Sunday, March 19, 2006

GM Bankruptcy?

Last Friday, GM announced the company had understated 2005 losses by $2 Billion and they would delay filing a 2005 annual report to sort through the accounting mess--company stock tumbled nearly 5% on the news. These accounting errors come to light 5 months after the SEC launched a formal probe into GM, and the news has severely hurt the company’s credibility. In an effort to find a way out of the mess, Rick Wagoner (the Company CEO) cut short a trip to Asia to hold an emergency meeting with company directors. In addition, looks like GM has been burning the midnight oil this weekend to negotiate a buyout package for Delphi UAW workers.

Delphi, Dana and GM are all tied at the hip, each is bleeding badly and the news seems to get worse each day. Will they ever find a way out of this mess? Could we actually see GM file for Bankruptcy in the future—If so, what are the potential ramifications?

This recent Bloomberg article discusses some consequences for just the derivatives market alone… Bottom line: A GM bankruptcy could have far reaching implications.

GM Bankruptcy Risk Exposes Imbalance in Booming Default Swaps

March 14 (Bloomberg) -- Time is running out for the $12.4 trillion credit derivatives market to clean up its act as the potential for history's biggest corporate debt default looms.

The possible bankruptcy of General Motors Corp. has exposed flaws in trading of so-called credit default swaps because the number of contracts has outstripped the bonds they insure. The market's trade association, meeting this week in Singapore, is working to prevent disruptions by computerizing record keeping and permitting contracts to be settled with cash instead of bonds.

The Federal Reserve Bank of New York last year warned deficiencies in credit-derivatives trading could threaten the stability of financial markets in the event of a major default. The 10 biggest U.S. banks, including Citigroup Inc., Goldman Sachs Group Inc. and JPMorgan Chase Inc., have about $600 billion of credit derivatives, according to the Fed.

``If there was a major credit event, or a series of credit events, it could really cost them,'' says Tanya Azarchs, managing director of financial institution ratings at New York-based Standard & Poor's. ``It's considered dubious risk management to build a market without setting up an infrastructure to cope with the volumes traded.''

As many as 150 bankers and investors have been meeting since December to develop new rules for credit derivatives, the fastest growing part of $270 trillion derivatives market. The New York- based International Swaps and Derivatives Association plans to have a cash settlement system in place by June 20.

Credit-default swaps were designed to protect creditors against non-payment of debts, and some investors now use them to bet on a company's credit quality. Contract buyers pay an annual fee and receive the full amount insured if a borrower defaults. Under the current system, buyers are obliged to deliver the defaulted loans or bonds to the insurer.

`Lack of Transparency'

The credit-derivatives market, dominated by credit-default swaps, is unregulated, with contracts traded over-the-counter and no requirement for investors to disclose their holdings.
With more credit derivatives being traded than bonds available, a default by GM could spark panic buying of the company's bonds, driving up prices. The contracts would be worthless if prices rose to 100 cents on the dollar because investors would have to pay the same amount for the bonds as they received in payouts.

``The current method has the potential to significantly distort the economics of the trade,'' says James Batterman, an analyst at Fitch Ratings in New York. ``There are no limits on the amount of derivatives exposure vis-a-vis deliverables, and a lack of transparency as to how many contracts there are in existence.''

GM Ratings Cut

S&P on May 5 cut the credit ratings of Detroit-based GM to junk-bond status because of its failure to address ``competitive disadvantages,'' such as its reliance on sport-utility vehicles. It is the biggest company to have had its ratings cut to high-risk, high-yield status.

Investors are demanding upfront payments, in addition to annual premiums, for derivative contracts that protect holders of GM's debt. Buyers of such contracts now pay $1.85 million in advance, plus $500,000 a year, to insure $10 million of GM bonds. Advance payments reached a high of $2.4 million in December.

Credit default swaps were created by banks in the 1990s to transfer credit risk off their books and boost return on the capital. The market for credit derivatives has expanded fivefold in the past two years as investors used the market as a cheaper way to bet on credit quality than buying bonds, which are relatively illiquid.

JPMorgan and Goldman Sachs are among the biggest buyers and sellers of credit derivatives. Traders of the contracts now include investors ranging from Newport Beach, California-based Pacific Investment Management Co., the world biggest bond fund manager, to Blue Mountain Capital, a New York hedge fund.

Out of the Shadows

``Derivatives took credit markets from being in the shadows of the financial markets to center stage; credit markets are now visible and liquid,'' says Tim Frost, a pioneer of credit derivatives at JPMorgan who now helps run Cairn Capital Ltd., a London hedge fund that specializes in debt. ``Credit derivatives raised returns on capital and gave the credit market the opportunity to develop beyond the buy and hold culture.''

The speed with which demand for credit derivatives is growing is creating headaches for the banks, which can't process the deals fast enough.

The New York Federal Reserve in September told the 14 biggest buyers and sellers of credit derivatives to take steps to eliminate a backlog of unsigned order confirmations.

`One Step Forward'

New York Fed President Timothy Geithner last month said the 10 largest bank holding companies in the U.S. had about $600 billion of potential credit risk from their holdings of derivatives. That represents about 175 percent of so-called tier-one capital, the funds banks must hold to satisfy legal requirements for safety and soundness. Tier-one capital is composed of common stock and retained earnings.

Since September, the banks have reduced by 30 percent the number of credit-derivatives contracts that remain unsigned for 30 days or longer. They have now committed to cut the number of unsigned trades by 70 percent before July, Geithner said yesterday in a statement on the Fed's Web site.

``A principle challenge is that this market is growing so fast that banks take one step forward and then realize they still have many more steps to go,'' says Gay Huey Evans, a former regulator with the U.K.'s Financial Services Authority who is now European chief executive at Tribeca Global Management LLC. ``The market now understands operational risk can be just as severe in stressful markets as the actual market risk they are taking.''

`I Continue to Worry'

Incomplete recordkeeping lies at the heart of the fragility of the credit-derivatives market, and cash settlement won't solve the problem.

``Cash settlement will help get around the bond scarcity problem, but if you don't know the who, what and how much, it will be futile,'' says Mike Greenberger, a law professor at the University of Maryland and a former director of trading and markets at the Commodity Futures Trading Commission, the U.S. futures market regulator. ``I continue to worry about this market.''

As part of the cleanup, the Fed asked all regular users of credit derivatives to confirm transactions through the Depository Trust & Clearing Corp., a non-profit organization that processes most of the bond and equity transactions in the U.S. The goal is to convert the system from paper records to electronic ones. The largest U.S. banks have said they won't trade derivatives with investors that fail to comply with the Fed's request.

DTCC last month said it would create a centralized database to track all credit derivative transactions and process payments between the parties. The system would be able to quantify the value of contracts outstanding for the first time. DTCC, which initially planned to begin offering the service by June, now targets the fourth quarter, says Stuart Goldstein, a spokesman for the organization.

`Taking the Right Steps'

Some market participants are reassured by the industry's attempts to police itself and have taken advantage of market movements created by the mismatch of derivatives and bonds.

``The market is taking the right steps,'' says Tim Warrick, who helps manage $94 billion of bonds at Principal Global Investors in Des Moines, Iowa. ``There will be disruptions along the way, but they're not likely to dislocate the market, because the market understands those risks now.'' Warrick says he isn't concerned about a potential default by GM.

``With any company where there is substantial risk, we actively manage it,'' he says. ``In those cases we look to manage down that risk, or eliminate it totally.''

Toledo, Ohio-based axle maker Dana Corp. last week became the latest company in the auto parts industry to seek bankruptcy protection. The company defaulted on $2.5 billion of bonds and loans this month, resulting in a rise in its bonds as investors sought them to settle credit-derivatives contracts.

Dana Default

Dana's 5.85 percent 2015 bonds have risen 10 cents to 74 cents on the dollar since the company filed for bankruptcy protection. They traded for about 60 cents on the dollar Feb. 24, when the Wall Street Journal reported Dana had hired Miler Buckfire & Co., which advises companies in financial distress.

Delphi Corp., Collins & Aikman Corp. and Tower Automotive Inc. had previously defaulted after automakers such as GM and Ford Motor Co. cut back production and put pressure on suppliers to lower prices, says Chris Benko, managing director of PricewaterhouseCoopers' Automotive Institute in Detroit.

The demise of parts suppliers has eliminated a safety valve for GM and Ford, making it more difficult for them to survive, Benko says.

``In the old days, when conditions were tough they could always put pressure on the auto parts makers,'' he says. ``Now that's not possible.''

`Nothing But Questions'

GM, Delphi's former parent, is working with the company and its labor unions to avoid a strike that Morgan Stanley analyst Jonathan Steinmetz said could bankrupt the world's biggest carmaker. As part of Delphi's 1999 spinoff, GM agreed to cover the costs of certain Delphi retirees in the event Delphi couldn't make the payments.

Marilyn Cohen, the president of Envision Capital Management in Los Angeles, says she is concerned the flood of credit derivatives may skew prices in the bond market, hurting retail investors like her clients.

``God forbid if GM files for bankruptcy,'' says Cohen, who oversees $225 million of bonds, including those of GM's finance unit. ``What will it do to the market? We have nothing but questions, and no answers.''

1 comment:

Out at the peak said...

Up to $140K offered to the Delphi employees. Nice severance package. I haven't seen those since the dot com days.

GM ... could they be the first domino that falls or is that FNM's job?