Driven to Bankruptcy?

I’m sure it won’t have escaped most people’s attention that the big American car makers are suffering at the moment – sales by the big three, GM, Ford and Chrysler were down 23% last month. Both GM and Ford announced last week that they have been spending their cash reserves at a hefty pace, and GM has said that it could run out of operating cash as soon as the end of the year.

This has lead some – including Nancy Pelosi, Speaker of the House of Representatives – to call for a government bailout of the troubled firms funded by the TARP. The Troubled Asset Relief Program was designed to buy distressed assets owned by banks, although over time it has evolved and is more likely to make direct investments in bank equity than to buy asset backed securities.  Last night the automakers were turned away from Congress having failed to convince Democratic leaders that they’d spend any aid wisely, but they can come back and plead their case again in December.

As pressure mounts for bailouts of honest blue collar industrial heartland businesses (rather than paying for the bonuses of Ferrari driving Gordon Gekkos) what might that mean for the bonds of the auto makers?  These are huge bond issuers – together, Ford and GM have a face value of $125 bn bonds outstanding. This chart shows that as bankruptcy fears have developed the (long dated) bonds have plummeted in price to around 20 cents in the dollar. We’ve been bearish on these car producers since 2004, but is there a risk that whilst in a free market these companies would probably go bust in 2009, in today’s Keynesian borrow and spend world, they could survive, and a government equity injection could bail out not only the blue collar car workers but also the white collar owners of Ford and GM bonds?

So what’s the bull case for buying the automakers at 20 cents? Well, even in the event of a default, a typical recovery might be between 25-30% of the bond value, and the long dated bonds are trading below this historical recovery rate. However in this case recoveries might be lower than history suggests as the liabilities held by bond investors are dwarfed by those held by former employees in pension and healthcare benefits (interestingly GM is the worlds biggest private buyer of Viagra).

Another factor to take into account is where any government cash would sit in the capital structure. There hasn’t been much talk about this thus far but clearly the issuance of common equity or preference shares would be much more attractive to bond holders than a senior secured loan as an equity-like injection would sit below the bonds in the capital structure, and would be further down the queue for repayment in the event of further difficulties.

Ford currently have a bond maturing in Feb ’09 trading at around 85 cents in the dollar which, if they secure government funding, one would assume to be money good. As I said, the team has been bearish on autos for five years but with the bonds trading at these levels, and with continued political pressure on Bush/Obama to do something for the “real” economy they might be looking interesting.