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Bad for GM, bad for America
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A strike at Delphi would cripple GM by shutting down almost all of the auto giants North American production. General Motors last faced a long strike in 1998, when a 54-day work stoppage closed 95% of its North American operations. Merrill Lynch estimates that a 60-day strike at Delphi would cost General Motors $7 billion to $8 billion in cash. That sum wouldn't just come from lost production. It also comes from swings in the company's cash flow created when hard-pressed suppliers, also shot down by a Delphi strike, increase their demands that GM make prompt payments of existing bills. Payables -- what GM owes suppliers -- stand at $26 billion. And they're paid in cash. That's a significant figure even for a company like GM with $20 billion in cash.
You'd think $20 billion in cash would be enough to reassure the credit-rating agencies who have graded GM's debt "junk" or, to be polite, "below investment grade." But it's not, because there are so many demands on that cash, including the recent early retirement offer to workers at GM and Delphi that could cost GM $2.2 billion in cash, according to estimates by Bernstein Research, and $5.4 billion in pension obligations. And then add in whatever size loss General Motors is likely to show this year on its car-making operations.
All this is bad for General Motors, but why is it bad for the country?
Insurance buyers, in good hands?
The short answer is that bond traders are scared enough about the possibility that General Motors itself could wind up in Chapter 11 bankruptcy that they're buying insurance, but they're not scared enough to worry how good the insurance is.
If they want to insure a debt against default, big investors turn to a kind of derivative called a credit default swap. (Derivatives are securities based on other securities -- derived from them, if you will.) Forget about the details -- they involve an investor who thinks default is relatively likely who then buys what amounts to insurance from another investor who thinks default is less likely. So that, for example, on April 6, a default swap on GMAC to insure $10 million of GMAC debt for five years cost $385,000.
This makes prices in the default swap market a good barometer of how likely investors think a default is. More likely and the price of the insurance goes up. Less likely and it falls. Recently the credit-default-swap market has been pricing in a 50/50 chance that GM will go into bankruptcy some time in the next five years.
The insurance provided by the credit-default-swap market takes some of the worry about of buying GM bonds. Oddly enough, that works to keep yields on those bonds lower than they might be. If you can insure against the bonds going bust, your risk is lower, and the yield should be lower, too. The existence of the derivative market for credit-default swaps -- where recently it cost 18.25% to insure GM bonds against default for five years -- has lowered the yield on the actual GM bond by lowering the risk of default.
On April 7, a General Motors bond due in January 2011 was priced at $73.50 per $100 of face value, a yield of 14.73%. That's a very nice yield but, I'd argue, not what I'd expect for a company with a 50/50 chance of going bust before the bond matures. (The original coupon on this bond when it was issued was 7.2%.) And I'll bet that some of those bonds, thanks to credit-default swaps, have found their way into pretty conservative portfolios.
That would be just about perfect if we could count on the credit-default-swap market to provide perfect insurance. A credit-default swap as insurance is only as good as the money of the investor on the other end of the deal. If that investor pays off in a default, great. If the demand for payment, or the prospective demand for payment, creates a scramble to sell before the insurance bill comes due, then the cost of insurance can skyrocket. That, in turn, would lead some investors to sell any credit-default swap contracts with lower "premiums" (assuming the market would allow this) and would send other investors back into the bond market, where they'd demand higher yields rather than paying higher premiums in the credit-default-swap market. And, if a weak hand fails to pay up on that insurance, then pricing in the whole credit-default-swap market runs amuck, with prices for contracts soaring or with supply collapsing -- or both.
Testing, testing
No one knows, of course. This isn't an old market, and it's not well tested. Moreover, the derivatives market has failed some past tests as weak hands have proved unable to meet commitments.
And the risk in the credit-default-swap market rises as events get more uncertain. More uncertainty brings more investors to the market looking for insurance. And the growing demand increases the odds that one investor or another offering insurance will make a mistake or get overextended. That can lead to exactly the swings in price and supply that could lead to a collapse of liquidity in this market.
We've already seen clues to how volatile this market can be. The most actively traded credit-default swap in March was that of GMAC. In a matter of a few days prices moved from lows of $300,000 for $10 million in insurance to highs of $485,000.
That's about a 62% swing. Without a strike at Delphi or a wildcat strike against GM. Without fears that the Cerberus-GMAC deal might collapse. Without another ratings drop on GM debt.
I don't have much faith in any of the parties to this mess. But I sure do hope they work it out. I can get along without another real-life test of the derivatives market.
Updates
Sell General Cable
Remember that there's no such thing as a free lunch. Sure, soaring copper prices are great news for copper stocks and investors in copper futures, but high prices are bad news for companies that have to buy copper as a raw material. When General Cable (BGC, news, msgs) projected first-quarter 2006 earnings, back on Feb. 7, of 22 cents to 29 cents, the company said it had based those estimates on an average price of $2.20 to $2.30 a pound for copper. (Copper prices averaged $2.03 a pound in the fourth quarter of 2005.) Well, on April 10, copper futures for May delivery hit $2.71, a new record and the ninth new high in nine trading sessions. Spot copper hit $2.7390, an all-time record. I think that makes it likely that General Cable was feeling raw-materials cost pressure during the first quarter and, since the cost of copper makes up 30% to 35% of the company's cost of goods sold, that it could lower guidance for the second quarter when it reports first-quarter earnings on May 9. With the stock trading at 24.4 times projected 2006 earnings per share, a rather heady multiple for this stock, and Wall Street analysts counting on earnings of 27 cents (52% growth) for the first quarter, I think investors are facing the real possibility of an earnings or guidance miss that seriously hurts the stock. On Feb. 7, when the company last reported earnings, the share price fell by more than 8% on good news: The company raised guidance and beat estimates by 11 cents a share. I think that's a solid indication that a significant number of the company's shares are now in the hands of momentum investors who will sell on any short-term weakness. So while I continue to like the long-term infrastructure story behind this stock, on short-term price and earnings risk, then, I'm going to take my profits. I have an 88% gain in the shares since I added them to Jubak's Picks on Sept. 9, 2005. (Full disclosure: I will sell my personal shares of General Cable three days after this column is posted.)
New developments on past columns
Why the greenback is back
Glamis Gold (GLG, news, msgs) is bucking a gold industry trend. Usually as gold prices soar, gold mining companies move to increase supply by adding production from mines with relatively low-grade ores. This does indeed boost gold production, but it also increases production costs because the gold mining companies are spending more to get gold from lower quality ores. According to TD Newcrest, a division of TD Securities, six of the 13 mining companies it studied showed a decline in the grade of ore mined and only four showed improving grades (the rest were neutral), with Glamis Gold showing the biggest improvement in ore grades -- 161% better -- thanks to the opening of two new mines with higher grade ores than the company's existing mines. That puts Glamis Gold in the small group of gold miners where costs per ounce of gold produced could actually decline in 2006. With gold prices still in an uptrend, I'm therefore increasing my target price on Glamis Gold to $40 a share by September 2006 from the previous $34. (Full disclosure: I own shares of Glamis Gold in my personal account.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: General Cable and Glamis Gold. He does not own short positions in any stock mentioned in this column.
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