Today's Market Observation 06.01.2009 Mon Tue Wed Thu Fri Kirby Archive
Auto Companies
Forensic Examination of Their Woes
BY ROB KIRBY | june 1, 2009
A couple of weeks ago in this space in an article titled, Theater of the Absurd: a view from the inside, a case was made that Interest Rate Derivatives, not credit derivatives, are the ‘root cause’ for the macro economic problems our global financial system is currently facing.
The gist of the piece explained how interest rate swaps [IRS], specifically, have been utilized by agents of the Federal Reserve [primarily J.P. Morgan and Goldman Sachs] to “neuter usury.” Because IRS greater than 3 years duration typically have U.S. government bond transactions embedded in them – the cancerous growth of outstanding notional amounts of these instruments [beginning mid 1990s time frame], absent end-user demand – effectively gave these players [the Fed in drag] control of the ‘long end’ of the interest rate curve, beyond the historic, accepted and generally understood purview of the Fed – namely, the short term Fed Funds [overnight] rate.
Source: U.S. Comptroller of the Currency
Prior to the proliferation and explosive growth of interest rate swaps, values at the long end of the interest rate curve were determined by a breed of investor / trader known as the “bond vigilantes” who regularly enforced corrective and sometimes bitter discipline on the bond markets when naturally spend-thrift governments incurred too much debt. The IRS edifice that was created was so overwhelming – and created so much artificial demand for government bonds - it “steamrollered” the bond vigilantes into extinction.
Source: U.S. Comptroller of the Currency
The explosive growth of outstanding interest rate derivatives notionals was concurrent with increasingly substantive changes to inflation reporting, which has been so meticulously documented by John Williams of Shadow Stats fame, which provided the intellectual ‘cover’ / excuse necessary to explain the wholesale, fraudulent, gross mis-pricing of capital which followed.
In response to the article Theater of the Absurd, I received a great deal of correspondence from folks seeking further commentary and explanation as to exactly how this mis-pricing of capital has impacted things in the real world.
So here’s a snippet of how this mis-pricing of capital has contributed to our current situation:
The Auto Companies' Problems are Not Really of Their Own Making
I’ve written about this before but it bears repeating. Today, General Motors filed for bankruptcy protection. Their demise has been widely followed for years with a great deal of commentary regarding their sinking fortunes centered on ‘legacy costs’ or spiraling expenses being borne by their pension plan.
Some Background On Pensions
Auto workers' pension plans were, for the most part, devised and modeled by actuaries 50 - 60 years ago. The framers of these plans were smart. They well understood the math, or rather, the demographics of their work forces. They knew and were able to model and plan how much capital would need to be set aside over the years to meet their future obligations. Implicitly in their models, these actuaries used "assumptions" on expected rates of future return; namely, that fixed income investments would return a minimum of the real inflation rate + 250 [or so basis points].
It should also be understood that pensions - broadly - fall into two broad categories:
Defined Benefit Plans - In a defined benefit pension plan, an employer commits to paying its employee a specific benefit for life beginning at his or her retirement. This type of pension plan was more common pre 1980s.
Defined Contribution Plan - In a defined contribution pension plan, the amount of the contributions are set in advance. The amount of the eventual retirement income is not set in advance. A member's retirement income will depend on several factors, including the total amount accumulated in his or her account:
- the member's contributions, if any
- the employer's contributions
- sums transferred to the member's account, if any
- interest earned
Foreign auto makers’ pension plans are almost exclusively Defined Contribution Plans. Most North American pensions today [since 1980] are also Defined Contribution Plans.
Understanding how changes in inflation reporting have adversely impacted the auto company's pension plans is KEY to understanding why the auto companies are in the financial straight-jackets they now find themselves.
Auto companies labor contracts stipulate that pensions are of the Defined Benefit variety. Additionally, labor contracts with the car companies have traditionally required the car companies to keep their pensions "fully funded" meaning that any shortfall in pension performance required the subject company to "top up" the fund out of operating revenue.
So, as health care costs escalated in the real world at the real world inflation rate, PENSION ASSETS [or the fixed income portion thereof] were only earning a FALSE rate based on corrupted or "rigged" interest rates.
To get your head around how debilitating this was:
In recent years General Motors has had pension assets under management of roughly 100 billion. Their asset mix is roughly considered to be along traditional lines of 55% - 65% invested in equities and 35% - 45% invested in bonds [fixed income]. Using the mid-point on the fixed income allocation, this means, by extension, that GM's pension assets have roughly 40 billion invested in bonds [fixed income] or equivalents.
Now, if interest rates are 800 - 1000 basis points lower than modeled expectations - this amounts to a 2 – 5 billion per year shortfall in pension asset return from that which was modeled! This cancerous shortfall has been funded year-in-and-year-out by the auto companies and has had a disastrous material impact on their financial positions. These funds were not available to be reinvested back into operations to improve the product.
The situation described above is a logical outcome which confirms and reinforces the work of John Williams. This is an outcome that has afflicted virtually all legacy defined benefit pensions - **with the exception of the defense-related industries** - from the steel industry to the airlines. They've all shared, more or less, the same fate arising from benefit costs being bourn in the real world versus income being derived by falsified fixed income benchmarks.
The Danger of the Military-Industrial Complex – The National Security Thing
**Of course, the beloved defense industry has always been “unaffected” by this debilitating drain on their resources because their defined benefit pensions have clauses that allow them to pass on any deficiencies that arise in their plans through increased costs of goods provided. That’s the real reason why their financial positions remain relatively healthier and it also explains why stealth bombers are 3 billion bucks a copy.
Today's Market
Overseas equity markets began the week with "pop" with Japan's Nikkei Index gaining 155 points to 9.677. North American markets were also unfazed with the GM bankruptcy filing with the DOW gaining 221.10 to 8,721.40, the NASDAQ adding 54.35 to 1,828.68 and the S & P ahead by 23.70 to 942.85. NYMEX crude oil futures gained 2.00 to end the day at 68.31 per barrel.
In the interest rate complex the benchmark 5 yr. government bond finished the day at 2.52% while the 10 yr. bond ended the day at 3.68%.
On foreign exchange markets the U.S. Dollar Index fell .30 to 79.15.
Precious metal ended a topsy turvey day with COMEX gold futures down 4.80 to 975.80 per ounce while COMEX silver futures fell .22 to 15.61 per ounce. The XAU Index dropped 1.49 to 158.67 and the HUI Index lost 9.57 to close at 388.49.
On tap for tomorrow, at 10:00 a.m. April Pending Home Sales Data is due - expected +.5% vs. prior +3.2%. Then at 2:00 p.m. May Auto Sales data - last 3.2M and May Truck Sales data - last 3.8M is due.
Wishing you all a pleasant evening and successful investing!
Rob Kirby
Registered Representative
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