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

"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 (GM), Ford (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.

Comments

[Ishortyou:]

Iteresting opinion, the fate of us automakers is political driven rather than market driven or maybe a combination of both, but not so sure about their economic moat being so slim because Toyota and Honda are already in a good position to assert themselves in the future eco friendly automarket.

2008 Aug 03 11:24 AM

[bearfund:]

I stopped reading at "RSC-types largely control the Republican Party". If this were true, the earmark explosion of the past 7 years could not possibly have occurred, since Republicans controlled - ruthlessly - both houses and the executive for 6 of those years. And if it were true, the so-called housing bill (pork + bailout+ handouts), would not have passed by wide margins of 72-13 (veto-proof) and 272-152 (nearly so). There are a lot more than 13 Republican senators and a lot more than 152 Republican representatives. There is no significant "small-government" wing in either major political party today. To the extent that such wings exist at all, they are marginalised in practice and have no greater effect on public policy than do genuine small-government advocates like the Libertarian Party.

I never bet on the government coming to my aid; even if you win, you lose. If you want to play the TBF game, short Treasuries. It's easier to make the blanket assumption that the powers that be will deem many entities TBF and thereby drive up supply of their own debt than it is to pick and choose the names they will or will not bail out. That takes the tortured political logic out of the equation and reduces it to a straightforward macro trade. If you don't want the directional interest rate risk (or opportunity, as I see it), consider spreads on US corporate paper in general.

2008 Aug 03 12:45 PM

[CrossProfit:]

Mr. Weston,

Nice article.
There are a few more points that need to be taken into consideration.
1) The 'Big 3' combined supply less than half U.S. car (not trucks) demand.
2) The 'foreigners' manufacture the majority of their U.S. sales mix in THE USA!
3) Any slack from the closure of GM or Ford will be picked up by the 'foreigners' thus adding/replacing jobs in the U.S.

From the macro economic fallout, there is little to gain in terms of jobs or the economy from any bailout.

Just food for thought.
CrossProfit

2008 Aug 03 02:54 PM

[Doug Korthof:]

GM deserves its fate for killing the EV1. Nothing should stop GM from dying, painfully and slowly, unless it resumes production of an Electric car.

2008 Aug 03 03:48 PM

[User 237430:]

GM does not know how to efficiently run a company. Instead of keeping up with the times, they fought vigorously to keep women-blacks-Latinos out of their white-collar workforce. This caused an environment of overpaid, white "yes" men who said yes to anything that upper management said. For example, people in the field heard over and over from dealers the need for more fuel efficient cars and trucks. GM ignored this and fought Congress to have any legislation for more fuel efficiencies. GM also spent the largest portion of their money in advertising on the internet. Even when there was proof that the money they took out of TV to pay for the internet banner advertising was decreasing their sales. There was an analysis done on this on a market by market basis that statistically proved the concept that the internet advertising was far less effective in selling cars than TV and newspaper. Yet, people were told that this information should be hidden. People wanted to say "yes" to the GM executives who came up with the idea of spending more money on the Internet.

2008 Aug 03 04:05 PM

[Greg Weston:]

Bearfund: "largely control" does not mean "perfect control." And since we are mostly talking about after the 2008 election, the RSC types in safe districts will have even more power as non-RSC types in swing districts lose their seats to Democrats.

Cross-Profit: Even when foreign makers assemble their vehicles in the US, a much smaller % of the parts are made by US workers, and the design, R&D, and HQ jobs are mostly still overseas. The foreign makers also pay less and offer less generous benefits.

A collapse of the D3 simply will not result in an equal number or quality of US jobs at foreign automakers.

2008 Aug 03 05:26 PM

[CrossProfit:]

Greg Weston

Acknowledge and agree. However, GM and Ford use imported parts and also do R&D in Europe. Not sure that the net trade off is as bad as it sounds.

Take the Boeing 787 as an example. There we know the breakdown and 80% of parts are imported! Assembly and the 'nose' is made in USA (avionics and a few other trimmings as well).

The point is that if you took a GM car today chances are that 50% is not made in USA. GM doesn't disclose the information.

CrossProfit

2008 Aug 03 05:38 PM

[raising4dau...:]

"GM does not know how to efficiently run a company. Instead of keeping up with the times, they fought vigorously to keep women-blacks-Latinos out of their white-collar workforce."

C'mon, GM's entrench bureaucracy fought hard to keep any TALENT out (or in low ranks) of its white-collar workforce. I have no doubt that they kept out women, latinos, blacks as you state, but GM also kept a lid on talented white guys too, I can assure you.

Seriously, about 99.9% of us white guys buy into equal rights and equal opportunity. This isn't the 1940s. But, to blame GM's woes on its lack of diversity reveals that you may be a diversity Nazis or anti-caucasianite.

History shows us that there are plenty of successful organizations with entirely or predominantly white leadership as well as ones with an ethnically-diverse leadership. There are also failed companies led by whites and failed companies led by minorities or women.

The bottom line is that race, ethnicity, or gender of a company's leadership is RARELY a predictor is its success or failure.

2008 Aug 03 06:10 PM

[buyitcheaper:]

TBF? How about TSTS - Too Stupid To Survive? The big 3 are abject failures in management. The unions a big part of this failure in choking the golden goose with the rope of excessive benefits. (when the cost of healthcare and pensions is almost half the cost of production you have a problem.)

No, we have no need of an umbrella company like GM any longer who as recently as a year ago were pressing forward with their "big truck" idea as visionary. What a farce.

They've been outmanaged, outmaneuvered and simply pummeled by better foreign firms who focused on quality up and down the supply chain. When a new GM car is worth LESS than a 3 year old toyota equivalent, that says a hell of a lot about the public's perception of GM product.

No, not too big to fail, too stupid to survive. Pave over Detroit, (specifically its management) or better yet, wait a few more years and most of the workers will be in the south east working at Toyota and Hyundai plants.

2008 Aug 03 06:18 PM

[User 237430:]

The Demographics has changed in the car buying population, yet over 90% of GM’s mid to upper management is still men – even though 49% of the workforce in America are women. I do not think GM knows how to take care of women. That's why women, who make up 65% of new car purchasers and influence 95% of new car buys, try to find whatever man they can to come with them into the dealership. It is like walking through a construction site with the men whistling. It is an awkward feeling that you do not feel safe; that the men at the dealership are about to take advantage of you. Studies show that both men and women prefer to buy their cars from women. Yet GM has only 3% of their dealerships owned by women. Another fact, those dealerships that are owned by women far out-pace, on average, the average male dealership in terms of sales.

2008 Aug 03 08:25 PM

[serfes:]

The dealership model today is highly flawed. Old school car dealers and salesman (who are all complete pigs) running dealerships and selling cars. They forgot who the customer was years ago...like 40 years ago! They never learned that lesson back. Now we have 2nd and 3rd generation owners that learned how to run dealerships from their parents the old school way. They still push the customer around using greed and fear. Some new sales technology and methods have come into play and a few dealerships are trying to use this, but they are still being run by pigs. This is just a pig with lipstick and that is a still a PIG!

The manufacturers are the same basic group of people. Stupid, slow to change idiots. Educated, maybe??? But, they just don't get the whole picture. Honda and Toyota DO and have been perfecting their business models for years. Now, they can reap the rewards of their hard work over the past 30+ years. Big 3, I have no sympathy for you. I hope the big 3 trims their dealer network by 75%...get rid of all these pigs running slop fest stores. The impending dealer blood bath is going to be fun to watch! LOL!

2008 Aug 03 10:57 PM

[Kunst:]

chistletoe: is the Us government itself "too big to fail"?

What, you mean the emperor has no clothes? No problem, mon, how much we owe? $10 trillion, $60 trillion, whatever. Here, I'll write you a check. There, all paid off. No problem, see?

2008 Aug 03 11:12 PM

[Steve Funk:]

All the standard cliches' here about "dumb executives" and marketing mistakes are arguments that ignore the macro environment of the auto industry. I have worked with GM executives and they are some of the brightest and best trained you will find. I have also been in a key GM plant years ago during an important strike during an election year. The plant manager was paged for an "urgent phone call from Washington" and the strike was over in an hour. Let's not forget the Justice Department decree against GM in the 60's. That was truly the beginning of the end. The government has has their hand in every major shift in the auto industry, and we all know how adept Senators are at business. I think this article is spot on, as in the past, the future of the auto industry will be determined by Washington, not the skill of industry managers. Since the current trend is psuedo-nationalisation and government arranged marriages, why not force Honda and Toyota to absorb the Big 3?

2008 Aug 04 11:41 AM

[ggillin:]

Aaaaakkkkk! Pa'tooiee, as a certain famous cat might say! He might have one eye closed most of the time but there is nothing wrong with the one that is open.
Why, oh why would anybody want to tie up their funds on this HY junk that almost for certain is only going to return a very few pennies on the dollar at best. All of the really secured debt that is going to be paid off is held by the banks and YOU are not going to get one penny of it, if they can help it. Buyer beware, is never more appropriate then right here in the American auto companies debt, sad to say.
The handwriting is on the wall for Ford (tbf) and for GM also if it is needed. This will be the payoff from the govt to the auto company's for sticking with ' THE HYDROCARBON FUEL TAX STRUCTURE' right down to the very last drop, now the taxpayer is going to get ripped with all of their debt after leaving all that they had at the gasoline pump. BUT WAIT, this game is not over yet, Somehow no matter who wins in November I think these boys are not going to be able to be hogs at the table because of all of the other problems and no surprise here but, a HUGE outcry from the public against their salvation.
Chrysler is done, Tata, is going to say 'tata' and walk away if they have any brains, let the German's and Cerberus eat the debt, the German's where smart enough to get out only holding 20 percent of the bag, sooner or later the others will figure this out. F, GM, you really do not have the brains, ability to innovate or sense of what the market needs and respond to it in a timely manner. What would make any debt holder think things would be any different this time around even after your govt bailout.
There is a lot of GOOD debt out there that is secure, paying a very nice interest, way above the long term norm in a stable economy. All of the debt holders that I know (including myself) like to sleep very well at night. Why turn yourself into an insomniac! for what, a few more pennies, don't be foolish!Get ready for the coming MASSIVE tax restructuring programs by the govt to begin very soon on ALL of your earnings, nothing and nobody is going to escape. The govt needs money and they are going to take it! So what's new.
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2008 Aug 04 01:19 PM