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GM & Ford: Are Credit Derivatives Markets Really Efficient?
April 20, 2006

GM & Ford: Are Credit Derivatives Markets Really Efficient?

In the market for credit derivative swaps, General Motors (NYSE:GM) is currently trading around 2,000 bp or 20% for five year protection against a credit default, while Ford (NYSE:F) is trading around half that level or a 10% probability of default or "P(D)".� We tend to be a little more sanguine about the prospects for the latter, but it is clear, to us at least, that rising gasoline prices are a more important factor that the�prospect of a UAW strike when assessing�the P(D) for both GM and F.

At the NY Auto Show, GM CFO Fritz Henderson told the FT that "the first rule as CFO [of GM] is do not run out of money." Henderson went on to say that "if we were where we are but delivering 50 percent more Cobalts [cheap Chevrolet saloons] and 50% fewer sport utes I wouldn't be so calm."

If expectations regarding higher�gasoline prices in the US this summer�and resulting retail auto sales trends for�2006 are right, then GM may be headed precisely for the situation Henderson describes, forcing�both GM and F�into bankruptcy due to falling sales. Stable revenues are a necessary condition for GM and F to avoid default, thus the question: Why is GM trading at only a 20% implied P(D) in the CDS markets?�

Kevin Tynan at Argus Research tells the IRA that 2006 is "much scarier than 2005" for GM. "The Big 3 had to deal with $3 per gallon gasoline for three months in 2005. In 2006, we could see gas prices go over $4 and stay there. In the event, this implies a collapse in GM sales."

Tynan notes that GM truck sales were down 7% in Q1 2006 vs the year earlier, this even with the introduction of the new�products.� In March, sales at GM and Ford were down 14% and 4.6%. Toyota's sales were up 6.9% while DaimlerChrysler's increased 2.9%. Together, the Big 3's market share was 56.5%, down from 59.4% last year.

By no coincidence,�investor Wilbur Ross, who has been gobbling up failed auto parts companies like Homer Simpson eating discount lunch meat,�says that the Big 3 face the risk this year of lower sales, market share losses, and more consumer demand for smaller cars. If all three occur, Mr. Ross says that the effect would be "a business environment as hostile as Hurricane Katrina."�

As in the case of the pricing in the CDS markets for credit default protection on GM, observing Mr. Ross investing in the North American auto parts sector makes us wonder whether�even sophisticated market participants fully appreciate how close both�GM and F are to�the precipice.� If GM and�F survive to the end of the decade, both companies must move a substantial portion of their manufacturing and parts sourcing�offshore, most likely to Asia.�

So,�Mr. Ross, tell us again why you are so keen on buying US-based auto parts companies?

Bottom line: If gasoline prices move into the $4 range in the US this summer, then the P(D) of GM is likely to be a lot higher than 20% by Labor Day.� And F will not be far behind.� So much for efficient market theory.

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