GMAC hidden debt jeopardizes GM’s future

Renewed fears of bankruptcy were raised at General Motors last week, and sharp tremors raced through the credit derivatives markets on the news that huge hidden losses had turned up in GM’s financial arm—GMAC.

Important background to this story was reported March 24 by the Chicago Tribune: “General Motors Corp. announced Thursday it sold an even larger piece than planned of the commercial real estate division of its GMAC financial-services unit.

“The move may help the ailing automaker accelerate the sale of GMAC. GM wants to sell off a majority stake in GMAC to help raise cash to pay for the massive restructuring costs related to closing plants and the buyout of employees announced this week.

“GM said it sold 78 percent of its interest in GMAC Commercial Holding Corp., a transaction that will generate nearly $9 billion in cash for GMAC,” the Tribune reported.

If the real estate division of GMAC was its most profitable or saleable asset, what is left and how much debt remains?

Not a lot of attention has been focused on the derivatives development outside of financial circles.

Further trouble lies in the financial troubles of GM suppliers. Auto parts maker Dana Corp. defaulted last week on $2.5 billion in debt, after Delphi and Tower Automotive crashed last year.

Fears are that the Delphi default alone could push GM over the brink into bankruptcy and fry every major bank in the country. The derivatives at stake here amount to 175 percent of the cash reserves of the country’s 10 largest banks, according to Mike Ruppert, publisher of From the Wilderness. He advises anyone still in the equity markets to cash out fast.

Derivatives are securities whose prices are based on the cost of other underlying investments. The principal types are futures, options, swaps, warrants and convertibles.

GMAC requested a filing delay after fessing up to another $2 billion of debt, found in its accounting methods, according to a report by The Telegraph of London. GM already is linked to an estimated $200 billion in credit derivatives. That has raised fears an overheated credit market could fail in a crisis.

David Wessel, writing in the Wall Street Journal, said the problem is that the derivatives market has grown so rapidly, it has placed an inordinate strain on the infrastructure handling legal, technical and paperwork issues. Wessel said with existing conditions, nobody can be certain who owes what and to whom.

Timothy Geithner, president of the New York Federal Reserve, has been growing increasingly concerned about the derivatives market in the past year. He said that for the most part, the increased use of derivatives has happened under generally favorable market conditions, but “We know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.”

Shortfall in the infrastructure and risk management are most obvious in credit derivatives, he said, where the measure of credit risk “may not adequately capture the scale of losses in the event of default in the underlying credits or the consequences of a prolonged disruption to market liquidity.”

Global investors reportedly are very nervous after the Icelandic krona collapsed. It prompted investor bailouts from as far away as Hungary, Turkey and New Zealand.

Great concern also exists that unified tightening of money supplies in Europe, Japan and America might squeeze out much of the excess liquidity that is fueling the global asset boom.

Geithner noted the $300,000 billion derivatives market has outraced its support system. The flood of new investments may have produced a high concentration of risk. “They have not ended the tendency of markets to occasional periods of mania and panic,” he said. “They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial community from the effects of such a failure.”

The New York Fed was caught off balance in 1998 when a Russian default triggered global bond spreads to widen more than computer models had anticipated or programmed. Long Term Capital Management, a hedge fund that included two Nobel laureates on its management team, ended up on the short end of almost $100 billion in trades on Italian, Spanish and Portuguese bonds plus others, until it was saved by emergency rate cuts. The Fed said then the incident had put the global financial system at risk.

This time around, Geithner is demanding the International Swaps and Derivatives Association take prompt and correct action before any credit crunch takes place. The most obvious problems, he said, are in the $12,400 billion market for credit derivatives, which has doubled each year for the past 10 years.

Derivatives are an easy way to bet on credit quality without actually buying bonds, which have less liquidity. Geithner said the risk is very heavily concentrated, with America’s 10 largest banks holding $600 billion in potential credit exposure on $95,000 billion in notional trades, or 175 percent of their financial reserves.

“The same names show up in multiple types of positions,” Geithner said. “These create the potential for squeezes in cash markets, magnifying the risk of adverse market dynamics.”

Most of the traders are ignoring such warnings. Warren Buffett, a major player in the markets, has been warning about the derivatives problem since 2003. He likens it to a New Orleans levee with Hurricane Katrina bearing down.

Buffett has said it cost his company, Berkshire Hathaway, $404 million to get itself freed from derivatives inherited from its reinsurance group General Re.

“We are a canary in this business coal mine,” Buffett said. “Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully.

“General Re has had the good fortune to unwind its supposedly liquid positions in a benign market. It could be a different story for others in the future,” Buffett told The Telegraph.

Comstock Partners, a mutual fund management firm, commented: “In our view, the derivatives mess is another potential time bomb (among many) that could throw the financial markets into a severe crisis. In the last 30 years, every period of monetary tightening has eventually led to financial crisis. The derivatives market is a leading candidate to trigger the crisis on this cycle, although there are obviously many other candidates as well.”

A number of observers are wondering if General Motors will survive this year as navigating the financial markets becomes trickier and trickier.

As noted in the Tribune article, “GMAC earned $2.8 billion last year while huge losses in automotive operations put GM $10.6 billion in the red.”

From the March 29-April 4, 2006, issue

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