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The Impact of the Chrysler Bankruptcy
RGE Analyst Team | May 8, 2009
On April 30, Chrysler filed for Chapter 11 Bankruptcy protection from its current creditors.  As such, Chrysler will be able to operate as a going concern, while the company renegotiates its debt structure and other obligations.  The U.S. government has described Chrysler’s action as a ‘prepackaged surgical bankruptcy’, in which it hopes that the company will be able to exit the bankruptcy process within 30-60 days.  If Chrysler achieves this, then it will emerge with a new global partnership with the Italian based Fiat. Instead of cash, Fiat will provide the equivalent of billions of dollars in R&D related investments for a 35% stake in the new Chrysler.  However, many experts think that a quick trip into bankruptcy might be unrealistic.
In the administration’s view, cost cuts, implemented by Cerberus and the new management brought in by Bob Nardelli, who cut into Chrysler’s R&D budget and new product development, left Chrysler, the smallest of the Detroit automakers, with a very thin line up of new vehicles.  The Obama administration set partnering with Fiat as a precondition for any further government assistance.  Nevertheless, Chrysler was unable to avoid the bankruptcy process, because some creditors balked at the terms being offered in the proposed debt to equity swap by the government.
Fiat is vying to get a 35% stake in Chrysler, without paying anything for it.  What it brings to the table is billions of dollars in R&D that have positioned it well to produce new cars in the future.  Fiat exited the U.S. market decades ago.   The marriage between Fiat and Chrysler is based on harsh realities, as evidenced by continuing layoffs in Chrysler’s bloated U.S. and Canadian operations, but it seems to be a symbiotic relationship, aimed to help both car makers survive the new realities of an even more competitive landscape.  Moreover it is a reflection of the considerable overcapacities in the global auto sector which may require further consolidation both in several national and international markets.
The short term outcome of Chrysler’s bankruptcy filing may come to determine the path for General Motors, if not the entire U.S. auto industry. If bankruptcy proceedings for Chrysler go as the company and the U.S. government have planned, then Chrysler’s filing may very well turn out to be just a test case before the bankruptcy filing of GM itself.  GM has until the end of May to convince the government that it has a viable business plan to restructureoutside of an official bankruptcy filing for Chapter 11 reorganization.  If it fails to renegotiate its debt and convince its current creditors to undergo a debt for equity swap, as Chrysler failed to do, then GM will have no option but to file for Chapter 11 protection.  GM’s new CEO, Fritz Henderson has vowed to do whatever is reasonably necessary to prevent the automaker from going under including seeking loan packages from U.S., Canadian and European governments (especially Germany). However, GM can no longer afford its extensive European operations and is in the process of looking for bidders.
The significant role the auto sector plays in employment, exports and industrial production have heightened the political importance of responding to their vulnerabilities, which have been exacerbated by the credit crunch, prompting rescue packages including bridge loans, incentives to purchase domestic vehicles and increases in tariffs on imported cars and auto parts.  In the face of rising unemployment in other sectors, governments hope to avoid any disorderly bankruptcy proceedings.
Furthermore, the Chrysler-Fiat merger could set off a chain of consolidations within the auto sector which continues to have significant production overcapacities. Even emerging economies are likely to contribute slower auto demand growth in coming years. In Russia, automakers including Toyota have repeatedly shuttered production and domestic automakers are now increasing car loans in order to encourage purchases. Other countries like China also face the near-term challenge of consolidating its many automakers into several companies large enough to take advantage of economies of scale, increasing their share of the domestic market and possibly expand abroad.
Fiat is also trying to position itself to obtain an ownership stake in GM’s European affiliate Opel. The plan, which includes the other GM subsidiaries in Europe – Vauxhall in Britain and Saab in Sweden, would create a new global auto company with annual sales of up to 7 million cars and €80 billion ($106 billion) in revenues, which would secure Fiat a winning position in the post-crisis market.  The move however is likely to face political hurdles, as neither the German nor Italian governments would like to deal with the job losses (an estimated 8,000-9,000 jobs) likely from such a merger, particularly not in an election year (Germans vote this fall).
According to press reports, Berlin issued a list of conditions for Fiat, which includes stating where the headquarters would be located, where the taxes would be paid, the number of expected job losses and the future of Opel plants in Germany. GM though has the final say in assessing Fiat’s offer. Yet, the German economic minister suggested that Fiat needs German state credits in lieu of adequate financing, which might increase the German government leverage. However, supporting the formation of a global car maker with the German government’s credit guarantees may enrage other German carmakers such as the VW Group, BMW and Mercedes-Benz.
The pressure on domestic jobs has increased the political importance of responding to the automakers woes in many countries. In February, France raised protectionist fearsafter introducing state aid for the domestic car makers in return for an unwritten pledge to keep jobs and production at home. It posed a test for the EU’s single market rules and triggered an angry response from the Eastern European countries that would be hurt the most by the measure. Other countries like Argentina and Russia have increased restrictions on auto or parts imports in an attempt to support domestic industries. These might actually have the opposite effect; those in Russia hurt the business of used car sellers.
However, some government attempts to stoke auto demand may well erode future demand. So-called ‘cash for clunkers’ deals in which governments provide incentives for consumers to trade in their old cars for new (and often more fuel efficient) ones, have had the desired effect, boosting auto sales in countries like Germany and China for the types of cars targeted. These measures are helping to erode the inventory of manufacturers in a relatively orderly manner, but may be deferring the adjustment process that the automakers face. Moreover, rising unemployment is likely to weigh on consumption especially of large credit-dependent purchases like cars.
The bankruptcy also has significant repercussions on the corporate bond market. Chrysler’s bankruptcy filing was preceded by tough negotiations among creditors and the government to conclude an out of court restructuring in which lenders would receive 29 cents on the dollar in cash in exchange for wiping out about $6.9 billion of Chrysler’s debt. A group of about 20 secured creditors refused to sign off on the deal, arguing that their stake was worth more and demanding that their seniority rights be observed. However, recent empirical evidence shows that as default rates increase, recovery rates are falling fast in this cycle. Moody’s reported that in the past seven months, completed CDS auctions resulted in a recovery rate of 30 cents on the dollar for loans and about 15 cents on the dollar for bonds compared to 85 and 70 cents on the dollar, respectively, for all of 2008. The latest research by Edward Altman yields similar results stressing that distressed exchanges to avoid bankruptcy have surged since 2008 and that they usually yield significantly higher recovery rates to participating bondholders. In fact, S&P warns that due to loose covenants and missing early warning triggers, the losses even for secured creditors in this cycle might turn out to be substantial if a company cannot reorganize and liquidate.
Henry Hu from Texas University points to the ‘empty creditor’ phenomenon to explain why some lenders prefer to hold out and force a bankruptcy seemingly against the company’s and thus their own best interest. In short, creditors with enough credit default swaps may simultaneously have control rights and incentives to cause the debtor firm’s value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court. See: Distressed Debt Investors Dictate The Terms: How Big An Issue Are ‘Empty Creditors’ With CDS Hedges? Another example is the case of the Kazakh bank BTA. Gillian Tett reports that Morgan Stanley in mid-April called for repayment of a loan thus forcing the already troubled lender into partial default. The fact that just after calling the loan, Morgan Stanley demanded ISDA to initiate a CDS settlement of contracts written on BTA, exposing Morgan Stanley to the ‘empty creditor’ criticism even if many details are missing. Dynamics of this kind make defaults more likely and need to be taken into account when forecasting the severity of the current corporate default cycle.
But are credit markets finally thawing? Indeed, corporate bond issuance has picked up substantially since December especially in the high-yield segment amid tighter spreads since the immediate Lehman aftermath. On a more cautious note, the IMF notes that given shortening credit lines and still tight bank lending standards (confirmed in the April Bank Loan Officer Survey), corporations are taking advantage of this window of opportunity to refinance themselves in the bond market despite substantially higher costs. An additional factor fueling this frontloaded corporate bond activity is the likely future crowding-out by sovereign and government guaranteed debt. While the high-yield segment has returned 17.4% YTD in 2009, the fate of Chrysler and GM shows that the default rate may not yet have reached its peak.
RGE Monitor