Bitter pill for GM

Article after article, class after class and discussion after discussion seems to lead to one topic these days: General Motors.
Be it Roy Smith, David Yermack, Nouriel Roubini, Ed Altman or any other finance professor in school, discussions invariably funnel down to GM and on what they believe is the right approach to solve the problem. Give or take a few, the unilateral resolution is for GM to file for Chapter 11 bankruptcy.

Let us take a look at the CDS spreads that I noticed on the Bloomberg terminal this past week for General Motors.
Source: Bloomberg terminal in school
Based on industry perception, currently, there is a 60% probability that GM will default on it 5 year and 10 year debt. That is a very high probability given that most firms have a sub 10% probability of default.

Max Holmes very interestingly taught us last week the basics of Bankruptcy law in the US of A. He talked about how it is a hotch-potch between the Queen's [British] Bankruptcy Law and the law devised in the US by the founding fathers [maybe not the founding fathers of the nation, but rather the founding fathers of the corporate and bankruptcy law]. Chapter 7 of the Bankruptcy law is straight from the Victorian era [for the uninitiated, that is the British part] which talks about liquidation and is fairly severe. Chapter 11 of the Bankruptcy law on the other hand talks about restructuring and reorganization rather than pure liquidation. It is far more accomodating and forgiving, though not always for the management.

The unilateral [footnote: the ones I have heard] opinion in the NYU Stern academic fraternity is that General Motors should file for a Chapter 11 bankruptcy. In order to facilitate in its transition and reorganization out of bankruptcy, the firm should raise DIP [Debtor-In-Possession] financing. This will most definitely wipe out the Equity holders under the new capital structure [not that they have much left on the table anyway]. It is likely to impair the various existing tranches of its debt as well [including senior secured debt] as the DIP creditors will hold the highest priority [after the lawyer and administrative costs of course].

While the credit markets have frozen, it is likely that DIP financing should be available for the firm as it will be on very favorable terms [for the creditor] and will hold the highest seniority. There will be a lot of monitoring mechanism in place as well. The biggest factor is the possibility that the government will either provide the DIP financing itself [less likely] or will secure the DIP loan.

The other benefit of bankruptcy will be that all the UAW contracts will be null and void. GM workers are currently paid higher wages than those [for the record: all of them are American workers, in the US] workers at Toyota, Honda and the like. Coupled with that are high health benefit costs, pension costs and labor restrictions as part of the UAW deal. While GM has been able to negotiate some of these liabilities with UAW, they are far from being optimal.

Another aspect of the bankruptcy will be its effect on GM's pension liabilities. When a company in the US files for bankruptcy, all of its pension obligations are transferred to a independent corporation called the Pension Benefit Guaranty Corporation or the PBGC. As the name would suggest, the job of the PBGC is to guarantee pensions. While this will place a cap on the maximum amount of pension paid out and restructure [read: impair] the pension payments, I am sure that is not the first thing that is there on management's mind. At least, it should not be. Bloody capitalist you may scream. Well, no. When the boat is sinking, the captain of the ship has to take tough decisions.

There is sufficient pressure on the government to act on this matter. The government is likely to give its current bailout of USD 25Bn to the Big Auto companies. However, this is more like pocket change, especially given that it will be split three ways. GM's problems are far more grave than most people realize. Definitely more grave than a third of USD 25Bn for sure. The other option that the government has is to double the bailout package to USD 50Bn. Even in this scenario, GM is only likely to postpone judgement day. All it will achieve will be that it will live to fight another day. What GM and Big Auto need are policies that go beyond this.

Let us take a step back and see what GM is doing as a firm to address its problems. First of all, it has been working very hard on the technology front. While it was the last kid on the block when it comes to smaller and cleaner cars, it is desperately trying to play catch up. From what we hear, it is on the right track. Business is fairly diversified. The Latin America Africa Middle-East or LAAM business actually posted a profit on increase in sales. China, India and rest of Asia have seen a bit of slowdown, mostly due to decreased consumer spending in this region. In the US, the firm has been hit in a multi-fold problem: lower consumer demand, difficult financing options, financial crisis and oil prices.

On the financial side, the firm has tried to free USD 15 Bn. in cash to support these challenging times. This includes measures such as stopping dividend payments, reducing capital expenditures, streamlining processes and earmarking labor efficiencies. They have also looked at asset sales and raising money from the debt markets, though that has been the most difficult part. At the end of their previous quarter, they increased their self-help targets from USD 15 Bn to USD 20 Bn. These measures will significantly reduce the cash burn and free up additional cash for the firm.

These are merely short-term measures. One of the four scenarios are likely to happen.
General Motors gets NO bail-out: Highly unlikely, though a probability. The firm uses its self-help measures to sustain itself. Car sales go down drastically because customers are worried about the status quo and what that means to the future of GM, their cars and spare-parts and after sales services for them. This seems like a business killer.

General Motors gets a bail-out: This is what the firm is lobbying for. In Washington and through voters, the firm is trying to drum up support for this idea. This may work only if the credit market are back in time before GM has exhausted its new resources. However, the firm is still saddled with the possibility that this could mean a reduction in customer demand for their products, owing to the uncertainty.

Credit Markets get back to good ol' days: If the credit markets get back into shape before GM has to cry 'wolf', GM could potentially tap the credit markets to raise operating capital. Credit markets are probably the single most important reason that GM is facing the crisis of today. I agree that a lot has to do with sub-standard products and strategies in the past and a late realization of their fallacies. Nevertheless, GM would not have been in such a bad shape, if the credit markets were in a better shape. The possibility of credit markets coming back soon is remote, purely based on the manner in which they have broken down. That said, they will eventually come around. The question is: will it be in time? A million dollar question that I [and most economists] don't have an answer to. The general perception though is a flat NO.

General Motors files for Chapter 11: Firm gets the money to restructure, liabilities are pushed into the future and the firm comes out of bankruptcy [whenever it does] leaner and fitter.

The final option seems to be the most plausible, reasonable and most likely to work towards a long term solution. Nevertheless, we need to consider the impact it will have on the US markets. While it will in no way match the mayhem seen in the aftermath of the Lehman Brothers bankruptcy, it will be perceived as a major failure. While most people expect it to happen, when it finally dones, it will be seen a major stamp on the malaise that the US markets are seeing right now. This is likely to adversely affect other major corporate names on Main Street.

It is interesting to note that the management is pushing very hard for a bailout package from the government. All they say is that they are doing what they can from their end. And they are looking towards Washington for help. As Rick Wagoner said, 'Bankruptcy is not an option'. All of this leads me to wonder why the firm is so shy of courting bankruptcy.

First of all, there is the point of a tarnished image. There are a lot of costs associated with the bankruptcy. This will spell difficult times. Brand value will decrease. This could result in a reduction in their sales. Suppliers and dealers will not provide credit [assuming that they do right now] and may not be ready to stock up inventory as well. Overall, this will have a negative impact on the business. The question is whether it will be more than we currently see right now.

Another factor is that the firm believes that this is a credit market phenomenon and if credit facilities are made available, they should be able to tide this time and come out stronger. This goes in line with the live to fight another day belief.

I personally believe that the biggest factor in this 'No Bankruptcy at all costs' pitch is the fact that management will most definitely lose their jobs in such an eventuality. Rick Wagoner is unlikely to be around, even if he is an inside man and may be the person best suited for the job. Simple reason is that he sat over this current crisis and did not see it coming.

With DIP financing in place, with our without government support, there will be a strong clamor for the management to be replaced. On the other hand, if the management are able to secure a bailout or are in any manner able to hold off bankruptcy, they will be hailed as messiahs. This, even though they were the people who got them into this mess in the first place.

When management starts talking about the burden on PBGC in the scenario that GM were to go bankrupt, you know that there is more to it than meets the eye. When management talks about bankruptcy not being an option, you know that there is more to it than meets the eye. Or when they talk about shareholder value or fallout on labor for that matter. Corporate Governance? I think otherwise. Each one for himself if you ask me.