GM: Bankruptcy Is No Longer an Option

Felix Salmon, who contributes frequently to Seeking Alpha (and I mean frequently), wrote recently in "When Stocks Go to Zero" that "the whole leverage aspect I think is not well understood by the public". He made an excellent analogy about the amount of equity in a home in contrasting Citigroup (C) to Apple (AAPL). I agree with Felix that many investors and certainly most non-investors don't understand fully that the value of a company consists of both its stock as well as its debt obligations.

I recall realizing this fully when Bear, Stearns was imploding. The financial press kept regurgitating the notion that the stock was clearly depressed since it was trading at less than the value of the new headquarters. Of course, this analysis neglected the mountain of debt for which the company was responsible as well. As equity values in now all sectors of the economy continue to get pounded beyond seemingly rational possibility, it is worth elaborating more in detail on this notion that Salmon touched upon.

I don't believe that Salmon used the term "enterprise value", but many investors are familiar with the concept. Essentially, a better measure of a company's value is the sum of the market value of its stock plus the its debt less cash on hand.

I believe that a simple example should help to understand this concept, though the house analogy is pretty good too. For the house, the total cost of a house is what the seller receives (not the amount of cash they buyer kicks in). It's the same for a company.

Assume Company A and Company B start a manufacturing business at the exact same time. Company A sells stock for $500 and issues debt for $500. Company B's owner starts the company with $1000 of her own money. Each company experiences the same level of business and costs. Which company is worth more?

Neither, they are the same, each valued initially at $1000. As time progresses, though, the debt issued by Company A stays constant, with Company A making interest payments, though it must eventually repay that debt through refinancing or through retirement.

In good times, Company A's stockholders will benefit more than the stockholder of Company B on a percentage basis due to the leverage, but the converse is true as well. So, in a bad time (like now), both companies will make lower profits or become unprofitable.

If someone could now come in and start the exact same business with $600 (instead of the original $1000), one would expect that the new value of A and B would be $600 as well. In that case, Company A still has an obligation to repay $500, which leaves just $100 for its stockholders. Company B's stockholder loses 40% of her investment, while Company B's stockholders lose 80% of theirs. The damage to each company's total valuation was the same.

Now, I have to say that the above example and definition of enterprise value aren't exactly reality. It is possible (and actually widely common now) for the debt to trade at a steep discount to its maturity value. This means that the total value of the company is actually lower than the traditional enterprise value.

For those of you who aren't exactly up to school on the bond market, now would be a great time to become so. This whole crash has a lot more to do with bonds than with stocks. Stocks are last in line in a downside scenario (claim on assets of a firm that is liquidated) and first in line in an upside scenario (profits). Stocks theoretically are wiped out before preferred stock holders or debt holders realize a penny in losses. For this penalty, they get the privilege of getting all of the excess earnings (usually a pretty good deal over the long-haul).

The equity investment in a company is similar to being long a call option, with unlimited upside and losses limited to the initial investment. The bondholder is short a put and gets paid a premium for being so (the interest). An initial bondholder who holds to maturity can never make more than a return of principal plus the interest. For that privilege, he assumes the risk of becoming an equity owner in the event the company can no longer make those interest payments. The bondholder can lose everything.

I know those last paragraphs are rather boring, basic stuff, but I ask the question: How can many stocks be worth anything, when their bonds are priced for increasingly high probabilities of bankruptcy? There was absolutely no problem with Lehman Brothers (LEH) equity holders getting wiped out (or any financial institution for that matter) - the trouble is when the bondholders have to become equity investors.

The bankruptcy route of Lehman Brothers was liquidation rather than reorganization, and debt holders got less than ten cents on the dollar. This was unprecedented. With so little capital available for debtor-in-possession lending, liquidation will become the new normal. This fear has spread to all sorts of industries outside of Finance. Witness the liquidation of Linen's and Things (LIN) and now apparently Circuit City (CCTYQ.PK). The lack of capital for asset purchases compounds the problem - these liquidations are going to be very ugly.

Equity prices above zero for companies with significant debt reflect hope that the bond market's pessimism is unwarranted. But, rationally, the markets appear to be saying that bondholders are the new stockholders, and the stock isn't worth much. This brings me to my main point: We must bailout GM (GM) (and the auto industry).

Ouch! I can't believe I actually said those words, as I am a life-long libertarian who believes in free enterprise and minimal government. I have actually changed my mind on this subject just this weekend as I have better understood the repercussions of not doing so. First, let me define "bailing out", as it isn't what one might think. I believe that we must prevent a liquidation of the auto industry. If I understand correctly all of the parameters, a traditional bankruptcy is effectively a permanent death sentence as opposed to what would usually be a restructuring. There isn't money available for lending during bankruptcy, especially of that size.

I am not a bankruptcy lawyer and don't even pretend to understand all of the laws surrounding the operation of a company that seeks the court's protection, but I do realize that times are much different today. Without anyone to actually lend them money, we will see a Lehman-like liquidation. Anyone need all those factories?

What many opponents of "saving" the auto industry don't seem to gather is that the failure would off-load billions of dollars of obligations onto society anyway - these companies have been de facto bankrupt for years. I would prefer to see a solution that would allow for a more orderly transition to a restructured industry, one that would most likely have a much smaller footprint in the future.

I would like to see a negotiated settlement (maybe this is pre-packaged bankruptcy) that would wipe out common stock holders and give current debt holders a combination of mainly equity and a reasonable amount of debt. The government would have to absorb some of the restructuring costs (which it will anyway if there is liquidation) as well as provide initial cash into the reorganized entity. I believe that this type of solution would minimize the overall costs to society.

The problems that our economy faces are gargantuan and global. We can't increase both savings and spending simultaneously, which seems to be Washington's solution, unless we are willing to do so by either cutting taxes or deficit spending at the federal level.

While we hear about "too big to fail", the truth is that many entities are too indebted not to fail. Our government can't and shouldn't save every company, but it can help mitigate some of the many negative impacts from failure. Just as we believe our government has a responsibility to prevent a run on the bank, I believe it has a responsibility to prevent a run on the economy. Yesterday's "bank" is today's debt-holder that lies outside of the traditional regulatory environment, though not for long, as I see many debt-holders, like GMAC and the insurance companies, back-dooring their way into TARP assistance.

In normal times, I would say "bring it on", let the dinosaur perish. While clearly our auto industry is a failure, an embarassing one at that, we just can't afford to let its true owners, the debt-holders and its supply chain, get "Lehmanized". In case you are not familiar with the GM balance sheet (and I am not intimately familiar either), take a look. I have tried to strip out the Finance and Insurance operations. I think you will be a bit surprised and come to the conclusion that We the People already do own the company:

A real top-level look at their finances is frightening. As of 9/30,they have some cash and receivables, but short-term liabilities are well in excess of short-term assets. The suppliers are shuddering, as they know in bankruptcy that the payables won't be paid. In a liquidation, what are those plants really worth? How much will be left over after using the cash, the collected receivables, the proceeds of unsold cars and the factories?

The real problem, though, is on the long-term liability portion. We as a society will be on the hook to some degree in a GM failure for a portion of those $45 billion in liabilities that represent pension and other obligations. Interestingly, the equity value of GM is zero if one EXCLUDES all obligations beyond current liabilities and long-term debt. Folks, debtors here shouldn't expect to get much here at all. It's no wonder they are quoted at about 14 cents on the dollar.

My proposal would be to take this $43 billion in debt obligations and turn it into a combination of debt and equity. The current value of the debt is $6 billion. To incentivize them, give the debt holders 25% of the company's new stock in exchange for reducing those obligations to $8 billion. The government would get the balance in exchange for a capital commitment sufficent to allow the company to operate and fulfill its other obligations. I am not sure what the exact amount required would be, but remember, if the folks who are expecting pensions and other obligations of the company aren't paid, they will turn to the U.S. anyway. NEW GM would also be permitted to renegotiate any prior contracts with suppliers or labor. What about Ford (F) and Chrysler? Yes, this is going to be expensive.

I would encourage you to think through the consequences and realize that the credit crisis has totally changed the landscape with respect to bankruptcy and reorganization. Our automobile industry has been and will continue to suffer a slow death, and we are already on the hook via safety net protections in place (Pension Fund Guaranty Corporation, Welfare, etc.). Without some sort of swift efforts to prevent liquidation, we risk yet another massive hit to the U.S. Titanic. So, while I called this a "bail-out", I really think that it is more of a recapitalization or an intervention to prevent a catastrophic escalation of the economic crisis. The CEOs had no plan because there is no plan. Let the auto industry shrink, but in an orderly fashion.

Disclosure: No position in stocks or bonds of any company mentioned

Comments

[Steven Hansen:]

Alan, this was a good presentation which your bottom line i agreed with before reading your article - it just added more logs to my fire. but gm needs to escape from its current management and unions, and needs a bankruptcy where the usa becomes the lender of last resort. really, only a bankruptcy will clear the rubbish and dead limbs so new growth can begin.

2008 Nov 23 07:52 PM

[Alan Brochs...:]

Robert, I appreciated your points and agree with you and The hand. We are talking semantics here, though - Chapter 11 with the government then intervening to provide financing is similar to what I am suggesting. Unfortunately, as the massive obligations show, this isn't something that is really fixable easily. By the way, parrot lovers might be horrified to hear about their use in coal mines. I think it's canaries!

2008 Nov 23 08:47 PM

[SW Richmond:]

"We must bailout GM (GM) (and the auto industry).

Ouch! I can't believe I actually said those words, as I am a life-long libertarian who believes in free enterprise and minimal government."

No, you're not, and no, you don't. A libertarian understands that government has no right to take money from me to save any business, person, or entity, under any circumstances, period.

You are a Socialist.

2008 Nov 23 08:55 PM

[SW Richmond:]

P.S. You have allowed fear to get the best of you. Socialism feeds on fear and apprehension. Libertarianism feeds on courage and self-confidence.

2008 Nov 23 08:58 PM

[The Simple ...:]

The auto industry problem has many facets but aside from the specific business problems of the individual firms, there is a basic economic problem of excess capacity.

The quick & dirty analysis in this articles correctly surmises that there is no saving the Detroit Three as they stand. Why not use the $25B loan guarantees to help capitalize private ventures, that purchases their viable assets? As noted, GM and Ford have some marketable newer vehicles like Fusion and Malibu and CTS, iconic cars like Corvette and Mustang, and heavy diesel pickups that will always have some demand.

After the asset sale, the bad managements and bloated structures and legacy costs and UAW are gone, as is much of the excess capacity. Equity holders are almost wiped out already, bond holders and pensioners will take a haircut, and suppliers will be left holding the bag. Bad outcomes but not catastrophic, and certainly better than keeping the old dogs on what would almost certainly be permanent life support. The industry goes forward with new ownership and a smaller footprint, but most importantly a chance to compete and survive.

2008 Nov 23 09:11 PM

[Jan Rogozinski:]

Dear Richmond:

You really should not use words, the meaning of which you do not understand.

The word "Socialism" has a very precise meaning. It means that all aspects of the economy are owned and controlled by the government. The author nowhere advocates Socialism.

For you, the word has no meaning, other than "Duh! I don't like that." Which makes your comment gibberish.

2008 Nov 23 09:13 PM

[MJN:]

I think there are 2 items we need to consider:

- First of all, the issue of "idle factories" would be temporary. Cadillac, GMC Trucks, and the Chrysler Minivan, etc. are valuable brands. Toyota (or some other auto maker) will move to buy and produce these brands if given the opportunity.

- Secondly, the total market cap of the "Big 3" is less than $12 billion. If (as you conclude) their obligations ultimately belong to the tax payers, then perhaps it would be cheaper for the Government to simply purchase these companies from the equity holders, and deal with the obligations as they see fit.

2008 Nov 23 09:20 PM

[Research123:]

Alan, an excellent and absolutely correct analysis! If this is extended to the entire auto industry (Ford, Chrylser and the most closley connected supliers with UAW-type cost structures) as it must since that entire industry is in the same state of crisis, one component of a lasting solution should be to nationalize the pension problem in some way. Otherwise, the industry will be back in ten years with the same set of problems.

Detroit needs to rest its employee cost structure to more closely match Toyota et al.

2008 Nov 23 09:57 PM

[breadwinna:]

Citi is a lot of trouble, If one wants to buy a stock which is highly undervalued I would say buy Sprint at 1.71, watch it reach 3 bucks in less than a month... just an opinion.

2008 Nov 23 10:12 PM

[Middat Yildiz:]

The big three is not too big to fail. If a company produces desirable products, and if it is marketed properly, the consumers will pay for it. By any measure, products coming out of the U.S. auto manufacturers fail to give consumers any more benefit greater than that of buying a competitor’s product. It is likely that Democratic controlled Congress in order buy votes will come up with an unreasonable auto bailout package to try to save what is unsalvageable. A first condition for an auto bailout should be to force the top management of each of the Big 3 to buy at least ten percent of each company’s common stock and keep it for at least five years. These companies should also issue common shares first in order to raise capital, instead of using taxpayers' money.Congress has asked each to file precise written plans for what they will do with the money by December 2nd, 2008. Whatever plans the big 3 files is not going to be sustainable as it is clearly shown that as part of a strategy, the big three are not doing anything differently, or anything different. A sustainable corporate strategy depends upon doing either something differently, or doing, offering something different. They should just declare bankruptcy and reorganize. The biggest excuse to save these certain failing companies is risk of increasing unemployment by three million that will allegedly cost too much pain to bear or major dislocation in the region. That probably would be so. The three million number however is too exaggerated. Not everyone who is employed by auto companies will become unemployed right away first of all. A majority of these people who are currently employed will still be employed by the very same companies. A mechanic shop fixing GM cars is certainly also able to fix a Toyota or a BMW and can just make the adjustments to change its service offerings. Government’s unnecessary intervention will therefore only interfere with allocation of human capital resources. It is going to tell an engineer at a GM plant to stay put there, until retirement for so many more years, instead of letting that engineer go and find something that could be more productive in allocating his skills for the benefit of his family and that of society’s. Government’s job therefore should not be try to allocate human capital in areas it sees fit to interfere for simply political reason. Government’s bailout fund can be used to provide training for the involuntarily unemployed in the field of person’s own choosing and let the individual allocate his resources and skills in the manner he sees fit, useful, profitable and personally satisfying. If these companies are not allowed to go bankrupt, thousands of people will be kept at jobs where they are not productive and will permanently lose the chance to retrain and learn something else. This is how the Congress in order buy votes is going to prevent individuals and the society as a whole from growing and evolving.

2008 Nov 23 10:52 PM

[Donald Johnson:]

Simple Accountant is on to something. Hold a fire sale of the three companies' assets. Some private equity firm could come in and buy a nice headquarters, accounting, marketing and information technology system with the two or three plants it would need to produce a couple of the top brands. Then it could cherry pick the dealers it wants to sell its products and hire production workers, etc. it needs. It could write a new union contract or freeze out the UAW, which has destroyed Detroit.

Say it did all of this for $5 billion and put $30 billion into the biz. It would make big bucks, having bought assets for pennies on the dollary, owing no retiree benefits and rallied greatful workers to its venture. Hell, the workers could buy into the biz.

Buffett, Gates, Jobs and Hank Paulson can finance the thing with a little help from Harvard and Yale endowments. And maybe the Ford Foundation.

2008 Nov 23 11:06 PM

[john1940:]

This is a good post and has most of the issues and options surrounding bankruptcy fairly accurate. The auto companies can go through a debtor in possession bankruptcy and restructure the company while continuing to stay in business, pay suppliers currently, etc. They also get the opportunity to reject contracts of all types and settle them in a restructuring. The stockholders will likely get "0" and bondholders get a substantial discount represented by new stock and maybe some new bonds.

The union contracts and pension benefits get renegotiated. Now, however, the company has better leverage to restructure for survival. I believe the union pension plan's liabilities are higher than the amount that the govt pension guaranty is required to assume. The pension benefit haircut is at least the amount that GM should be able to shed with a new contract.

Other issues that also need changes are wages, work rules, and things none of know about except company and union insiders.

Don't be too scared of the bankruptcy. The suppliers and all those other 3,000,000 jobs should also survive although they may need restructuring too. They manufacture for other companies as well as the bit three. It's inconceivable that our government, the auto companies, the unions, and other stakeholders can't work this out in bankruptcy. Are we to believe that not one car can be built by American companies in the near future? That's a risk I'd be willing to take.

Interestingly, the fate of the car companies lies solely in the hands of the unions. Lately (think airlines), unions have been comfortable going through bankruptcy even though I've never seen much victory for them. If they want a future, they can achieve it with compromise. If not, we will drive cars from China and India. I left out Japan because their costs are higher than China and India and will have an opportunity in the future to address Asian competition.

2008 Nov 24 12:03 AM

[somtam:]

The Americans are strange people. During the election campain the Dems and Reps said we are too dependent on foreign oil, loose jobs to overseas etc. Now, they are willing to hand-over to auto-industry to the foreign companies? How much did the car-industry in the south pay the Senators representing these States. Loosing around 3 millons jobs,i.e. 3 million individual hardships etc..just because they can't fork out 25-30 billion. How much did the Americans waste in Iraq?
Citibank...of course had nothing to do with the subprime(?), got without submitting a plan, without grilling the CEO, 20 billion plus 300 billion in capital and guarantees over the weekend...strange.
Let the "big 3 fail'..wipe out the value of the shareholder, bondholder get a haircut etc...that's an invitation for investments in the US...No thanks!

2008 Nov 24 01:38 AM

[Alan Brochs...:]

There is tremendous anger regarding the auto industry - I think it has a lot to do with a perception of unions impeding long-term economic success. You make a great point about "invitation for investments", but this is reality. I don't believe that there is any way to not see equity values get wiped out increasingly without an end to the credit crunch. Don't think for a minute that Citi equity holders will be dancing in the streets. None of the "bailout" recipients has really been "bailed out" - it's just life support for now. Hopefully, the patient survives.

I do think that my view of "saving" the auto industry is somewhat similar what is being done to banks. I don't see how the government can't wipe out the equityholder and most of the bondholder's investment. It's going to happen anyway. It's a gargantuan task, but the role of government here isn't to propagate bad businesses indefinitely but rather stem systemic collapse. My view of how to handle GM is one that allows for a gradual winding down and reduction in size.


On Nov 24 01:38 AM somtam wrote:

> The Americans are strange people. During the election campain the
> Dems and Reps said we are too dependent on foreign oil, loose jobs
> to overseas etc. Now, they are willing to hand-over to auto-industry
> to the foreign companies? How much did the car-industry in the south
> pay the Senators representing these States. Loosing around 3 millons
> jobs,i.e. 3 million individual hardships etc..just because they can't
> fork out 25-30 billion. How much did the Americans waste in Iraq?
>
> Citibank...of course had nothing to do with the subprime(?), got
> without submitting a plan, without grilling the CEO, 20 billion plus
> 300 billion in capital and guarantees over the weekend...strange.
>
> Let the "big 3 fail'..wipe out the value of the shareholder, bondholder
> get a haircut etc...that's an invitation for investments in the US...No
> thanks!
>
>

2008 Nov 24 07:02 AM

[SW Richmond:]

You refute your own argument. The author advocates a "bailout" of the automakers. Bailouts mean injecting government money, and in return, receiving partial ownership and a management interest. This is precisely Socialism, by your definition.


On Nov 23 09:13 PM jan_rogozinski@yahoo.c... wrote:

> Dear Richmond:
>
> You really should not use words, the meaning of which you do not
> understand.
>
> The word "Socialism" has a very precise meaning. It means that all
> aspects of the economy are owned and controlled by the government.
> The author nowhere advocates Socialism.
>
> For you, the word has no meaning, other than "Duh! I don't like that."
> Which makes your comment gibberish.
>

2008 Nov 24 09:32 AM

[Alan Brochs...:]

SWRichmond, if you don't mind my asking, how old are you? I have read some of your other comments on boards, and I tend to think that you are actually older than me (43).

I am sorry that you think that my pragmatism is a cop-out. I understand your point. I was so idealistic as a youth, but, the older I get, the more I realize that the world isn't exactly as black and white as I once thought. Maybe you are right that I am just afraid, afraid of the alternative to letting everyone fail. My thought process is that we are not islands. Even since Ayn Rand wrote, we have become more and more interconnected, more specialized in what we do to earn money. I can't fathom to think about how far our society could fall if we just "let everyone fail".

Yes, it makes me sick how individuals, companies and governments have made the mistake that you have pointed out: credit is not capital. I believe that the lesson is being learned, and a return to the Dark Ages is probably not necessary to drive home that point.

I am not suggesting that the government bureaucrats begin running our banks and industrial companies, but I do believe that as a "lender of last resort", it must act. If you want to call me a socialist, that's your choice. In any event, I hope that capitalistic tendencies do prevail again soon. It's tough to imagine, though, in a world without capital.

2008 Nov 24 10:52 AM

[SW Richmond:]

When principles are abandoned, all that is left is a bidding war. That is where we are now. Bailing out this corrupt system only begets more corruption, at the expense of taxpayers like my children. It must stop.

People came to America to escape the European monarchy and guild system. That system has followed us here in the form of central banking, Socialism and a moneyed elite to run it all. I am here to demand the liberty that is my birthright. I will settle for nothing less, and I am unwilling to compromise, because in a compromise the system wins and I lose.

2008 Nov 24 12:04 PM

[Addfast:]

What any workout fails to realize is that the Detroit autos are dead men walking, no matter how you structure a bailout. When the November sales come out we will see GM has sold less than 100,000 cars and trucks. No matter how much money you throw at the Detroit three you cannot save them. There has been so much damage to their brands nobody wants their cars. Their cars are viewed as poorly made, by pampered overpaid union workers and every American nonunion worker resents them. No one on either coast will buy a Detroit car, and the Midwest hates the autos for mismanaging themselves into oblivion. Add to this the statements by the leaders of the Detroit auto industry and their GM sales could go to 50K. A large Chevy dealer in Denver Colorado reported 25 cars sold this month (so far) with last year's number at 600. How many cars do you think they will sell over Thanksgiving. Put a fork in them, they are done.

2008 Nov 24 09:47 PM

[replyseekin...:]

just curious, what does a "controlled bankruptcy...with the company split into 2 parts - a viable and heavily encountered division" mean for a stockholder? does that mean that a shareholder might have a portion (albeit very diminished) of the resultant viable entity and NOT be completely wiped out?

Apr 01 06:19 PM

[Alan Brochs...:]

When you say "very diminished" you understate it. It's like the eyelash on an elephant most likely.

On Apr 01 06:19 PM replyseekingalpha wrote:

> just curious, what does a "controlled bankruptcy...with the company
> split into 2 parts - a viable and heavily encountered division" mean
> for a stockholder? does that mean that a shareholder might have a
> portion (albeit very diminished) of the resultant viable entity and
> NOT be completely wiped out?

Apr 01 09:05 PM