GM bankruptcy, U.S. debt threaten recovery

General Motor Corp.'s expected bankruptcy filing and massive U.S. Treasury debt issuance this year will drive up the cost of capital, at least in the short term, threatening the incipient economy recovery, managers say.

“It's like a stone that gets thrown into a lake: the bigger the stone, the bigger the ripple,” said Jonathan Rosenthal, co-portfolio manager at Saybrook Capital LLC., a Santa Monica, Calif.-based hedge fund, fixed-income and private equity manager.

“It doesn't get any bigger than GM.”

The question is how big of a risk premium investors will demand from the government and corporations.

Some investors, such as Mr. Rosenthal, believe that unsecured bondholders were shabbily treated in negotiations with the government and GM, and that will escalate risk premiums.

Under a restructuring proposal GM unveiled May 28 in a Securities and Exchange Commission filing, the Department of the Treasury would initially own 72.5% of a new GM company; the UAW voluntary employee beneficiary association, 17.5%; and unsecured bondholders, 10%.

In addition, the bondholders would receive warrants to acquire 15% of the new GM, exercisable over the next 10 years as new shares are issued. Ultimately, the bondholders could wind up owning more than 15%, should they exercise the warrants, depending on the dilution any new shares has on the bondholders' 10% initial equity and the original equity of the Treasury Department and the GM VEBA.

The new GM would have $17 billion in debt, including $8 billion owed to the Treasury and $2.5 billion to the VEBA.

This proposed restructuring goes against the laws of “financial physics,” said Mr. Rosenthal “What the government tried to do in Chrysler (LLC) and what it is doing with GM is allowing the union claim to step in front of the bondholders.”

“When you move pieces in unpredictable ways, worldwide investors feel that risks are higher and the U.S. becomes a less attractive repository of capital. and they will require higher return,” Mr. Rosenthal said.

The higher cost of capital will affect every business that relies on debt. Middle-market companies whose loans are variable and based on the London interbank offered rate will see their debt costs soar, leaving them less operating capital and forcing some without sufficient cash reserves to go out of business, he said.

Milton Ezrati, senior economist and strategist for Lord, Abbett & Co., Jersey City, N.J., agrees there will be a hike in the cost of capital, but he's hoping the impact will be small and short term.

“It's easy to exaggerate the effect (on the cost of capital) because other investors will say it (GM) is a special emergency situation and does not mean we have rescinded the rule of law in the United States,” Mr. Ezrati said. “People may demand a little premium for a while ... for 12 to 18 months.”

If the government orchestration of GM's bankruptcy remains an isolated incident, investors will stop requiring a premium to invest in U.S. Treasuries, corporate bonds and equities, he said.

Andrew W. Bischel, president and chief investment officer of SKBA Capital Management LLC, San Francisco, said about the anticipated GM filing: “I don't think it will have a big impact because the bankruptcy is so widely anticipated.”

GMs expected Chapter 11 filing will come just as investors have begun renewing their appetite for corporate debt, including high-yield bonds.

“What we've seen in the last couple of months is yield spreads between corporates and Treasuries have narrowed,” said David A. Hershey, managing director and senior portfolio manager at Lotsoff Capital Management, Chicago. “Asset-backed securities' spreads have narrowed, too.”

However, a spike in bond yields last week could pose a more serious threat. The 10-year Treasury bond yield jumped rose to 3.67% May 28 from 3.19% May 20, according to the Treasury Department. It was 2.46% at the beginning of the year.

Robert Tipp, chief investment strategist, Prudential Financial Inc.'s fixed-income management in Newark, N.J., expressed concern an expected $2 trillion in debt the Treasury expects to issue this year will push rates up further.

“To let the rise in Treasury yields go unchecked will revive investors' concern about the ability of the economy to recover because interest rates are going up,” Mr. Tipp said. “That will also spook foreign investors, who see their wealth threatened.”

“If the economy doesn't recover, it will be hard to get the (federal) deficit under control,” Mr. Tipp said. “The rise in rates threatens the economy, which leads to more issuance of Treasuries,” putting more pressure for a rise in rates.

“This is crunch time,” Mr. Tipp added.

Lotsoff's Mr. Hershey is not alarmed. The rise in rates “is a sign of better credit market conditions, when so much has been related to a flight to quality and a fear of risky assets,” Mr. Hershey said. “It's a sign of health in the economy.”

“We've had a significant (rise) of 50 basis points in the last week” in the Treasury 30-year bond rate, Mr. Hershey said. “The increasing yield might be related to better economic fundamentals and better credit markets,” greatly assisted by the Fed's plan to buy Treasury and mortgage-backed securities to help stabilize the markets.

In the credit markets, one- to three-year AAA and AA asset-backed securities, which yielded 5.5 percentage points over LIBOR in December, now “are more like 200 basis points over LIBOR,” Mr. Hershey said.

“That is a positive sign” for the economy and markets, he said. “These are securities collateralized by credit cards and car loans. So for consumers in the economy, it's lowering the cost of their ability to borrow and spend. It's improving their access to credit.”

A big reason for his optimism is that federal government programs to stimulate the credit markets are working, Mr. Hershey said. In particular, the Term Asset-Backed Securities Loan Facility is helping revive the credit market for consumers and the Public-Private Investment Program — expected to start in July — should enable banks to shed bad debt and bring in fresh capital, he said.

Brett Hammond, chief investment strategist for TIAA-CREF, New York, said there is plenty of room for money managers to position portfolios to reap positive returns in the coming year or two.

“The good news is that if you are a good equity manager you have been seeing this coming for a long time and you will have already positioned your portfolio,” Mr. Hammond said.

TIAA-CREF will seek to identify expected survivors in the auto sector as well as in consumer-related sectors such as durable goods and consumer discretionary — anything consumers will touch.

The stock market run-up just as GM is entering a possible bankruptcy shows that investors are optimistic that eventually GM will recover and, slowly, so will the economy, Mr. Hammond said.

“There will be a shakeout,” he said. The economic crisis is separating the winning companies that have the cash flows and reserves to survive a downturn and those companies that don't, he said.