be similar to the terms and conditions applied to correct the Mexican meltdown, or the Asian meltdown of a few years back. Or the truly distrubing occurs and the entire world economy goes into the toilet. Nobody wants that outcome so I do not think that likely.
I do think there will be general questioning along the lines of "Why does the US think they are running things when they are morally and financially bankrupt? They don't give a damn for international law, or their own constitution, yet they want us to finance their extravgant debt. At the same time they seek to consume a dsiproportionate share of all the worlds energy, and callously export CHG while continuing to deny there is any problem at all with any of these behaviours.
If any of the above comes to pass, it truly will be "Morning in America" and that strange aroma you smell will be something other than your morning coffee.
How much Peak Oil has to do with the meltdown?
I think (from a non economist point of view) that the USD meltdown is finely bound to the Peak Oil event. The US has gone over the Hubbert Peak and instead of consuming kept consuming more and more every year, creating a monstrous Energy Deficit.
If we can establish a strong link between Peak Oil and the USD possible meltdown we can have a better picture of it.
That's the much easier way to get rid of our 7 trillion dollar federal debt. I think that's why the Bush administration has been spending like there's no tomorrow. Because financially, there isn't. Money today doesn't equal money tomorrow, and we're stealing as much from China as we can right now. The problem we'll run into though is that after the "reset" it'll be a mad horse race in the manufacturing sector to build up wealth (or weapons) and that's something that the Chinese will easilly beat us at. I think we're hedging on massive unrest and revolution in China and India. It's just scary to imagine how they're planning to keep our population in check.
Anyway, that's why I almost welcome financial collapse. If there was someone with an FDR-like vision for rebuilding society as oil-free, the bottom of a depression would be the easiest place to start. A command economy is easier to direct that way than a free market. That's my prognostication for the day.
If we are going to keep using our military as an economic tool, I hope we've made sure our 'Military Credit Rating' is still in good standing. I understand those dollars aren't as easy to print right now.
When that happens, there's no doubt I'll be joining our fairer friends to the north.
Don't worry. We can always sneak him in. :-)
over time it accelerates. It does this in an orderly manner
with few problems to trouble it. Over time, more and more
energy is stored in the train until it is speeding down
the track at a remarkable pace. Then something begins to go
wrong, ominous noises are heard. The engineer applies the
brakes, but it take a long time to slow the train.
The train begins to shudder violently, then it derails
spectacularly. The only significant difference between the
train at the beginning of the day and before it derails is
its momentum.
This may seem like a silly analogy to our present situation,
but it helps me to better understand what is happening.
Don't focus on GM to understand the problem. Investigate GMAC which is the loan and lending arm of the parent GM. My understanding is that GM has been profitable since the mid 1980's ONLY because of the revenue stream of GMAC. It has been like a bank lending money just to move cars, as well as other things. GMAC gets their capital from many sources to originate their loans. The interest on the loans is where all the profit is/was.
Recently no interest loans and steep discounts on GM cars stopped the GMAC profit center from keeping the parent GM in the black. I believe that GMAC is for sale now, but without built in car sales where is the future income stream?
Other posters can confirm, deny, or clarify my understanding of where GM profits have come from. But this is a symptom of our economy. It is built on interest payments on loaned money, not on wealth created through manufacturing processes.
That is probably true even with the "0% interest" offers. You need perfect credit to qualify for those offers. I suspect many of their customers do not qualify, and end up paying interest on their loans.
Of course, this means they'll be in up spit creek if people start defaulting on their loans.
Just to pay the overhead piece for plant and equipment costs a similar amount, no matter the car. In other words, it doesn't costs significantly more to build an excursion than it does an escort in terms of the depreciation on the building and the salary for the guy ordering parts.
So you'll have a given amount of sunk costs in a "vehicle," regardless of what it is. Let's say that's $8,000 (it isn't, but that's an easy number)
Then you have your two vehicles, and one gets a bigger engine and leather seats and a power moonroof. These parts cost more than a small engine and regular seats in the other car, but you get to charge a premium to the customer (everyone "knows" that leather seats add a couple thousand to the price of the car, sure).
So in the end if you sell your escort for $15,000 and your Excursion for $40,000, you will reap tremendously higher profit percentage on the bigger vehicle. The problem, of course, is that the world only NEEDS or WANTS (your pick) so many $40,000 vehicles. Once everyone who might want one has one, you have to have some new trick to get them to replace it.
This, IMO, is where GM and Ford are losing it. Look outside (at least here) there are TONS of big cars and trucks. People have been buying them for the last five years, taking advantage of low interest rates and "employee pricing" or whatever. Killing the profit to the company in terms of markup and interest income, but they still make money since the big trucks are so profitable (the materials and labor in an excursion is nowhere NEAR the $40-60K they are getting, even at a discount)
But nobody wants to replace the behemoths. Not when gas is $2.50 and going up.
I'm certainly preaching to the choir about all this. In my area easily 70% of vehicles are either a pickup truck or SUV. This won't change anytime soon. But folks will make these cars last a bit longer before they replace them, and when they ultimately DO replace them, they'll at least think about downsizing or getting something more efficient. It will not make a significant impact on fuel consumption for many years, I don't think.
"Produce where marginal revenue equal marginal cost."
I'm sure that fits there. I just don't know enough about the auto industry to say for sure.