The two credit events the world's bond investors have been most dreading came together at about 1pm yesterday (Thursday) afternoon in New York.
The downgrades hit the market faster and more severely than anyone had been expecting in recent months, as S&P dragged General Motors and GMAC down two notches from BBB- to BB and cut Ford and Ford Motor Credit down to BB+ from BBB- and placed all four on negative outlook.
Ford and GM spreads in the dollar market widened more than 100bp on the day, while the rest of the market was frozen by the realisation that the high grade bond market as they knew it no longer exists.
The meltdown was worse in GM, partly because its bonds had tightened by as much as 90bp on Wednesday on news that billionaire Kirk Kerkorian, who is credited with having saved Chrysler, was planning an $868m investment in its stock to take his stake in the company up to 9%.
However, the wilder predictions that the credit market could collapse if Ford and GM were downgrade appeared wide of the mark.
Spread volatility was largely confined to the car industry, if only because investors were still working out the ramifications of an index re-weighting.
"The rest of the market was pretty much frozen, as all anyone wanted to think about was what to do with their auto exposure and what they should be buying in place of it," said one syndicate manager.
As of March 31 this year, GM had $291.8bn of consolidated debt outstanding and Ford $161.3bn outstanding. Of that $450bn total, about $100bn is unsecured bonds in dollars.
"This is a seminal event for the credit markets," said Edward Marrinan, managing director and head of credit strategy at JP Morgan in New York. "We now have two of the three biggest corporate constituents in high grade bonds facing index ejection and the ramifications of ejection are considerable. Perhaps the most important is that GM and Ford now need to find a new investor sponsorship from an amalgam of the high grade and high yield communities."
One global head of high yield at a European investment bank said on Tuesday — when, like many in the bond market, he expected GM to be downgraded within a matter of months and Ford perhaps six months later — that the auto firms' arrival in the high yield market would cause a temporary upset in that market, but that the market would cope with it.
Market participants had expected S&P to give Ford and GM until the second half of the year to show some improvement before downgrading them, but Scott Sprinzen, chief auto analyst at S&P, said he had been taken aback by the speed of deterioration in the financial performance of both GM and Ford in the first quarter.
Last month GM announced a $1.1bn first quarter loss and suspended its earnings guidance for this year. Sprinzen said both Ford and GM had been hit badly by a downturn in sales of sports utility vehicles (SUVs) due to rising fuel prices and increased competition in that market from Japanese car makers. GM had been further burdened with punitive health care costs for its employees and retired staff.
"The impact [of deteriorating market share for Ford and GM] on financial performance has been dramatic," Sprinzen said in a conference call on Thursday. "You have seen that with the successive earnings revisions at Ford and at GM there is a reluctance to even offer guidance."
The global head of high yield said: "My view is that Ford and GM make second rate cars. They can become unreliable after a couple of years, they often have yesterday's technology and they don't look as good as Japanese cars. And they're having to give them away to customers.
"They have to get the cars right. If you make a product that people actually want, you start to have pricing power and you can build up the margin to deal with the other issues — the astronomical retirement costs and union contracts that are from a different age."
Back in the index by July?
Further complicating matters is the fact that the downgrades have come at a time when inclusion rules for the Lehman Brothers Corporate Bond Index are in flux.
Under current rules, a junk rating by either S&P or Moody's means ejection from the high grade index.
In January, however, Lehman Brothers altered its rules for the index, precisely to cope with the risk of a Ford or GM downgrade. The bank now allows a company with one junk rating to stay in the index, and ejects it only when it gets two speculative grade ratings out of Moody's, S&P and Fitch.
But S&P has moved faster than Lehman expected, and the new rules only come into force on July 1.
"We are facing a scenario where $100bn of auto bonds will fall out of the index at the end of this month and then, if Moody's and Fitch don't do anything, will be back in again at the end of the next month," said one head of global bond syndicate. "That's the reason why auto spreads have been all over the place today — in 50bp one minute, out 70bp and now they're more than 100bp wide."
Market dislocation is not expected to last long, however, and already bankers are looking forward to the opportunities to be had from the improved risk-reward dynamics in the high grade market, now that GM and Ford have gone.
Take out GM and Ford's $100bn of high grade bonds and the Lehman index trades 13bp tighter, for instance.
"It could be a positive in that you now have an index that trades 13bp tighter and individual credits looking relatively cheap to the index as a result," said one banker.
The market will be more concentrated in the financial and telecom sectors, making borrowers that offer diversity even more sought after by investors.
Long road back to health
If S&P's gloomy outlook for the two firms is any guide, it will be some years before GM and Ford claw their way back to investment grade status.
GM, in particular, is in dire straits. Sprinzen has little faith in current management being able to turn around GM's competitive disadvantages.
"Even with the extensive efforts to renew its products, GM continues to lose market share in North America, despite an aggressive pricing strategy — and we believe the company's reliance on discounts has itself been detrimental to its brand equity," he said.
GM recorded losses of $1.56bn in its key North American operations during the first quarter.
"We believe profitability could remain poor for the rest of this year and prospects for a return to adequate profitability in the next few years are becoming increasingly uncertain," Sprinzen added.
GM, Ford and their respective financing arms are expected to be shut out of the unsecured debt markets for a time and will have to rely on other sources of financing, like asset backed securities and 'whole loan sales' — selling portfolios of car loans to banks.
The financing arms of both firms have prepared well for the downgrade and have both diversified their forms of funding in recent years by securitising more assets and selling whole loans.
Analysts expect both GMAC and Ford Motor Credit Corp to be able to fund themselves for several years without having to go to the unsecured debt markets.
Even so, Sprinzen is concerned about them relying too heavily on the secured markets and what effect that could have on the subordination of unsecured bondholders.
"If GMAC remains heavily dependent on ABS funding this would be detrimental to the asset protection for unsecured debt holders," Sprinzen said.
GMAC has investigated ways in which it could obtain higher ratings than GM and has moved to ringfence some of its assets.
This week GMAC completed a long awaited transfer of the ownership of both GMAC Mortgage Corp and Residential Funding Corp. Both are now held by Residential Capital Corp, a wholly-owned indirect subsdiary of GMAC, which will seek its own credit rating.
"Given the advantages to a finance company of having a higher credit rating, GM could restructure the relationship between itself and GMAC to allow GMAC to receive a higher rating," Sprinzen said. "Elements of such a plan might include the sale of a significant ownership stake in GMAC to a third party, installation of independent board members and the inclusion of relatively comprehensive and restrictive financial covenants in borrowing agreements."
There is also the possibility that Kerkorian, in his bid to maximise shareholder returns, might force management to turn GM round aggressively by selling off GMAC or some of its assets.
Apart from an improving financial performance, Sprinzen said he would want to see two things happen to GM: reaching an agreement with trade unions to get some relief on health care costs and introducing a solid group of new products that would improve its competitive position in North America.
