Saturday, May 9, 2009

Will The Real Chryslergate Fallout Please Stand Up

Now that the issue of those pesky first lien hold outs has been dealt with once and for all, the Chrysler saga audience can turn their attention to the more relevant question of how the bankruptcy will actually affect not only upstream suppliers' production and their employment levels, but the overall domestic and global economy. In order for readers to grasp the magnitude of the 2nd and 3rd derivatives of this implosion, I republish the most recent docket notification list, which demonstrates just how many entities have an immediate vested interest in this case.

More relevantly, the question arises of just what all the Chrysler posturing will imply for the process of the inevitable GM bankruptcy, which as of today is a mere 3 weeks away. If the Chrysler case study is any indication, the administration will once again put the blame solidly on any and all investment fiduciaries (i.e. ad hoc bondholder committee) who are unwilling to relinquish absolute priority, which is not surprising. What is paradoxical, as was in the Chrysler case, is that the administration needs bankruptcy in order to cancel and amend existing contracts, full stop. If Rattner can scapegoat someone in the process of filing GM, so much the better - he would thus accomplish his operational mission of fixing a terminally faulty contractual system and take the political pressure off his master with his core UAW constituency. Of course, the derivative of the latter is that one may very well expect a million man march, fully equipped with tar and feathers, on Wall Street from Detroit come June 1st when the bankruptcy is official.

Thereby the politics of the problem, as Homer Simpson would say, are "wrapped in a neat, little package." And after all, Obama has thus far been a master of the depoliticizing of any economically disastrous issue, and removing any potential blame from D.C. and associated lobby group interests and redirecting to the populist path of least resistance. What would be a curious detour is if the ad hoc creditor committee were to relinquish any claims against their paltry 10% equity in the pro forma company, and thus call Obama's bluff, who would still need to pursue the bankruptcy court route, however this time with no "straw man" scapegoat available.

But the real question remains, now that we are set on the course of epic bankruptcy fall out, bizarro market moves notwithstanding, what really happens to the U.S. economy?

For an attempted answer, I turn my attention to a series of articles by none other than Moody's, which in all fairness, has actually been providing some rather admirable primary research as of late. Moody's focuses on the problem from several angles, the first of which is the question of containment and the fate of GM.
Despite the Obama administration’s assertion that Chrysler’s filing will be “a quick and surgical” reorganization under section 363 of the Bankruptcy code, the process could be more complicated, contentious and protracted than the government anticipates. In addition, it is uncertain whether various government initiatives will be effective, such as those to contain the collateral damage of the Chrysler filing on the rest of the U.S. automotive sector, and the government’s commitment to supporting Chrysler through the bankruptcy process.

It is clear that the Chrysler bankruptcy filing will help define the path that a GM bankruptcy filing might take. However, because of the complex, highly fluid, and largely uncharted nature of many of the legal and operational issues surrounding the bankruptcy of a U.S. auto manufacturer, it is unclear how that path will evolve. It is also unclear whether the bankruptcy filing of Chrysler will materially increase or decrease the likelihood that GM will follow Chrysler down that path. We continue to believe that the probability of a GM bankruptcy is very high, as reflected in the company’s Ca Corporate Family and Probability of Default Ratings.

The ongoing resolution of the Chrysler bankruptcy process will have an important impact on the behavior of GM’s constituents including creditors, the UAW, suppliers, dealers, and the U.S. government, and on their respective willingness to make concessions necessary to avoid a bankruptcy filing. GM has until May 31 to resubmit a viable restructuring plan to the government or it may be forced to file for bankruptcy. To date, the company has not been able to accomplish the three key targets identified by the government as being essential to a viable plan: eliminating two-thirds of its unsecured debt; achieving UAW wage and benefit parity with transplants; and, reaching an agreement with the UAW allowing the company to fund up to half of its future VEBA contributions with company stock.

The legal issues that will be addressed by the court hearing the Chrysler proceedings include: collateral valuation, the potential sale of assets, determinations of adequate protection for secured lenders, the priming of secured lenders’ interest by the government as debtor-in-possession lender, priority of claim of unsecured creditors, and the rejection of burdensome contracts. The court’s determinations in these matters, and the time frame necessary to conclude the proceedings, could well determine the degree to which GM’s various constituents, including the government, view bankruptcy as an effective path for GM.

In addition to the legal issues that the bankruptcy path poses for Chrysler and potentially for GM, this path also poses a number of operational risks. All of the Detroit-3 OEMs have maintained that there are considerable operations risks associated with a bankruptcy filing by any of them. These risks include: 1) a rapid and severe decline in shipments as consumers retreat from the products of a manufacturer that has filed for bankruptcy; 2) a resulting decline in the retail price of vehicles sold by the filing OEM; 3) wide-spread bankruptcies among that OEM’s already stressed supply base; and, 4) increased stress upon other OEMs due to price pressure within the new car market, and the mutual dependence upon suppliers.

The Obama administration and its Automotive Task Force recognize these risks, and have taken a number of relatively aggressive steps to contain the collateral damage and disruption that could potentially result from an OEM’s bankruptcy filing. These initiatives include:
  • Providing government guarantees for new-car warranties of Chrysler and GM vehicles;

  • Providing government guarantees for approximately $5 billion in Chrysler and GM payables due to suppliers.
In addition to these initiatives, which were put in place prior to the Chrysler filing, the government has taken two critical steps intended to support a successful reorganization of Chrysler and limit the disruption within the U.S. automotive sector. These steps are:
  • Providing debtor in possession financing for Chrysler;

  • Arranging for GMAC to provide retail and wholesale financing in support of Chrysler’s operations.
Since December 2008, when GM and Chrysler accepted government bailout loans, consumer anxiety about the ongoing viability of each company has taken a toll on their U.S. shipment levels and contributed to a loss of market share. In contrast, Ford, which has consistently maintained that it does not need government loans, has picked up share. Consumer willingness to purchase Chrysler’s products now that it has filed will be a critical near-term development that will be closely watched for indications of the revenue pressure that GM might face in the event of a filing. We expect that despite government support there would be an initially high degree of consumer reluctance to purchase a vehicle from GM were it to file for bankruptcy. This would exacerbate the pace of cash burn, and increase the level of government loans that would be needed. Nevertheless, we believe that the government will continue to view bankruptcy as an option if GM is unable to formulate an acceptable restructuring plan.

Although suppliers to Chrysler and the other domestic OEMs are vulnerable to an OEM bankruptcy, their greatest risk comes from the production cutbacks that will occur irrespective of whether an OEM restructures in or outside of bankruptcy. Consequently, additional government support for suppliers may be necessary in order to insure the viability of the Detroit-3.
Moody's then goes on to consider the likelihood of just how surgical this bankruptcy could be.
Section 363 provides the basis for major asset sales, rejection of burdensome contracts and the use of secured creditors’ collateral for a company’s “fresh start” envisioned by the code. But it is also structured to ensure procedural fairness for all creditors with an interest in the bankruptcy estate. Property of the bankruptcy estate under section 363 can only be used over the objections of a party with an interest in that property after the issues have been fully litigated in formal hearings. A 363 proceeding would likely include hearings on collateral valuation, among other things, with expert witnesses from each side.

Section 363 mandates that any party with an interest in property to be used in a reorganization receive “adequate protection” in order not to violate the U.S. constitution’s “takings clause.” A security interest is a property interest. In this respect, the U.S. and Canadian governments’ $4.5 billion DIP loan ironically could further prolong the bankruptcy process. The code allows first lienholders’ interest to be primed or superseded (in exchange for a replacement lien) by debtor-in-possession (DIP) lenders provided the “adequate protection” standard is satisfied. “Adequate protection” hearings involve complex issues such as whether secured lenders have a comparable equity cushion in any substituted collateral. In this respect, the holdout lenders also could contest a proposed sale of “good assets” to Fiat under section 363 as not affording them “adequate protection.”

Furthermore, secured creditors contesting a reorganization plan can argue that the value of the collateral in which they have a security interest is well in excess of that proposed that they receive by the plan’s proponents. The bankruptcy code includes a “best interest” test under which each interest holder will receive at least as much under a Chapter 11 plan as it would in a Chapter 7 liquidation. If the holdout lenders prevail in such an argument, they could seek to convert the proceeding to a Chapter 7 liquidation. Alternatively, the reorganization plan would need to be renegotiated so as not to violate the “best interest” test.

All these issues need to be resolved before any vote on a reorganization plan – even if the plan’s proponents have the necessary votes. And given the continuing decline in the fortunes of the auto industry, the plan’s “feasibility” – which they must demonstrate to the court – may become a real issue, particularly if the proceedings become protracted.

Whatever scenario eventually unfolds, the Chrysler bankruptcy is historic and may become either a template or a warning sign for future bankruptcies, such as that of General Motors. At this point, it is difficult to make any predictions other than that the process is likely to take considerably longer than the 30 to 60 days projected by the administration.
Now that the lender hold out issue has been resolved, this might indeed streamline the process somewhat, however in the odd chance that some overbidder to Fiat's stalking horse bid does emerge out of left field, the process is likely to be detoured into a lengthy, burdensome and expensive process: just what all the various lawyers are currently hoping for.

But back to the law of unintended consequences. It has long been Zero Hedge's contention that the ultimate impact on the upstream suppliers to the D-3 is where the pain will be most acute. Moody's agrees.
Chrysler LLC’s bankruptcy will likely lead to further financial and operating disruption within the automotive supplier sector. The ratings of issuers within the sector that are most exposed to Chrysler’s bankruptcy have been adjusted in anticipation of a filing; many have Corporate Family ratings in the Caa category, reflecting an elevated risk that they too may need to seek bankruptcy protection. However, a potential liquidation of Chrysler under Chapter 7 of the bankruptcy code would have a more severe impact on expected loss assumptions for certain automotive suppliers. In such a scenario, further downward adjustments of ratings could be necessary.

In December 2008, we estimated that there was a 70% likelihood that one or more of the Detroit-3 auto manufactures would file for bankruptcy. Since that time, the Obama administration and its Automotive Task Force have taken steps to help mitigate the potentially disruptive effect that an uncontrolled, free-fall bankruptcy could have for the domestic automotive supplier sector. These steps include providing a guarantee of selected automotive supplier receivables through the Auto Supplier Support Program, and actions to support GM and Chrysler vehicle warranties. Details of these programs are developing.

The administration will likely continue to take steps to contain the disruption that might be caused by Chrysler’s bankruptcy. However, given the high level of interconnection among automotive manufacturers, automotive suppliers, and other constituents, uncertainty remains as to how successful these programs will be in providing support for the auto supplier industry.

...Automotive manufactures are continuing to adjust manufacturing capacity to the lower level of consumer demand, while announcing the elimination of certain underperforming models and brands. The radical changes occurring at the automakers will necessitate restructurings of a similar scope among the parts suppliers, and could give rise to more bankruptcies in the industry.
Additionally, the impact on domestic auto retailers should also not be ignored. This is especially relevant as this is a sector that has seen an impressive short squeeze recently, and current shareholders would be well-advised to consider all potential implications from the slow death of the D-3.
We expect the initial impact on rated auto retailers from the Chrysler’s bankruptcy to not be material. As the rated dealers generate a limited portion of their sales from Chrysler products, we expect this event will be manageable, absent contagion spreading to the industry as a whole. Our primary focus for auto retailers from this event will be on liquidity, and assessing whether or not weaker operating performance will reduce headroom under financial covenants for any of the auto retailers’ committed credit facilities.

The larger auto retailers that we rate, listed below, have been reducing their exposure to the Detroit-3 for some years. The exhibit shows the rated universe and their disclosed contributions to total new unit sales from all Chrysler brands (including Dodge, Jeep and Chrysler).

It is important to note that while new car sales are a large driver of an auto dealer’s revenue, profitability is driven primarily by parts and service (particularly servicing cars that remain under manufacturer warranty) and finance and insurance sales. Used car sales are an important, and less volatile, contributor as well.

We have taken a number of negative rating actions in the auto retailing sector in 2009, primarily as credit metrics weakened as consumers deferred purchases of new and used cars and ancillary services. The deteriorating positions of Chrysler and General Motors, specifically, have not been significant drivers of these recent rating actions.

The framework agreed to by Fiat, Chrysler, the UAW and the U.S. and Canadian governments as part of the Chapter 11 filing contains certain elements that will limit disruption for rated auto dealers:

The U.S. Treasury will make available the Warranty Support Program to Chrysler, which will provide a U.S. Treasury backstop on the orderly payment of warranties for cars sold during the restructuring period. This program should help support values of new cars held and to be acquired by auto dealers and facilitate sales to the end consumers.

Chrysler will enter into an agreement with General Motors Acceptance Corp (GMAC) to provide dealer and customer financing. The U.S. Government will support GMAC in its support of the Chrysler business, including liquidity and capitalization.

Chrysler will seek “first day” hearings to honor customer warranties and dealer incentives for those dealers who are expected to be part of Chrysler’s distribution network going forward. Certain higher risk dealers have been identified by Chrysler and GMAC and will not continue with Chrysler. To date, the names of these dealers have not been made public. However, in view of the overall standing of the rated auto retailers, we would expect few, if any, of their individual Chrysler dealerships to be on the list for anticipated wind down.

We do not rule out some level of modest short-term disruption to rated auto retailers as some dealerships are closed and their inventories liquidated and also due to consumer uncertainty in the initial stages of the bankruptcy. We will monitor developments with Chrysler, noting these developments may also create some precedent in the event there is a similar restructuring or otherwise by General Motors in the near term.
Lastly, and perhaps most importantly, is the consideration of the impact on U.S. financial institutions that have numerous and branched interests in both auto producers through direct and indirect exposure.
The bankruptcy of Chrysler and, possibly, of other manufacturers/suppliers will surely affect some banks, although in a limited way. Most directly, the exposures they do have will become impaired. However, the long timeline associated with domestic auto manufacturers’ decline is a primary reason that the rated U.S. banks have relatively limited direct exposures to the Detroit-3. Over a period of several years, banks exited or otherwise reduced their exposures. Those who are still exposed have significantly marked down their assets.

A number of U.S. banks, particularly those with lending concentrations in the industrial Midwest, also have exposure to primary suppliers of the domestic manufacturers. Nonetheless, many banks that remain exposed to the industry have been able to shift from unsecured credit facilities into secured exposures, where possible, and they have been provisioning for possible losses. Therefore, for rated U.S. banks, direct exposure to domestic auto manufacturers and suppliers is largely secured and not a major concentration risk. As a result, we do not consider auto manufacturer or supplier exposure to be a rating driver for any U.S. bank and the developing situation at both Chrysler and General Motors should not have material rating implications for the banks.

Although auto supplier exposures are a risk, the U.S. Treasury’s Automotive Supplier Support Program will likely enhance the viability of the supplier network by supporting payment of a bankrupt manufacturer’s receivables. That, in turn, will support the repayment of credit that the banks have extended to those suppliers. Other ripple affects from a possible bankruptcy will be felt, including those that impact small businesses and consumers in the local communities where manufacturing is concentrated. Local housing markets, already under pressure, will be further strained as unemployment remains elevated. Finally, future business volumes in those communities, potentially both deposits and loans, will suffer.

Despite these obvious challenges, the direct rating impact from any manufacturer bankruptcies will also be limited by the fact that the majority of rated U.S. banks tend to operate in multiple markets and have diversified portfolios. As an example, Comerica (rated B- for bank financial strength and A1 for deposits with a negative outlook) has disclosed a 46% drop in auto manufacturer/supplier outstandings since year-end 2005, to $1.5 billion at February 28, 2009. In addition, Comerica, which until recently was headquartered in Detroit, reported no direct exposure to Chrysler and less than $100 million in combined exposure to GM and Ford.

These balances compare with roughly $6 billion in tangible common equity (including hybrid equity credit). As a result, although Comerica is comparatively more exposed to the auto sector than many of its peers, its overall exposures have been reduced and are manageable within the context of its capital base. We believe that is the case throughout the rated banking universe.

Another potential concern is exposure to auto dealers, either through floor plan lending or through lending against a dealership’s real estate assets. Even if some or all of the auto manufacturers do not go bankrupt, the number of dealers is widely expected to decline significantly. However, the impact on most rated U.S. banks in this scenario is also limited.

This is so because the rated banks have, for the most part, focused on large dealer groups, which are those dealers with multiple locations and multiple franchises, both foreign and domestic. In contrast, smaller dealers that are exposed to only one domestic manufacturer are often financed by that manufacturer’s captive finance company or by a local community bank. Nonetheless, the bankruptcy of one or more domestic manufacturers could result in some credit losses from this business for the rated U.S. banks.
While there are no definitive conclusions to be drawn at this point, the bankrtupcy of Chrysler and, in short order, General Motors, will, just like the bankruptcy of Lehman Brothers, almost definitely comprise a core case study in business schools on the law of unintended consquences. Unlike the Lehman chapter 11, which was at the heart of the financial system and thus its impact was felt instantaneously, the D-3 fallout will be gradual, more pervasive, and as inhibitory measures take much longer to be enforced, likely have a much more adverse and far-reaching impact on both the U.S. and global economy.

The administration has started down a path from which there is no return, and while for the time being everyday cheerful TV appearances can mollify and suspend disbelief in what is happening due to the phenomenally orchestrated bull market now in its 10th week, the instant rationality returns (again, not if but when) to the market and cooler heads prevail, we will see the same market response as was witnessed in the days and months after September 15th, only this time, there will be no quick acronym-alphabet soup fix. Sphere: Related Content
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