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Current State of Auto Industry

Synopsis
The long-awaited sale of GMAC is positive for GMAC’s credit quality (assuming the transaction closes), but neutral for GM’s credit quality. With the deal, GMAC is far less vulnerable to being exposed to a GM credit quality decline and GMAC might be able to return to an investment grade rating, particularly if Cerebus is able to stabilize GMAC's credit quality and bring in an investment grade partner in the near future (we have placed GMAC on positive watch.) Regarding GM, it will benefit in the short run from the cash, which will probably be used to support Delphi and ex-GM workers but will be hurt because of the loss of earnings (it is losing 51% of GMAC’s earnings in exchange for $7B). Regarding the transaction price, the $7B realized is far less than the $10 billion expected even a few weeks ago. A valuation of less than $15 billion is skimpy for an asset that was supposedly earning $2.5 billion per year; a normal multiple is in the area of 12 times, but GMAC earnings need to be adjusted and GM was a motivated seller. GMAC has a receivable from GM (for the zero and low interest rate loans and leases) which will probably be supported by some cash held back from the sale price. We and the other rating firms will be making an assessment of GMAC’s credit quality based on the following factors:

Capitalization of GMAC post transaction,
Operational safeguards to ensure that ensure that good transactions will be booked,
Future exposure to GM – GM owes money to GMAC for interest rate subsidies and residual value guarantees.

GM and Ford remain under significant pressure from operating losses, declining cash, market share losses, weakened suppliers, high leverage, increased funding costs, a possible accelerated payment demands by the PBGC, and in a possible strike by Delphi (in GM’s case). Fortune magazine writer Carol Loomis is now supporting our position that a GM bankruptcy is highly likely:
http://money.cnn.com/magazines/fortune/fortune_archive/2006/02/20/8369111/index.htm
Many have said GM will not file because it has sufficient cash and a filing would hurt its reputation and future sales. However, we believe GM will soon be cash short (see below) and that it will have no choice but to file. Ford has the same problems as GM, but has been slower to record some of the financial hits; we expect GM to file within the next 9 to 18 months and Ford to file within the next 12 to 24 months.

GM's auto unit had $16.8B of cash in Dec., but Delphi might be paid $4B to $10B and the burn rate is over $2B per quarter; hence cash is down to $5B to $10B without a GMAC sale. After GM sells GMAC, GM earnings will fall. Regarding vehicle pricing, Ford will match GM cuts with the result being losses for both.

Recovery rates: the recovery rates for Ford Credit debt in the event of a bankruptcy (GMAC is unlikely to be bankrupt if the sale to Cerberus is consummated) should be fairly high because the liabilities are supported by receivables and vehicle assets. On the other hand, GM


recovery rates would be minimal because of lack of earnings and high worker and retiree liabilities. Regarding Ford, unless Ford plans on selling Ford Motor Credit, the short-term debt (maturities of 9 months or less) of Ford Credit are probably the safest bet.

Attractive hedged trades:
long Toyota and Honda securities,
long GMAC,
short GM and Ford bonds, and
short GM and Ford shares.

Our estimate of the probability of GM’s filing for protection is:
Within 12 months: 75%
Within 18 months: 90%
Within 24 months: 98%

Our estimate of the probability of F’s filing for protection is:
Within 12 months: 50%
Within 18 months: 60%
Within 24 months: 80%

Note, 1) GM and Ford will probably only be able to get rid of their legacy costs via bankruptcy filings and 2) a filing by the parent does not guarantee a filing by the credit side or the non-US entities.

Current state
The sale of a “controlling interest” in GMAC to Cerebus is a slight positive and we expect Cerberus will take actions to reduce GMAC’s funding costs and then sell to a GE Capital type. Regarding the credit quality of GM and Ford, although the sale of the credit units will generate cash, such a sale would deprive the parents of their main sources of earnings, and we expect both GM and Ford to continue to slide.

A pressing issue for both GM and Ford has to be that of obtaining dependable, low cost funding for new vehicle buyers so the firms can keep their plants running. With a 250 basis points or more increase in unsecured debt rates for GM and Ford over the past year, tapping the unsecured debt markets currently is not an option. Below is an evaluation of some options for addressing the Ford’s funding problems:

Continue using secured debt funding -
Use the asset-backed markets via whole loan sales and asset-backed financings (collectively secured funding). The major problem with secured funding is that it places pressure on the unsecured debt holders via de facto subordination, it requires over-collateralization, and the major rating firms are likely to reduce their ratings if the parent of the servicer (i.e., GM and Ford) continues to slip. The auto OEMs can probably continue to tap the market for 6 to 12 months. As the portion of secured debt grows, the auto OEMs are likely to partner with firms such as a major bank, GE Capital or AIG to keep the funds flowing.

Selling a Controlling Interest
Ford should bring in a funding partner to calm anxious investors and maintain access to capital. By raising some additional capital for the lending arms and bolstering underwriting standards, the funding arms of the OEMs might boost their credit units’ ratings, increase short-term earnings (by the gain recorded for the sale of an interest in the units) and reduce their funding costs, but at the risk of reducing the pool of acceptable buyers for their vehicles.

Other developments over the next couple of quarters –
We expect some charges at both firms for the present value of retiree healthcare benefits (charges of $5+ billion for GM and Ford is possible), GM’s additional $3B to $9B charge for Delphi over the next 3 years, workforce and plant closings, and possibly for declines in residual values on leases.

Regarding Kerkorian, at a time when many of his living peers are more concerned about the quality of nursing home care, 87 year old Mr. Kerkorian is embarking on a potential run of control for one of the largest and most influential firms in the world. Many analysts point to Kerkorian’s Chrysler acquisition as a guide for the likely course of action, which involved a near death experience of the firm, the granting of US support for Chrysler, and an eventual acquisition by Daimler-Benz. We believe that Kerkorian is most interested in making money and that he might choose a different path to get there in GM’s case.

The first issue is whether Kerkorian is going to succeed in obtaining significant influence over GM. On this score, Kerkorian might decide to sell or greenmail his position if he perceives increased difficulty in gaining influence (in Chrysler’s case, his agent was given a board seat only after a long fight, and Kerkorian had influence but not control) or conditions are worse than Kerkorian expected. Assuming Kerkorian stays around and is able to exercise influence, some of the likely changes will be good for credit quality and some will be harmful.

If Kerkorian gains control, he will 1) accelerate negotiations with unions and attempt to cut costs, 2) sell non-core assets, and 3) return some available cash to shareholders. The first two actions will be helpful to GM debtholders and the last one will be harmful. Cutting pension liabilities via a transfer to the PBGC will probably be difficult if GM is not in or close to bankruptcy.

Visteon
After recording losses before taxes of $1.5B for the nine months ending Sept. 2005, we expect the losses will continue especially with the production cuts (the $1.8B gain in the Dec. quarter was non-cash). The $75M per quarter “grant” from Ford is not enough, and Ford might be weighing the cost of a Visteon bankruptcy (Bill Ford announced Ford is not a Santa Claus). We would not be surprised by a filing by Visteon by the end of 2006.

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