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Wag the Swap: Auto CDS Spreads Rally as Fundamentals Slip
August 21, 2006

Wag the Swap: Autos Rally as Fundamentals Slip

We periodically like to return to a basic question which confronts all risk professionals: Are Equity Markets Complete and Sufficient to Predict Default Probabilities? Each time we ask this question and look, by way of illustration, for answers in the booming market for credit derivative swaps, the answer which comes back is a resounding "NO." Yet despite evidence that equity prices are entirely inadequate for predicting defaults, most if not all market participants carry on using internal Merton�models and products supplied by the major risk solution vendors which rely on efficient market theory.

Consider trading in equity and CDS focused on the US auto sector. Over the past several months, the market value of Ford Motor Co (NYSE:F) fell to near all-time lows, with the share price coming close to $6 in late July. Since that trough, F had�to redouble restructuring efforts in the face of market share erosion, additional financial losses and an embarrassing restatement of pension liabilities -- all indicators that management still does not have a firm grip on the corporate wheel. To read F's summary financial risk flag analysis from the IRA Corporate Monitor, click here.

And yet, over the past several weeks, F's market value has miraculously rebounded. The stock price rally began�in late July�and�gained momentum with the announcement that CEO Bill Ford hired former Goldman Sachs (NYSE:GS) M&A; whiz Kenneth Leet to serve as a strategic adviser. By mid-August, the stock rose�to over $8 per share or more than a 25% gain�in about 30 days.� F common�closed on Friday at $8 on the nose.

The story is much the same in CDS.� At the end of last week, F was trading inside 700 basis points for five-year swaps, while General Motors (NYSE:GM) was trading closer to 600bp, implying a remarkable single-digit probability of default in each case. In the past month, F CDS rallied over 350bp while GM has come in 250bp, closely tracing equity market gains for both names. Could it be just a coincidence that�credit derivative�spreads have tightened for GM and F at the same time that the equity markets were rallying?�

Once again, it seems that the efficient market theory equity tail is wagging the credit market dog, especially when you note that F is rated only "B" by Fitch Ratings, a default probability rating which roughly equates to 1,200bp CDS spread. Indeed, judging by the tight spreads for GM and F visible in the CDS market, Wall Street hedge funds and ibankers seemingly believe that a transaction involving F is imminent, meaning that there will be short-term profits for all willing to take the risk of owning F shares or being short the credit default swap.

Some observers speculate that Leet, the third former GS banker turned�insider and now advising Bill Ford, may be leading an effort to sell the entire company, pushed by members of the Ford family. It is suggested that the Ford clan may have finally lost patience and are seeking an exit strategy that will salvage some part of the value of their investment. The Detroit News reports that the Ford family eventually may have to give up some control to save the company.

Besides the prospects of a C-Suite change or sale, another factor behind the rebound in the valuation of F seems to be the willingness of large Wall Street hedge funds and brokers to buy into a down-on-its luck story. Several Sell Side firms have upgraded recommendations on F even as they have downgraded peer GM.

Bear, Stearns & Co (NYSE:BSC), for example, noted after upgrading F: "We believe most of the good news is behind GM but ahead of Ford. At the margin, we're buyers of Ford's on-the-come restructuring news and sellers of GM's sales-dependent recovering, consistent with our thesis that the way to make money on the Detroit Big Three is to trade around turnarounds."

The irony is that the bond and credit markets, blinded by credit risk models which employ stock prices to assess default probability or "P(D)", still do not recognize just how serious the financial situation facing F has become -- and just how little time remains for F to avoid bankruptcy if monthly sales results continue to crater -- with or without Bill Ford behind the wheel. As we noted in Barron's last year, �"dependence on price-based risk models contaminates every aspect of modern finance."

No amount of C-Suite change or investment banker spin can compel energy-shocked American consumers to buy Fords, Volvos or Jaguars. This reality will eventually surface, we believe, in a sharply lower share price and widening CDS spreads -- that is, when the credit derivatives markets stop watching short-term stock price moves and re-focus on F's dismal fundamentals.

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