The Next Crisis Unfolding - Auto

On 15th October 2008, I posted on the upcoming demise of the US auto sector:


Watch for the auto sector - this is where the pain will shift to. Big companies will fail or be merged and job losses will be massive - the auto sector consolidation has been brought forward by the events over the last couple of weeks. The auto sector combustion will cause the media to focus away from the carnage on Wall Street to carnage on Main Street. Expect markets to be wobbled by this. Keep cash at least 50%, trade out on weak signs - the worst may be over, but the general conditions still shifty. Jobs is where we should really look at. We can expect more job losses in the coming weeks and even months. I forsee some industries will see MASSIVE failure - the first to go will be the US auto makers.... pension problems, no credit or loans for people to buy cars, consumers delaying changing of cars now, problems with unions... very difficult to refinance their lines of credit moving forward... watch for at least two of them being merged or absorbed by a foreign competitor at cut throat prices. The auto industry are big employers, and that will hurt employment, and drag property prices weakness in those states where auto industry is strong.
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General Motors Corp. stock fell to its lowest level since 1946 as concern intensified that the auto maker could run out of cash and be forced to file for bankruptcy protection. The stock's decline came as several analysts issued dire reports about GM and the company acknowledged in a government filing it could be at risk of violating the terms of some of its debt if it doesn't steady its deteriorating finances by year's end.

Should governments bail out GM? If GM is allowed to fail, what are the repercussions? How far does it spread in terms of employment and loss of business activity? How far do GM bonds reach, and what are implications of default? The size of bonds outstanding for the entire US auto industry comes to about $250 billion. The good news is that most of these bonds are already at very junk status, most trading at less than 25 cents to the dollar. The loss to bondholders have already been triggered way way before today. Hence if any of them were to go bankrupt, it would not have strong repercussions on the actual bond holders. The bad news is that over the past few years, there is the invention of Credit Default Swaps, which has been the bane of AIG's demise. When actual companies do fail, these CDS clicks into action. How many holders of CDS are actually able to pony up the funds to pay back these bond holders? Thats why they trade at just a fraction of their face value. The market does not think that the CDS will actually be able to come up with the cash to pay back the face value of the bond (which is what CDS is designed to do). The worse news is that if say one-third of these bonds crumbles due to bankruptcy, the actual $100 billion losses is manageable, but many of these holders (think AIG) will also be holding many other CDS - a payout to a GM bankruptcy will have cascading effects on the "validity" and "viability" of the other CDS these people are holding.

This might make CDS totally unworkable and will collapse. Hence many more insurance firms will have to file for bankruptcy as well to avoid paying many of these CDS. Thats also why AIG keeps needing more and more capital infusion. Thats also partly why the government needed to bailout AIG, and the likes, in order for a properly functioning credit market to continue. Is the $125 billion into AIG sufficient?

Hence in all likelihood, the government is UNLIKELY to risk having GM go into bankruptcy. You DO NOT WANT TO STRESS TEST the CDS market to see if it would hold up. It might also unravel all the hard work done so far to keep AIG afloat. If the government pump money into GM, how much money is required and what is the direct purpose? By purpose, what will the money be used for? Will the initial injection be enough? Can any amount of money make the company a strong, viable competitor again? Will other national governments pump money into their car companies too, further increasing competition? If you look at how the Big 3 auto companies are operating, they are not financially viable over the long term.

I suspect Obama will not allow GM to fail so early in his Presidency as its not just the car maker, its the supporting sub industries and flow on job losses effect which is not what he would want at such a critical time.

The chart above shows average hourly compensation for the Big Three ($73.20) and Toyota ($48.00), compared to average hourly compensation for Management and Professional Workers ($47.57), Manufacturing/Goods Producing ($31.59) and all workers ($28.48). The auto industry in the US has long been crippled by the unions. We can argue till the cows come home but unions can kill an entire industry. They now have pensions that the company cannot fund, which in turn put unbearable claims on the company's balance sheet. At the end of the day, unless you make a much much better car, you cannot justify operating at cost per hour that is 70% higher than your competitors. The $73 and hour includes legacy costs. Union member don't make anywhere near that much money in reality. That number is at least $15-$20 high and includes benefits like health care. Well, you know what, no matter how you cut it, its still $73 and counting.

I think Obama will inject money into GM in exchange for control, and then institute a merger with maybe a foreign car maker - its pointless to merge an American car maker with another, it just compounds the problem. A foreign car maker will come in but with huge concessions and with a union that is willing to make huge sacrifices. Unions will have to be controlled and ask to forsake a lot in order to keep the company afloat. Job losses will be severe but it will be a lot less than allowing GM to fail. Allowing GM to fail is not an option owing to the flow on effects on the CDS and hence the entire bond market and credit viability.

The danger for financial markets is IF GM is allowed to fail, then you could get another freeze up in credit and sent all markets much lower. You could see the 7,000 being tested. If GM is being bailout, its still not blue skies. Things are still fluid and I see huge volatility in the coming weeks til end of the year at least.

p/s photos: Iwa Moto