Swaps: It’s Bailout or Bankruptcy for Carmakers

New price data on credit-default swaps written against Ford and GM point to a government rescue or bankruptcy, with no middle road.
Marie LeoneDecember 5, 2008

While executives from the Big Three automakers made their case to Congress for a government bailout last week, at least one investment banker had his eye on the price of credit-default swaps for Ford and General Motors. At last look, the car companies had “an either/or situation,” says William Welnhofer, managing director at asset-management company Robert W. Baird. The automakers either get the government rescue they have been asking for or file for bankruptcy, he says.

Welnhofer backs up his grim prediction with new data from the Baird CDS Index, which indicates that the cost of insuring against a credit default by Ford or GM doubled last month. But “the situation is changing day by day, hour by hour,” says Welnhofer, who told that the price of Ford and GM CDS contracts has fallen since the car company executives headed to Capitol Hill last week, and a rescue has become more likely.

On the last business day in November, the cost of the premiums paid to insure $10 million of reference debt over a five-year period was $11 million for GM and $7.2 million for Ford — twice as much as buyers paid in October. The cost is based on Bloomberg price quotes on CDS contracts and represents the present value of the premiums paid.

But by December 2, the cost of insuring against GM’s debt default had dropped to $8.5 million, while Ford’s contract cost sunk to $6.7 million. “The price of CDS contracts is falling as the risk of default lessens and possibility of a bailout increases.” GM, Ford, and Chrysler are “effectively closed out of the capital markets,” says the investment banker. “The only capital available to them right now — outside of bankruptcy…is from the Federal government.”

This is the first time the Baird CDS Index has identified “imminent bankruptcies,” contends Welnhofer, who says that was never the purpose of the index. In fact, the companies in the index were selected for their long-term viability so the benchmarking tool would be able to track the price of credit risk for a wider universe of companies.

CDS contract prices rise and fall on the transaction of two kinds of CDS buyers: lenders and bondholders, as well as speculators, such as hedge funds. For lenders and bondholders, as the price rises on Ford and GM CDS contracts, the cost of the hedge rises, “and all things being equal, this extra cost is usually reflected in higher borrowing costs” for the car companies, explains Welnhofer.

Speculators make money a different way. As the perceived risk of bankruptcy rises, so does the value of the default insurance, which allows speculators to offset their long credit-default positions by selling the CDS contracts at higher prices. In the end, they collect an investment profit on the spread, says Welnhofer.

The index, which was launched in January 2006, identified a rising credit risk in July 2007, when the subprime-mortgage crisis produced the first pronounced jump in the index — from below 100 to 146. Since the collapse of Lehman Brothers in September, however, the index has skyrocketed, climbing to 365 on September 30, 554 on October 31, and 905 on November 30, for its fifth-consecutive record monthly high.

“Despite unprecedented government intervention, there is extreme sensitivity to counterparty risk, which is now being felt by the nonfinancial companies represented in the index.” Witness the doubling of CDS contract prices for index companies Lear Corp. — an auto-parts supplier — Lyondell Chemical, Smurfit-Stone, and Unisys in November, says Welnhofer. What’s more, he believes the deepening recession is exacerbating the problem, and that the likelihood of a credit default by those nonfinancial companies will “rise dramatically.”

However, Welnhofer points out that anyone tracking the index should be aware of two important caveats. Severe CDS contract price hikes don’t always mean that bankruptcy is a foregone conclusion. The data simply indicates that the risk of bankruptcy “has increased dramatically.”

He also says that the contract cost calculation can be misleading if speculators believe a default is imminent before the five-year period is up. That leads some buyers to snatch up the contracts regardless of the price because they assume they won’t have to make very many premium payments before the companies default.