General Motors & Credit Markets - Overview

by James N. Ward, Professor of Quantitative Finance.

In my last article I wrote about fund inflows and outflows affecting spreads in the High Yield credit market. I also made the prediction that either Ford or GM would be downgraded and become a fallen angel within 2005. This was a timely call, as some credit market observers, and most importantly Fitch, placed GM on credit watch negative after my article appeared. We got a lot of positive feedback from our readers. My call was just every day fundamental analysis, and a widely held minority view also shared by other high yield fund managers: GM paper started trading as on ‘crossover’ credit spreads in late January. But GM trading wide is a perfect example to discuss some of the drivers of credit downgrades, probability of default, and the effect on credit spreads.

We need to look at this credit move in some scale to view how it will affect the speculative grade credit market and spreads. Let me make a metaphor: GM becoming a high yield credit is a hurricane, but not a tsunami, and even if GM (and Ford) gets downgraded, it is not like an asteroid hitting the earth. Of course, whole credit indexes will change, and long-biased index-hugging HY managers will have to sell lots of credits and buy GM (or Ford). But most of that movement already is over, and the game is now to watch the equity and the credit default swaps, which I will cover in the next issue.

Why is the action in the credit cash market already over? Let’s look at the players in our drama: GM’s management, GM’s bankers, Investment Grade fixed income fund managers, Speculative Grade (High Yield) FI fund managers, and the Credit Default Swaps dealers and speculators. For the present, I ignore the credit rating agencies and simply note they are reactive to, rather than leading or affecting, the market spreads.
 

General Motors & Credit Markets - The Players

by James N. Ward, Professor of Quantitative Finance.

GM’s Management

GM’s management wishes to avoid a credit downgrade for both the obvious corporate capitalization reasons of increasing the cost of capital, but also because it will call into question the current structure: should General Motors and GMAC still be the same firm?

I agree with analyst’s views that GM currently is a pension and healthcare provider with an auto manufacturer attached out of historical circumstance, the whole being carried by relatively profitable financing units. I had the opportunity to speak with senior GM management last year in one-on-one sessions, and kept asking about the liability structure and demographic waves in their health care plans and pensions. Managers and their banker-handlers deftly kept steering (no pun intended) the conversation to cars and loans. I talked for a long time with the head of a GM credit unit about the credit scoring models they use to make loans. He was very genial, but as he made elliptical remarks I kept wondering how those models would score GM itself.

At this point, I look at the auto-manufacturing firm as a low value real option if GM accidentally comes up with a hit world car. I do not expect the auto units to unlock any future value otherwise, as GM’s autos are as commoditized a consumer product as nails and toilet paper. And there is nothing they can do about it. Really.

A March 9th article by Bernard Simon in the Financial Times (“GM ‘lay-offs’ highlight car industry constraints”) noted there is little GM senior management can do to change the behemoth auto manufacturer, as long-term liabilities and worker contracts prohibit any shake-up. I repeat: any shake-up. In other words: fixed methods, and therefore fixed costs for the future are bigger than they appear in the rear-view mirror. Nothing can change. The question is if GM is a sleepwalker or a zombie. As one observer noted “the trouble with GM in HY-land is that these dogs can operate unprofitably for a very long time, by playing collateralization games. Very much like the airline industry.” In other words, GM could be dead (a zombie), but keep appearing to be living by securitizing everything in sight (little zombies of packages of loans and “assets”).

Meanwhile, GMs financing subsidiaries are in a curious position: their own cost of debt is trading nearer high yield spreads, and they still make zero interest loans for new cars. This is a vast (and admittedly unfair) oversimplification of these sales teaser offers, but I make it to overstate the case that such a model clearly is unsustainable. But it does mean that GM financing subsidiaries must make loans at spreads higher than their own debt spreads. Which in turn means sub-prime lending to unqualified borrowers. Or go off balance sheet for higher returns.

Anyone remember a company called Enron?

GM financing unit asset managers have to be complaining about pushing to diversify funding sources from the GM balance sheet to riskier off balance sheet financing precisely because of GM’s slow decay to speculative grade spreads. As one observer noted of the GMAC situation “It's damn near impossible to [make competitive, stable returns over] BBB spreads.”

What should GM senior management do? Few analysts doubt that all of GM’s financing subsidiaries could be ring-fenced or even spun off as an independent entity that would retain an investment grade rating. Few also doubt that if GM autos and GMAC were decoupled GM autos would go straight to B- territory, or worse. In addition, under either a slow drift to downgrade, or a ring-fenced scenario, GM’s counter parties will either demand higher security deposits, or be put under pressure from GM itself. In other words, a GM downgrade prompts a cascade function across the industrial credit landscape.

A GM insider, who for obvious reasons wishes to remain anonymous, observed that GM senior management “need to get concessions on pension and healthcare liabilities” for there to be any possibility of maintaining investment grade. He added that under a simple demographic projection the company is demonstrably insolvent on a present value basis. Until the pension and healthcare liabilities become manageable “there's not a lot senior management can do to get relief from lenders.”

GM’s Bankers

Of course GM’s bankers are working desperately with the firm to keep a downgrade from happening. Right now there are a lot of very worried people in very expensive suits. One trick bankers have tried is to change the rules of the game. Lehman Brothers recently followed last year's decision by Merrill Lynch to add Fitch to its rating index, in addition to Moody’s and Standard and Poor’s. In other words, somebody may downgrade GM or FOMOCO, but it now will take a downgrade by two agencies to push them onto the junk list for most big institutions that mimic in their prospectuses the definitions of benchmark index. A banker friend at a competing firm wryly observed “Yet another ace in the hole expended. How many tricks are left?”

GM has USD 5.45 billion of loans to refinance before the end of 2005, along with USD 17 billion in bonds. There is no relief in 2006 either; they have another 7.2 billion in loans and another 26 billion in bonds to refinance. To put this in perspective, my colleague Prof. Edward Altman, of New York University, estimates the current size of the US corporate high yield bond market at approximately USD 800 billion. But even if GM’s woes would be a bucket of tears in a lake of sorrows, GM and her bankers clearly are concerned with such numbers on the table and a downgrade possibility near.

Curiously, credit analysts at agencies and investment banks typically treat debt due within 12 months as “short-term debt.” Many have made charitable exceptions for GM’s credit card bill, still characterizing it as long-term debt and again propping up the credit with tricks, sticks, and glue.

I asked some investment bankers who specialize in high yield capital markets if they had had any preliminary meetings with their colleagues who typically focus on investment grade credits and service GM. Their reactions ranged from polite laughter (and changing the subject) to a brief pause of silence, to suddenly needing to take another call. When I noted that market spreads already should indicate that a handover to their team was imminent most said they were “currently excited about the next deal we will be bringing to market.” In other words, there have been extensive talks and meetings.

Investment & Speculative Grade Fixed Income Fund Managers

A leading investment grade fixed income manager for the asset management branch of a large French insurer believes that if GM becomes High Yield, it will double the total High Yield assets in the world and HY fund managers will be forced to buy GM and sell many of their other otherwise fine holdings. I wish this were true, because this is when I want to be a shark in the water: cherry-picking cash raising offers of not well-followed names at bargain prices.

Not likely, says a manager at a competing insurer who manages Euro 2 billion+ in global high yield paper. “These names are basically trading at junk levels already.” This HY manager emphasized that large absorption has occurred before in HY territory, and particularly noted Qwest Communications, which once enjoyed a market capitalization larger than GM’s. Upon entry into high yield status QWest paper constituted only 3% of the market, a big hurricane, but not unmanageable. He allowed that the GM supplier counterparty problems could disrupt the market (many of GM’s suppliers already are high yield industrials), and noted that GMAC would need to have emergency and expensive ring fencing (by bankers and lawyers charging fees), but said there would be no massive market disruption if GM became high yield. In other words, kiss the dreams of bargains goodbye fellas.

A Jan. 6th 2005, JPMorgan credit client survey backs up his views, and found “a ratings downgrade in the Auto sector may not have a dramatic long-term effect on spreads as only a small portion of investors would be forced sellers and the majority would hold their positions.”

In the survey JPM posed the following question: “In the event that the credit ratings of one of the major auto manufacturers fall to non-investment grade, what would you do with your corporate bond holdings of the name? Hold, likely to sell, or forced seller?”

In response, 66% of JPM clients said they would hold their current positions, 29% said they would be likely to sell, and 5% said they would be forced sellers. Some investors indicated they would view such a downgrade as a possible buying opportunity.

Debt of automakers lost 1.21 percent on average in February, while investment-grade bonds overall had a loss of 0.64 percent. Our HY fund manager source says of his investment grade peers “unless you are really asleep you should have already realized enough losses to inspire you to sell, long before the BBB/BB divide was reached.”

 

General Motors & Credit Markets - Equity impact on spreads

Equity Markets, Credit Default Swaps Dealers, Hedgers, and Speculators

In my next article I will detail the influence of credit derivatives on spread discovery in the high yield markets, again using GM as an example. But the major elements are capital structure, volatility of equity, the heat equation, and time. In the meantime, let me close with some concepts of why equity is important for credit spreads.

A March 10th article in Barron’s highlighted some analyst’s views that GM’s equity still had the major price to pay before a credit downgrade. This view is the perfect place to re-introduce readers to the Merton Model, and how credit is priced today. Recall that “Market capitalization is a call option on the market value of a company, the strike being that company’s debt.” Space limits a full treatment of the Merton model, but in review it is possible to calculate the value of a company by measuring the volatility of the traded equity and using the Black-Scholes formula. This method gives a measure of “distance to default” for which there should be an appropriate credit spread to compensate for the chance that you own the firm and only get the recovery or liquidation value of the assets.

Given the Merton method and the equity volatility, how far is GM from default? The answer is: not far enough. Which is why investment grade GM paper currently is trading at speculative grade spreads.

GM’s equity only accounts for 7% of its capital structure, the rest being made up of approximately 1% of short-term debt (I dispute this, but nevermind), and a whopping 92% of capital coming from long-term debt. In other words, GM does not have to destroy that much value, or make that many mistakes before the equity cushion is wiped out and hits the strike price of the call.

So if we are to properly understand the spreads on this crossover credit we are left looking at the equity cushion and GM’s cash on hand. Why? Because if you miss one coupon payment on any bond, you are in default and all of your debt becomes instantly due. As one understated wag in the credit default swap market put it “a plus 300 billion pileup would take quite a while to sort out.”

James N. Ward is a Professor of Quantitative Finance at The American University of Paris, and frequent lecturer on high yield bonds.