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May 11, 2005

The Legacy Costs of Doing Business
by Rob Kirby

On the back of both Ford [NYSE: F] and General Motors [NYSE: GM] having their credit ratings reduced to junk status this past week - I thought it might be appropriate to take a closer look at why?

Some would have us believe that North American automakers simply don't build them like they used to! Well, being a proud owner of a 1980 Cutlass Supreme, with less than 100k original kilometers on the clock, I would concur with this line of thought. But then again, who really does build them the way they used to anyway? Others claim that automakers' woes are simply an issue of quality; saying that North American automakers don't measure up to foreign competition? They would have us believe that Japanese, Korean, English, German, Italian, French and Swedes all build them better, ehh? Personally, I find this proposition a little bit hard to swallow - hook, line and sinker.

So what then?

The most oft recited culprit, to these ears, seems to be "legacy costs," which are more often than not identified as spiraling health care costs due auto company employees and retired pensioners.

Let's investigate exactly what's at the root of these spiraling health care "legacy costs":

Firstly, many of the benefits that current UAW members enjoy were negotiated into labor contracts in the heady days of the late 1990s - when returns in the financial economy [as measured by the DOW and NASDAQ] were super charged indeed. These giddy days in the investment arena were in no small part due to the now infamous Rubin/Clinton "strong dollar policy" of the 1990s. In reality, this was arguably a lot of smoke and mirrors - nothing short of inflationary policies being consciously pursued under the cover of hedonic manipulation/alteration of CPI, PPI and the rigging of the gold price. The disguise allowed unusually low [negative in real terms] interest rates to be established and maintained - creating dislocations like new credit-driven asset bubbles in real estate and commodities - and this is the same interest rate regime we are still saddled with even to this day. As with most entitlements in life, the ones negotiated by the UAW on behalf of its members in the late 1990s are still enjoyed by auto workers today. Once attained, they are only reluctantly given up.

So where is the disconnect? Sounds like a win - win, doesn't it?

Economic Dislocations

We all know that equity returns post 2000 have been negative to anemic at very best. So it's reasonable to assume that the equity portion of GM's pension fund investments have not done very well over the past 5 years or so. But then again, this is exactly why investment professionals have historically advocated diversification among asset classes that are not directly correlated, so mortal damage is not inflicted on an investment portfolio during a downturn. General Motors, for example, has pension assets under management of roughly 100 billion. Their asset mix is roughly considered to be along traditional lines of 55% - 65% invested in equities and 35% - 45% invested in bonds [fixed income]. This means, by extension, that GM's pension assets have roughly 40 billion invested in bonds [fixed income] or equivalents.

Now, I'd like to take you through a mental exercise explaining what has happened to these bonds, namely, the returns on these bonds over the past five years or so.

With inflation being underreported [somewhere around 2% a year] to the tune of perhaps one third of what it actually is [7.27% as reflected by GM's projected increased health care costs this year alone] from Reuters;

"The largest private U.S. provider of health care, GM has estimated that its U.S. health care costs for more than 1 million current and retired workers and their families will grow to $5.6 billion this year from $5.2 billion in 2004 [7.27% annual increase]..." [RK emphasis]

This might lead one [like me] to the conclusion that nominal interest rates are perhaps 5% lower than they otherwise might be in a world where inflation was being measured and reported truthfully and accurately. Strangely, 5% increased return on a 40 billion dollar bond portfolio comes in at a cool 2 billion a year in foregone return. Amazingly, this "missing" two billion in unearned interest income just happens to be the very same amount that GM's cash flow is projected to slip into the red for 2005.

"...Standard & Poor has downgraded GM stock to negative (from stable); insiders expect a downgrade to "junk" is in the works. The result will be higher cost of borrowing to finance operating cash flow, which is projected at a negative $2 billion for 2005; earlier forecasts had been for positive $2 billion...."

This, dear reader, is also the very same 2 billion a year albatross that's been hanging around GM's neck for quite a few years now - accumulating. It amounts to a great many billions of cumulative lost [intended] revenue that ultimately has had severe repercussions on the balance sheet.

The effect of this lost revenue has generally served to push some companies into newer [and quite possibly more risky] areas of investing, as they struggle to maintain their current obligations under diminished fixed income streams. For some, this has meant forays into areas like real estate and for others a move into non-traditional business lines like financially engineered derivatives - now wreaking havoc across the financial landscape. For many of these companies, financially engineered products have actually now become their mainstays - contributing more to their bottom lines than their traditional offerings - like building cars.

It suggests that there was perhaps more thought and attention paid to the fundamentals like asset allocation when these pension funds were established and their benefits originally instated. How could the framers have ever known that the golden rules governing natural investment law would be bent and twisted so far? That this has occurred is a shame. It has, at bare minimum, at least been partly responsible for the credit ratings at GM and Ford recently being downgraded to junk status. Unfortunately, no private pension plan [particularly Defined-Benefit Plan] is immune.

Rob Kirby
Kirby Analytics

Copyright © 2004 - 2006 Rob Kirby

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