Posted on: December 26th, 2008 Loans to Chrysler and GM Part II–Risky Credit Enabled Automakers’ Neglect

As part of the terms for $20 billion in public loans from Washington and Ottawa, Chrysler and GM must come up with a strategy for industrial renewal by March 2009.  It’s hard to see how they can given the automakers’ historical performance in developing manufacturing strategies.

Every time oil prices spiked in the last 40 years, US automakers struggled, but didn’t do much about it.  In 1980 Chrysler, on the brink of bankruptcy, went cap in hand and got $1.2 billion in government loan guarantees.  After 1980, from an industrial strategy perspective, nothing much changed.  Poor performance was without consequence.

By the late 1980s, with the development of securitization, auto executives found a way to forget about the demands of industry and began to behave a lot like bankers.  They developed excessive access to cash through their financing arms–GM had General Motors Acceptance Corporation (GMAC), Chrysler had Chrysler Financial and Ford had Ford Credit.  With securitization they were able to mask the fundamental weaknesses in their manufacturing strategy–fooling most of the people a lot of the time.

Today things have changed because financial markets are in chaos.  The Big Three are headed for failure.  They ignored market demand signals for decades; now their financing activities–once assets–have become huge liabilities.

Automakers stood by and watched their market share fall by almost 30% from 1995 - 2008; 20% of that decline in the past eight years. They focused on SUVs far longer than was prudent because of the wider profit margin they were able to realize on them.  A new strategy for smaller, more fuel efficient models would force them to live with narrower margins–not an easy adjustment.

The market for automobiles may be reaching a saturation point adding another degree of difficulty for manufacturers. Even without a recession–which is going to have a severe impact on fleet and other business related sales not to mention on consumer demand–the rate of increase in the demand for automobiles would be slowing down. This reality is not being discussed in all the lofty talks about returning the North American auto industry to profitability.

We have enough cars on the road. In 1960 there were 41 vehicles for every 100 people in the U.S. By 2006 it was double: there were 82 vehicles for every 100 people.  Growth in the demand for automobiles is certainly constrained. Rather than coming from an expanding market, future sales will come from vehicle obsolescence and population growth. What’s more, there are other long term trends at work reducing demand further. Peoples’ preferences for driving are changing because of environmental concerns and aging baby boomers have a tendency to lengthen the amount of time they take between purchases.

GM has ongoing obligations regarding the bankruptcy of its major supplier and former subsidiary Delphi.  Since spinning off Delphi a decade ago, GM has paid $7.5 billion to support the company. Delphi still requires $10.6 billion to emerge from bankruptcy. In September GM agreed to that support.  How do these obligations tie into the recent need for public sector loans?

What we do know for sure is that auto executives are adept at benign neglect.  Although that might qualify them for a job in the Treasury, Securities and Exchange Commission, or even on the Board of the Federal Reserve, it has disqualified them as industrialists.  They have proven they are unable to develop and implement effective manufacturing strategies.  Why do Bush and Harper think that over the next three months they can come up with ones that will work?

Not only have automakers failed as industrialists, they have failed as bankers.  These days, however, poor performance seems to be a precondition for reward–if an entity fails as a quasi-financial captive, after failing as a captive, like GMAC–it gets to become a bank holding company.  What makes the Treasury Department think that the same executives who created GMAC’s huge exposure will be able to shepherd them through these challenging times?

In 2007 Cerberus Capital Management, a private equity fund, bought 51% of GMAC from GM under the expectation that majority ownership would see GMAC’s credit rating improve and allow access to cheaper funding sources.   That didn’t happen.  The market already understood how compromised the company’s performance was.

All three automakers became extremely active in securitization during the early 1990s. They packaged up consumer automobile loans into asset-backed securities (ABS), thereby removing the receivables from their balance sheet, and sold them to investors.  By 1996 Chrysler was one of the largest issuers managing $28 billion in finance receivables. Their balance sheet assets were half that amount. It continued aggressively pursuing ABS throughout the decade. Chrysler’s exposure to off-balance sheet activity is probably greater in relative terms at present, although information regarding the recent past is being withheld by Cerberus (the same private equity fund that bought GMAC) who bought 80% of Chrysler from Daimler in 2007.

A rough estimate based on Chrysler’s historical activity and the size of the ABS market for auto loan receivables suggests its off-balance sheet exposure could be $100 - $150 billion.  With rising auto loan delinquencies and default rates, and the obligations Chrysler may have to fund shortfalls between the cash flow it receives and the cash flows investors expect, Chrysler Financial is potentially exposed to huge losses.

This unknown degree of exposure from off-balance sheet activity may be why we, as taxpayers, are really being asked for support; why we are being asked to do what Chrysler’s owner, Cerberus, wouldn’t.

In early December Bob Nardelli, Chrysler’s CEO told Congress that he had asked Cerberus for more funding but that the company had turned him down. Cerberus has approximately $27 billion in assets, and $100 billion in annual revenues.  Nardelli said that Cerberus is made up of investors who are unable “to commit…to put more” money into Chrysler. However, in October Cerberus loaned $1 billion to the Canadian Imperial Bank of Commerce to help it out with its sub-prime mortgage exposure. The return for that deal is expected to be 20% over three years.  Inability to provide support seems to be a relative issue—relative to whether or not there is money to be made.

What assurance do we have that public loans to automakers are not finding their way to Cerberus private equity investors through management and other fees? How do we know that taxpayers are not underwriting the returns to one of the largest private equity firms in the U.S.? At the very least, as part of the terms of the loan, a full accounting of the inter-company relationships should be forthcoming.

During the past decade, GMAC went a step further than Chrysler Financial and Ford Credit by expanding its securitization activities to include mortgages.  Its mortgage-backed securities (MBS) became a much larger part of its operation than its ABS activities backed by car loans.  In 2006 GMAC had $150 billion in off-balance sheet securities; $121 billion related to mortgages.  This is one of the reasons why GMAC’s financial problems started to present themselves early in 2007–GMAC was being hit hard by delinquencies and defaults in its sub-prime mortgage exposure. GM has been called upon to fund its 49% share of losses.  In the third quarter of 2008, GM’s year to date obligation was $2.7 billion.  Losses continue to mount because loan delinquencies and defaults in mortgages and car loans are rising.  By year end GM’s obligations could be substantially higher.

During much of the 1990s and into the first half of this decade, relatively cheap and ready cash from securitization meant that automakers were able to force-feed consumer demand. Not only has front-end loading of automobile purchases added to the current decline in demand, much like the sub-prime mortgage situation, lax underwriting standards have set up a wave of loan defaults in the months ahead.

Securitization accelerates and inflates the availability of credit.  An auto finance company, say Chrysler Financial, pools a number of auto loans into an ABS and sells this security to investors.  They promise to pay investors principle and interest, less a servicing fee.  Normally Chrysler Financial would have to wait for the cash flow from the loans to come in to make new loans.  By promising the stream of future payments to an investor, Chrysler Financial gets the value of the ABS up front.  If the ABS sells for $100 million, Chrysler Financial can turn around and make another $100 million in auto loans and then package them up into another ABS.

Each sale of a pool of loans to investors quickly enables another wave of lending.  How much more quickly does the access to ABS facilitate car sales?  The term for the average auto loan is a little over three years while the average ABS placement could happen in a matter of weeks.  Its easy to see how auto loan asset-backed securities grew from $71.4 billion in 1996 to $202.4 billion by 2006–a rate of almost 20% per year.

The automaker not only gets the profit from increased sales it also makes money on the servicing and financing of those sales.  Depending upon the accounting rules followed it may even be able to book the servicing profits from future years immediately, rather than waiting until the ABS has reached its term to maturity.  When market conditions are good, the results for car makers are really good since financing subs pass the profits through to the consolidated statements.  But when they turn bad…

Reported gains from financing activities are developed using assumptions about future market conditions. Prior to 2008 the future looked pretty bright and underlying estimates in financial statements reflected that outlook.  Things have changed dramatically; estimates will need to be adjusted. Cash and non-cash flows in consolidated statements will go the other way.  This will bleed necessary resources away from manufacturing. Losses from financial arrangements will prove to be far in excess of earnings from prior years—earnings that may prove to have been an illusion.

It has been known since the mid-1990’s that industrial firms who resort to ABS do so when they are financially weak; when debt markets have said “enough”.  The development of ABS market essentially enabled The Big Three to access funding when traditional debt markets were trying to signal that these companies posed too much risk; that they needed to do something about their business model. The market tried to speak–no one was listening.  Are we listening now?

Filed under: Economic Crisis

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