Default Risk of U.S. Automaker Debt: Too Big to Fail?

Includes: F, GM
by: Greg Weston

"Too Big to Fail" ("TBF"), to give a working definition, is the term used to describe institutions with financial obligations guaranteed by the good faith and credit of a sovereign government.  Many such institutions have an explicit guarantee.

The variable of "TBF-ness" is a matter of degree, and not always a clear yes or a no.  When considering debt as an investment, TBF-ness will figure into the decision.  Investors who estimate this variable, if they do so with even minimal accuracy, will on average and over time achieve a better rate of return than those who don't.

Sometimes the degree of TBF-ness of an investment is an easy question.  There is no probability that the US Government will bail out Sands Casino senior unsecured notes if it defaults on its debt.  There is a complete certainty that the US Government will bail out a $60,000 FDIC-insured certificate of deposit issued by First Hawaiian Bank.

To evaluate the TBF-ness of many investments, however, both political and economic analysis are needed.  I don't think there is enough of political style of analysis of TBF there, so I am going to take a stab that may be of practical value.

The three biggest TBF-ness questions, at least for private investors, apply to the debt of (1) each of the world's largest investment banks, especially Lehman Brothers (LEH); (2) The GSEs, namely Fannie Mae (FNM) and Freddie Mac (FRE); (3) The Detroit 3: GM (NYSE:GM), Ford (NYSE:F), and Chrysler.

For brevity’s sake, below are my detailed thoughts about the auto companies.  To the extent this article is favorably received, I may turn to the GSEs and investment banks in later articles. You might enjoy this New York Times article, in which the author downplays the TBF-ness of the Detroit 3.  Another interesting article on the TBF-ness of the GSEs, Banks, and the Detroit 3 can be found here.

An initial question is, what does the market think the TBF-ness of GM’s debt is?  To answer the question, we’d first have to look at the spread between GM’s debt and the Treasury’s.  GM’s debt trades at a very wide spread to Treasuries, with the exchange-traded bond XGM, for example, trading about 12.8 points over a comparable US treasury as of midday 8/1/08.  However, given the precarious financial and market position of the company, I think the market still assigns a high value to GM’s TBF-ness.  In other words, GM’s situation is so bleak that the spread would be even wider if the market did not perceive some chance of a federal bailout.  (We might also look at the value of GM credit default swaps, however right now that counterparty risk is so endemic to the CDS market that TBF-ness would be biased upward to a material degree absent the difficult task of controlling for counterparty risk.)

While high, GM’s TBF-ness is still obviously far from perfect, otherwise it would yield the same as comparable Treasuries.  GM’s bond-holders, management, shareholders, unions, suppliers, and retirees would be wise to take actions now to increase the company’s TBF-ness.  Management, in particular, needs to carefully weigh possible moves to reduce the risk of default, such as shutting down factories or fighting emissions regulation, against the effect these actions would have on the company’s TBF-ness.

Shutting down factories and downsizing in general, does reduce default risk.  But it may be damaging shareholder value since doing so makes GM a smaller company, with fewer employees, fewer dependant suppliers, fewer dependant local economies, and with less importance to the US economy.  If you want “Too Big” status, rapidly downsizing operations is not the way to go.  Thus Chrysler’s private owners seem to be shooting themselves in the foot by downsizing much faster than Ford and GM, which is especially risky given that its ownership is more concentrated and it is already the smallest of the three domestic automakers.

Slowing the advance of progress on environmental matters is another policy that reduces default risk by reducing future environmental compliance expenses, but also decreases TBF-ness because of the political impact of opposing environmental regulation.

Right now, within each of the two major US political parties, there is one group that right now would oppose a TBF-rescue of a major auto maker.  The Republican group opposing automaker bailout is the anti-earmark/small government wing of the party, which I will call for short the RSC-types after the Republican Study Committee, a GOP House group whose members typify this wing of the party.  RSC-types largely control the Republican Party, and a majority of House Republicans are members of the RSC.  Further, John McCain has explicitly said he is against TBF status for Detroit.  For RSC-types, this is a matter of their basic economic ideology, and there is little D3-bailout proponents can do to change alter the basic ideology of the most Republicans.

The opponents of TBF-status for Detroit within the Democratic Party, on the other hand, are not opposed to TFB-status as a matter of ideology, but as a matter of concern for the environment.  Right now they would see the failure of the Detroit 3 as fair desserts for a company that recklessly focused on producing vehicles that pollute the environment much more than necessary, and that vigorously opposed strong air pollution laws, to the public’s detriment, but to their private benefit. These politicians, who tend to represent high income districts without much manufacturing and where residents place a great deal of concern for the environment, right now would be conflicted between helping their mostly Midwestern Democratic allies, and the financial and environmental concerns of their own district.

A change in strategy from opposing environmental protection laws to favoring them, and an aggressive move to do even better on the environment than the law requires, however, would quickly melt the non-ideological opposition of environmentalist Democrats, and swing them into agreement with the union/populist members of the party favoring a bailout.  And Democrats appear certain to control Congress, and increasingly likely to control the Presidency, and thus will be in a position to implement TBF policies.  If I saw GM, for example, announce that it will take measures to comply with stricter CAFE regulations, and instead of the planned shutdowns of its SUV factories announce that it would be retooling them to produce hybrid mid-sized cars and small-engine compact gasoline cars of the sort it already is producing in Europe and Asia, I would be a buyer of GM debt, because such an action would dramatically increase its TBF-ness.

Thus savvy traders of GM debt and CDS should closely follow GM’s environmental and government relations policies rather than simply buy on factory shut-downs and sell on announcements of costly environmental/fuel efficiency initiatives like battery R&D.  Without government help, the company appears almost certain to go bankrupt.  But if Democrats win the presidency and an even stronger majority in Congress, AND the automakers get on board with the public’s new, increasingly progressive opinions on efficiency and the environment, I think a bailout is not only possible, but almost certain. These concrete actions would start with retooling factories now slated for shut-down to produce more efficient vehicles, dropping opposition to stricter CAFE standards, a new focus on political efforts at electing rather than opposing environmentalist Democrats.

Moreover, when a Democratic-controlled government turns to health-care reform, it’s possible the automakers will be gigantic beneficiaries.  Their workforce has both generous health benefits, and is typically older and more expensive to insure than their foreign competitors.  A package of loan guarantees, health care subsidies, and funds for the production of fuel efficient vehicles could be in place in less than 12 months if Detroit starts doing everything it can to elect Democrats in this election.  Such a package would save the Detroit 3, and produce handsome gains for anyone purchasing D3 bonds at their current depressed prices.  Right now I don’t see this happening, so I have no position in Detroit 3 debt.  Instead I see the Detroit 3 shutting down factories as fast as possible, continuing to oppose environmental regulations, and focusing their substantial political muscle on already friendly politicians in both parties rather than Democratic challengers and open-seat candidates for Congress. Time is running out for a pre-election change in policies, and inaction now could doom automaker debt in the future.

Disclosure: Author has no position in the debt or equity of any of the companies mentioned in the article.