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The major bailout of automakers seems to be focused on giving them financial room for survival while they restructure to make better, more fuel efficient and modern cars. However, if we check under the hood, the bailout might actually be all about bad money management linked to the US sub-prime mortgage mess.
The looming bankruptcy is said to be caused by high fuel prices, changing consumer demand, wages and benefits, and an unexpected downturn in sales as a result of the global financial crisis. There’s little argument those factors play their part in Detroit’s problems. But, in fact, the problems today relate in large part to what auto manufacturers have been doing in the non-manufacturing side of their business. Financing activities through General Motors Acceptance Corporation (GMAC), Chrysler Financial and to a lesser degree so far, Ford Motor Credit, have put at risk the jobs and retirement security of more than 400,000 Canadian workers.
By way of background, General Motors owns 49% of GMAC having sold 51% to Cerberus Capital Management in 2006. Chrysler owns Chrysler Financial but as of August 2007, Cerberus bought 80% of Chrysler from Daimler AG who still holds 20%. Ford owns Ford Motor Credit Co.
The interlocking relationship between manufacturing and financing must be understood. Steps need to be taken to ensure that any bailout package borne by Canadian taxpayers does not find its way to feeding the losses in the financial arms of the auto makers. If not, taxpayers could find themselves footing the bill for not only sub-standard auto loans to US consumers, but also bailing out a good chunk of the US sub-prime mortgage crisis. Without carefully negotiated rescue terms, layoffs and job losses are likely to continue with automakers failing anyway.
Financing arms of automakers were established to facilitate dealer inventories and auto purchases. This relationship was direct and risk underwritten accordingly. The financial side lent money to people to buy and lease cars and was responsible for collecting loan obligations. Funding future loans came from repayment proceeds and from direct debt; the cost of which was a function of corporate bond rating. When market conditions weakened, raising funds from traditional sources became more difficult so manufacturing adjusted and operating strategies more effectively matched economic realities.
Beginning in the early 1990s securitization became a new form of financing for automakers removing their need to rely on debt markets. Securitization takes place when asset-backed securities (ABS) are created from a pool of financial assets, such as auto loans. They are packaged together with the claims on loan repayment being sold in the market.
In 1997 ABS outstanding in the US were about $500 billion increasing rapidly to $2.5 trillion by 2007. Of these, $200 billion were backed by auto loans. What this meant was auto manufacturers had direct access to a new and powerful source of funding auto sales. They effectively front-end loaded consumer purchases. One of the major reasons for the downturn in demand is that the market has been saturated with inexpensive and easy credit terms made possible because of securitization. Many of these loans are now at risk.
Coincident with an increase in auto loan securitization was securitization of mortgages through mortgage-backed securities (MBS). Several major lenders used this market as a way to enter the sub-prime mortgage market. GM was a major player in the sub-prime market. By 2005 GMAC earned over 50% of its net revenue from its mortgage lending activity with total financing profits of $2.4 billion flowing through to GM’s bottom line.
In recent years however, GMAC’s mortgage lending activity has been the source of significant losses. In the third quarter of 2008 it recorded year to date losses of $3.7 billion. This year auto securitization activities also began to deteriorate with rising delinquencies and defaults. For the first three quarters of 2008, total losses in GMAC reached $5.6 billion putting GM on the hook for $2.7 billion.
Securitization isn’t the end of the story. Also important is the relationship between securitization, credit derivatives, and accounting methods used to record exposure. These can be the source of significant future losses.
In an effort to make ABS and MBS more marketable, particularly since the tech bubble burst in 2001, underwriters aggressively tried to minimize default risk through subordination where loan pools are segmented into different tranches. They also introduced a form of insurance called credit default swaps. These enhancements have actually increased risk, volatility and are partially responsible for massive, largely unanticipated losses.
Subordination of securities can result in the issuing agent holding an equity position and facing first claim on any losses. However, in order to place the securities in the first place, the agent may have given up its right to the underlying assets (that is, the cars or the houses the loans were made on). Its quite possible automaker financing arms have significantly reduced access to collateral when loans go sour.
The use of credit default swaps to reduce risk is a complex and sophisticated area of the derivatives market. The degree to which auto financing companies have been involved, either as a buyer or seller of default insurance, would need to be clearly understood. Otherwise, there is a potential for a very long tail of obligations to potentially numerous related financial institutions that has nothing to do with the making and selling of automobiles.
Creative structuring of ABS and MBS in specialized vehicles can allow them to be recorded off-balance sheet thereby reducing capital requirements and providing an appearance of greater return on equity. That is unless market conditions deteriorate and they are brought back onto the balance sheet. More capital can be needed in a hurry.
An effective barrier between manufacturing and financial obligations needs to be established with assurances that Canadian taxpayer money will not used to pay for credit market mismanagement. Last week, automakers asked Ottawa and Ontario for $6.8 billion in assistance. Any funding needs to go to maintaining jobs and supporting communities in Canada, not to paying off the bad decisions of US financial executives in the sub-prime mortgage and auto receivables markets.ß