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Exposure at Default: Delphi Files Bankruptcy -- Is GM Next?
October 11, 2005

In May, we predicted that a bankruptcy by one of the major tier one auto suppliers would begin a legal and financial process that would eventually lead to the restructuring of General Motors (NYSE: GM) and/or Ford Motor (NYSE:F). GM's former subsidiary Delphi Corp (NYSE:DPH), in fact, filed in New York on Saturday.

Daily Bankruptcy News reports that Delphi joins Collins & Aikman, Tower Automotive and Intermet among the major auto parts manufacturers in Chapter 11. We believe that GM, Ford and Visteon (NYSE:VC) may eventually go down this same road in order to escape from their pension liabilities and to finally kill what remains of the United Auto Workers union.

The DPH default has caused yet another ripple in the $14 trillion market for credit derivative swap contracts or "CDS" for short. Today, five year default cover for GM jumped from 500bp to 800-900bp over money, a mere 100bp bid-offer spread. Five-year GMAC rose to 520bp over money from 400 prior to the DPH filing.�

F moved sharply higher to 640-660bp this morning in New York for five years while Ford Motor Credit rose to 465-475. Note that both GMAC and FMC are cash-positive, self liquidating entities, but the CDS market is in a growing panic over the prospect that either of the major auto makers will be forced to file for court protection.

We hear that the steepness in the CDS curve for GM has caused the management of several banks to cut back exposure to F and GM alike, forcing the hedge funds that play in CDS to do likewise, thus the spreads on these names have widened from a 5-10bp market to a 50bp market, the tell-tale sign of falling market liquidity. Shorter-duration CDS contracts were not even being quoted for much of the morning in NY today.

We take no pleasure in being right about our earlier prognostication regarding a Chapter 11 filing by DPH nor in our overall negative view of the sector. The DPH filing, however, may highlight some important issues and opportunities facing F and GM, and the financial markets:

First, GM and F must start to aggressively move to separate their credit vehicles from the operating units, perhaps in preparation for a partial Chapter 11 filing by the respective operating units that excludes the finance vehicles. A lot of work has already been done in both cases, but it may be time to bring in the private equity funds to take GMAC and FMC off of the balance sheets of their respective parent companies, transactions that will generate a lot of cash for the operating companies.

Second, both GM and F must face the reality that DPH and VC are probably not viable as independent entities and may need to be re-acquired out of bankruptcy. As we wrote in May, allowing DPH and VC to go through Chapter 11 would save GM and F a lot of trouble in terms of restructuring costs and dismantling�the UAW. No doubt there will be securities fraud litigation against GM with respect to the DPH spin-out several years ago, a pattern that may repeat with respect to F and VC.

Finally, while we believe that GM must almost certainly go through Chapter 11 itself, F is another matter. Without FMC on its balance sheet and with the proceeds of the sale of a majority stake (not to mention the proceeds from the Hertz transaction), F would be flush with cash and thus might be a good candidate for a going private transaction, as several analysts have already opined.

If Bill Ford can take a page from his Uncle Henry Ford II's playbook and stare down the UAW, forcing them to accept the terms imposed by the bankruptcy court on DPH and eventually GM, he may be able to take his family's namesake private and preserve the independence of an American icon. Below $9, F's market cap is just $17 billion and net automotive�debt, excluding FMC, is in low single digits, a mid-size private equity transaction by today's standards.

So the good news is that the market uncertainty may provide CEO Bill Ford an opportunity to reclaim full control over F. The bad news is that the rest of the auto sector is headed down the restructuring meat grinder, including VC and many members of the auto parts sector not already under court administration. This process of rationalization could take a big chunk out of the liquidity in the CDS markets and the capital of banks and funds unlucky enough to be long Detroit. Such is life in the derivative economy.

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