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April 09, 2006

GM, Carry Trades and Derivatives
by David Chapman

As goes General Motors, so goes the Nation. This was a popular saying back when I was lot younger. Not so today. Some 30 years ago GM held 60% of the North American auto market and along with Ford and Chrysler they totally dominated the market. Well the foreign competitors came into the market and while back then they were dismissed as being unworthy today it is they who dominate the market. GM has fallen to roughly 25% of the North American market and that share is falling. GM has announced plans to close plants and eliminate 25,000 jobs just to shore up its operations and that is after already slashing its workforce by two thirds since 1980. Both GM and Ford are teetering on the brink of bankruptcy. Oddly it seems to be hardly causing a ripple in the markets or in the economy.

Or is it? Certainly there is no outright concern as GM's problems are not regularly on the lips of the either the talking or scribbling scribes. Nor is their any sign in the economy that GM's woes or Ford's for that matter is causing any problems. The prime reason is that despite the woes of the US auto giants the foreign competitors who have since established themselves in the North American market including plants are thriving. But with constantly falling numbers and falling market share the US auto giants are struggling every year with over production and often with the wrong product at the wrong time. An example here has been their concentration of investment into the gas guzzling SUV's. Of course with gasoline prices regularly north of US$3/gal or near Cdn$1/litre consumers are fleeing the gas guzzlers for economy models and often that means the foreign competitors.

But their real Achilles heel is actually a bigger problem in the US (and in Canada as well but to a lesser extent) and that does get considerable time if not on the airwaves or in the newspapers it does in Congress. Call them legacy costs of the health care and pension benefits negotiated years ago when times were good with the United Auto Workers. Instead of generally union free companies like many of the foreign competitors they are burdened with these costs estimated to be upwards of $1500/auto whereas foreign competitors were often lured to come into States with incentives and subsidies averaging around $1000/auto according to The Economist.

GM has 2.5 retirees for every worker and the burden for the health care and pensions is growing not falling. Under funded pensions and health care plans is not just a problem with the auto companies as this is prevalent throughout a host of industries many of who have already suffered severe problems such as airlines, steel and textile. In the case of the latter two much of the production that used to be done in America has now been shipped to Asia primarily China.

And the under funding of pensions is not just related to those industries as numerous companies in the US (and Canada) are facing similar problems. In the US the under funding of pensions and health care also prevails through the States and the Federal Government. Attempts at reform have been an exercise in frustration but it is these unfunded liabilities that are America's real Achilles heel. Something will clearly have to give as it will either bankrupt the companies or millions of pensioners particularly the aging boomer generation is about to be left with a very uncertain senior years living on incomes far lower than they ever anticipated unless they have been able to build their own retirement package.

So while this is not quite a major problem today it will be a major problem tomorrow and the clock is ticking down as the first boomers turn 60 this year. The guaranteed pension of yesteryear that are "defined benefit" programs (meaning you know what your benefits are going to be in advance) are being replaced by "defined contribution" programs (meaning you make contributions but there is nothing guaranteed). But it may be too late for GM and its workers where it is estimated that one out of every 100 jobs in the country is somehow tied to GM.

Oddly enough GM is also tied into the trillion dollar derivatives market and even the carry trade. GM recently sold a 51% stake in GMAC, GM's finance arm. The stake was sold to private equity firm Cerebus Capital for $14 billion. The deal, however, does not close until later in 2006 and it could still come unravelled. While GMAC was a major profit contributor to GM a lot of that comes because GMAC like all large financial institutions makes use of carry trades that while lucrative in a low interest rate environment could prove deadly in a rising interest rate environment. GMAC is rated junk status by S&P and Fitch while Moody's keeps it just below investment grade. Not even the 51% sale is going to raise GMAC's or GM's credit rating.

Last month GMAC asked for a filing delay after admitting an extra $2 billion in accounting errors that helped raise GM's loss to $10.6 billion for the past year. GMAC's debt already junk status jumped further in yield (meaning that spreads widen with the best quality credits). At around the same time car part supplier Dana Corp. (DCN- NYSE) defaulted on roughly $2.5 billion of debt following the bankruptcies of Delphi (DPHIQ-OTC PK) GM's battled car part supplier and Tower Automotive (TWRAQ-OTC PK). GM is being linked to roughly $200 billion in credit derivatives. Investors are naturally nervous.

What there is to be real nervous about is the potential for a credit meltdown particularly if the unions do not accept the court approved attrition agreement that Delphi won with former parent GM. While the agreement does provide options for the labour force the question remains whether the unions can swallow what is effectively a tear up of agreements. The Union is dammed if does and dammed if it doesn't but if it does accept than it might stave off even temporarily the crisis. A full blown strike would be devastating for all parties and GM could declare bankruptcy putting billions of dollars of debt and derivatives at risk.

The credit derivatives market is estimated to be roughly $12.4 trillion. It has roughly doubled in size every year for the past decade. Credit derivatives are a more liquid way to bet on credit quality. But it is very concentrated risk with the US's ten largest banks estimated to have $600 billion in credit exposure or about 175% of financial reserves. (Note: Credit exposure is different then the actual face value of the derivatives outstanding. A million dollars face value of derivatives may only be about $5000/$6000 worth of actual credit exposure depending on the nature of the derivative).

Globally the derivatives market is estimated by the Bank for International Settlements (BIS) to be $270 trillion for OTC derivatives and another $58 trillion in exchange traded derivatives. Of this the top 25 US banks have roughly $105 trillion. J.P. Morgan Chase leads the way with $48.6 trillion followed by Citigroup with $23 trillion and Bank of America at $22 trillion. Interest rate and currency swaps are the biggest component with $213 trillion. But the major growth over the past has been credit derivatives where they are up almost $4 trillion in the past year.

Authorities have not been happy with the massive growth of the credits derivatives market. Demands have been made to the International Swaps and Derivatives Association (ISDA) to effectively clean up their act. The exposure is just too big and the ability to properly hedge all of these positions is questionable. Veteran market traders of course scoff at the complaints.

But the recent collapse of the Icelandic Krone highlights the risks in the markets. As Icelandic debt became unravelled and carry trades blew up there was flights from other perceived weak markets particularly in Eastern Europe. It makes us of course recall the 1998 Russian debt collapse and the subsequent collapse of Long Term Capital Management (LTCM) that required the Fed to bail out the financial system.

Some analysts are excited about the sale of GMAC to Cerebus (no great credit quality itself) and are telling clients that it will have a positive effect on GMAC debt of upwards of 100 basis points. They estimate that while GM's March sales are not going to be good the perspective GMAC sale adds liquidity to GM and will allow them to boost capital spending. They do warn that all of this is could come unravelled if the unions do not accept the imposed attrition. Then all bets could be off and we could be thrown into a severe financial crisis with the ramifications of a potential collapse in the credit derivatives market.

Curiously all of this is occurring as the Fed stops reporting M3. It does feel rather odd checking the money supply numbers and not finding the one number your eyes always swung to every time you have looked at them over the past 30 plus years. We have always wondered what does the non-reporting of M3 really mean. Without those numbers we will not be able to get a grasp on big money put into the banking system to effectively stem the collapse of something like GM and the credit derivatives market. As goes GM, so goes the nation?

Note: Research compiled from articles from Reuters, The Telegraph London, Bloomberg, Credit Suisse, Executive Intelligence Review, The Economist and financial statements of GM.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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