GM – A Sign of Things to Come?
(March 17, 2005)
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First of all, I want to emphasize that this is not a commentary about General Motors (GM) and nor is it a commentary regarding the automobile industry, although it is definitely an appropriate topic to write about in one of our commentaries in the future. Rather, it is about the potential deterioration of credit quality and a potentially slowing world economy - which would not be as interesting if it wasn't for the fact that the respect for risk by retail and institutional investors alike have declined substantially over the last 24 months.
Yesterday morning, GM shocked the world financial markets by slashing its first-quarter earnings target from break-even to a loss of $1.50 a share, and at the same time cutting its full-year earnings from $4 to $5 a share to $1 to $2 a share. GM ended the day down nearly 14% - a 10-year low. The company's bonds also plunged. Quote from the Reuters article:
After the company slashed its 2005 earnings forecast and two rating agencies took first steps to cut the company's debt ratings to junk, GM's 8.375 percent bonds due 2033 are trading at their widest spreads ever, closing at 415 basis points, or 10 basis points wider on the day, after having traded as wide as 466 basis points, according to MarketAxess.
In the credit derivatives market, protecting General Motors Acceptance Corp. debt against default costs an eye-popping 360 basis points, or $360,000 a year for every $10 million of principal protected, up from 282 basis points on Tuesday. GMAC is the finance arm of GM.
Okay, I am not going to be an alarmist here, since in the same article, it stated: "For all its difficulties now, GM had some $57.7 billion of cash and marketable securities on its balance sheet as of year end, and has little corporate debt maturing for the next several years. The company has ample access to the asset-backed security market if it needs to raise funds"
However, readers should keep in mind that GM still has an ongoing pension and healthcare funding problem. In 2003, the company did a $13.5 billion financial deal to fund their pension plan, and at the same time, changed its investment strategy:
Historically, GM's pension assets have been split among the following investments: 55%-60% equities, 30%-35% bonds and 10%-15% other assets. GM's new strategy is to shift more of its pension funds into asset classes that aren't as closely linked to overall market performance. Instead, these investments would rely more heavily on active management--things like emerging market equity and debt funds, domestic high-yield bonds, small cap equities, real estate and private equity.
Let's just say that if the stock market actually closes down this year, GM may have a whole bunch of problems once again - given its appetite for risk with significant investments in emerging markets, small caps, and high yield bonds. Please note that these three categories have all been doing really well, but once they turn down, it could get pretty ugly on the downside.
This Financial Times article does a great job of summarizing the situation in the junk and the emerging markets bond markets over the last two years. I am tempted to just copy and paste the entire article on here, but let me show you the more significant (and very telling) quotes:
It is less than two weeks since Argentina imposed a draconian settlement on creditors in the world's biggest sovereign debt default, with an offer worth no more than 34 cents in the dollar. Yet investment banks are queueing up to take the country back to the capital markets. "Offers have already been made," Roberto Lavagna, Argentina's economy minister, has said.
For much of the last two years, a credit boom has encouraged a flurry of highly-leveraged takeovers and allowed the refinancing of dozens of troubled companies. In Europe and the US, more than $100bn of so-called "high-yield" debt has been sold in the last eight months alone at barely half the premium over bank rates issuers were forced to pay in 2002. Yet until last week, appetite among investors was usually so strong that most deals were oversubscribed. Several private equity firms have even been able to come back for more, using new loans to pay themselves special dividends within days of completing leveraged buy-outs.
Many of the biggest players in the debt market are reluctant to express their worries in public but privately admit to deep concern. The chief risk officer at a leading Wall Street firm says banks are being forced to lend on aggressive terms to "stay in the game", even though they know trouble is being stored up. "It's like a game of musical chairs. You just hope it is somebody else that gets hurt when the music stops."
The head of one of the biggest commercial lenders in the US describes the amount of leverage on some buy-out deals as "nutty". Much of the wildest lending is being done by hedge funds awash with cash, he says. "Some funds believe they have to invest the money even if it's not a smart investment. They think the people that gave them the money expect them to invest it. But it's madness." He concedes that it is difficult to predict when the market will turn - "it could stay frothy for some time" - but believes the catalyst is likely to be not an increase in interest rates but a large financing transaction that fails to get executed.
The shift in sentiment towards Argentina is the most surprising sign of exuberance in an asset class whose demise has been often predicted in recent years. With US and European interest rates still low by historical standards, investors have been pumping funds into the bond markets of Brazil, Russia, Mexico, Colombia, Turkey and a handful of other developing countries. The average yield spread over US Treasuries - the most widely accepted measure of political risk - has fallen to its lowest ever levels of about 3.4 percentage points.
Money has even been flooding into government paper denominated in local currency, traditionally shunned by international markets. The trend has been reinforced by the persistent weakness of the US dollar and the desire of fund managers to diversify their exposures. And high local interest rates - Brazil's overnight rate is 18.75 per cent - have enticed speculators. Vitali Meschoulam, an emerging markets economist at HSBC in New York, says 80 per cent of hedge funds' investment in emerging fixed income markets has gone into local currency instruments.
All this is reminiscent of the mood that preceded successive financial crises in the 1990s. "Mexico was able to borrow at five-eighths of a percentage point above Libor [London interbank offered rate] just before it defaulted [in 1994]," says Vincent Truglia, of Moody's, the credit rating agency. "I have seen it many times."
First of all, the average yield spread of debt in the developing countries over U.S. Treasuries has fallen to its LOWEST LEVELS EVER. Moreover, a significant portion of this money is being "invested" in government paper denominated in the local currency - in order to further take advantage of the falling U.S. Dollar. Furthermore, a lot of the Latin American countries are depending on a rising commodity market in order to fund growth and/or government spending. Let me ask my readers this: What happens if the U.S. dollar bottoms here and suddenly reverses on the upside? What if we experience a "blow off" of both oil prices and natural gas prices to the upside and then a sudden crash in energy prices (which is a very realistic scenario if oil prices rise enough to cut off the marginal user. hmmm. China? - think the 1997 Asian crisis and what subsequently happened to oil prices in 1998). I believe that these two themes will be the most important and overriding themes this year - and there is a very good chances that at least one if not both of these scenarios will pan out (which will cause the hedge funds to lose money big time - first from a currency devaluation and then second from a crash in emerging market bond prices).
The lack of risk aversion is also evident in the domestic bond market. Following is a monthly chart of the spread between the yield of the Moody's Baa bonds (which are considered medium grade obligations by Moody's) and the 20-year U.S. Treasuries from January 1996 to February 2005:
As the above chart shows, the yield spread of the Moody's Baa bonds over the 20-year U.S. Treasuries has not been this low since October 1997. Coupled with the fact the emerging market debt instruments are now priced for near perfection, and I would say that we are definitely in dangerous territory here (especially given the fact that the Fed is raising the Fed Funds rate, a commodity market that is pretty much rising exponentially, and a crashing U.S. Dollar that can reverse for up at any time). Also, given the fact that spreads were the highest in October 2002, one may wonder how much further on the upside the market can go here.
The lack of risk aversion has also been justified by the declining default rates of bonds over the last two years - as shown by the following chart (updated to the first quarter of 2004 only) created by Dr. Edward Altman, Professor of Finance at the NYU Stern School of Business:
The 2004 default rate has just been updated (but not shown) and it came in at 1.5% - a rate not seen since 1997. Given this low default rate in 2004, we may see a resurgence of bond defaults in the year 2005 and 2006 - in light of the recent Delta Airlines news, AIG being put on negative watch, and GM being downgraded to one notch above junk. I am not implying that these companies will go bankrupt (in fact, there is virtually no chance that either AIG or GM will go bankrupt anytime soon) but the timing of these recent events is significant, as it is definitely ominous and may actually act as a leading indicator of a credit crunch going forward.
Conclusion: Given the lack of risk aversion in both the high yield and the emerging debt markets, it is probably prudent to play it on the safe side here, especially given the recent near-exponential run-up of commodity prices and the decline of the U.S. Dollar. Please also don't forget that the Federal Reserve is continuing to raise rates, and yet the stock market is still prices for near perfection. I believe there is a huge possibility of a global credit crunch (which is very possibly especially given the recent underperformance of the Bank Index) sometime in 2005 - with the greatest sufferers being the countries that are the marginal users of credit and/or commodities, along with countries that rely significantly on commodity exports for their livelihoods.
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Henry K. To, CFA