Replies to This Discussion

Permalink Reply by Gary Schurman on December 22, 2008 at 11:11am

Are you coming from the perspective of an individual lender? If you are then your expected credit losses are a function of exposure at default (EAD) x probability of default (PD) x loss given default (LGD). You might want to increase PD if you think that a Big 3 bankruptcy is likely and will have a significant negative impact on the economy. This will affect all borrowers. You might want to increase LGD if you think that the resale value of Big 3 vehicles will experience a significant decrease post bankruptcy. This will effect borrowers who financed Detroit vehicles. Net result - Risk premiums increase.

Personally I don't think that the Big 3 will get a plan together that makes them financially viable because the parties involved have such conflicting interests. But I also don't think that the government can let them fail until an economic recovery is underway. Once we are in recovery mode then they pull the rug out from under the Big 3 and force them into BK.

Permalink Reply by JJ Hornblass on December 22, 2008 at 5:03pm

Gary, thanks. So how does your view on the Big 3's viability play out in PD in particular? What would be an appropriate modulation of PD? (Would you also boost LGD?)

Gary Schurman said:

Are you coming from the perspective of an individual lender? If you are then your expected credit losses are a function of exposure at default (EAD) x probability of default (PD) x loss given default (LGD). You might want to increase PD if you think that a Big 3 bankruptcy is likely and will have a significant negative impact on the economy. This will affect all borrowers. You might want to increase LGD if you think that the resale value of Big 3 vehicles will experience a significant decrease post bankruptcy. This will effect borrowers who financed Detroit vehicles. Net result - Risk premiums increase.

Personally I don't think that the Big 3 will get a plan together that makes them financially viable because the parties involved have such conflicting interests. But I also don't think that the government can let them fail until an economic recovery is underway. Once we are in recovery mode then they pull the rug out from under the Big 3 and force them into BK.

Permalink Reply by Gary Schurman on December 22, 2008 at 10:21pm

I think the probability of default would increase due to the ripple effect of a bad economy made worse by a Detroit bankruptcy. I don' t think that the fact that say GM went BK would have much impact on a borrower to default on his or her GM vehicle but I do believe that the ripple effect would affect that borrower. If you know the borrowers credit score and you can estimate default correlation and what the marginal effect on the economy as a whole would be given a GM bankruptcy then you can use some math to estimate (guess at?) the increase in default probability.

Loss given default would have to be increased to the extent that the resale values of Detroit vehicles would decrease post BK. You hear a lot on the news that no one would buy GM cars if GM went BK. If this is indeed the case then LGD would skyrocket. Most losses on auto loans take place at around year 2 (give or take) which is the worst time for a default because the gap between the balance of the loan and the value of the vehicle is the greatest. If you subtract a big number from the resale value of the vehicle then your loss given default really increases.

My two cents

Permalink Reply by JJ Hornblass on December 23, 2008 at 9:48am

That's helpful, thanks. If you look at the residuals being set by ALG today, they are expecting massive LGD for the Detroit 3. I know that they would view a bankruptcy as leading to a major increase in LGD.

Gary Schurman said:

I think the probability of default would increase due to the ripple effect of a bad economy made worse by a Detroit bankruptcy. I don' t think that the fact that say GM went BK would have much impact on a borrower to default on his or her GM vehicle but I do believe that the ripple effect would affect that borrower. If you know the borrowers credit score and you can estimate default correlation and what the marginal effect on the economy as a whole would be given a GM bankruptcy then you can use some math to estimate (guess at?) the increase in default probability.

Loss given default would have to be increased to the extent that the resale values of Detroit vehicles would decrease post BK. You hear a lot on the news that no one would buy GM cars if GM went BK. If this is indeed the case then LGD would skyrocket. Most losses on auto loans take place at around year 2 (give or take) which is the worst time for a default because the gap between the balance of the loan and the value of the vehicle is the greatest. If you subtract a big number from the resale value of the vehicle then your loss given default really increases.

My two cents

Permalink Reply by David Ruggles on December 23, 2008 at 6:48pm

Three months is not enough time for the auto industry to adjust to a 10 million SAAR. How can the Fed's measure the Big 3's viability unless they make projections. Projections are notoriously faulty. Should the viability of the Big 3 be judged based on $1.50 gasoline, $4.50 gasoline, or somewhere in between. One thing I can guarantee, "If fuel stays cheap people won't pay a premium for new technology to get additional fuel economy!"

Cheap gas is what lulled Big 3 Detroit to sleep in the first place. It allowed them to tolerate the disparities in wage and benefit payouts because of the large gross profits they were making on gas guzzling trucks and SUVs. And its not like this hasn't happened before. People think Iaccoca and the K car saved Chrysler. The K car was TERRIBLE when it hit the market. The engines vibrated so much you couldn't hold on to the steering wheel at idle without having your hands go numb. You couldn't see out the rear view mirror because it was moving around so much. The dash boards buzzed and rattled from the vibration. It was said "they vibrated like a cat pooping peach pits!" Chrysler loaded the first ones up with so many options they sat on dealer lots "sale proof." So what saved Chrysler really? As fuel prices stayed low they started selling a strong mix of NY 5th Avenues, the redone Volare. They made HUGE gross profits on these and other "heavies" that had stopped selling when fuel prices went through the roof. Gradually, the public "forgot" about the high fuel prices and the usual false sense of security settled back in. Chrysler started to get some volume out of the K car as they fine tuned the vehicle and developed some derivatives.. Then they developed the mini van off of the K platform. But the gross profits necessary for profitability didn't come from the basic K car.

If credit starts moving and fuel stays cheap a case for viability might be made in the next 15 months based on the mix of high gross profit vehicles the Big 3 might expect to sell. Without a MAJOR restructuring they won't be able to make enough gross profit on the size and price of vehicles that might sell if fuel stays at say $3.00 - $4.00 per gallon to be viable. To get a premium price and gross profit from intermediate size vehicles that get good fuel economy takes time to build a brand name. Think BMW 3 series, MB E Class, etc. Wonder what "viability yardstick" the Feds will to use?

Permalink Reply by Gary Schurman on December 26, 2008 at 6:44pm

Whatever the Fed decides to use for the "viability yardstick" it will most likely rely on projections. The viability option that I prefer is the net present value approach. This is where you present value free cash flow, which comes from the projections and includes costs cuts, and then subtract out debt, which is reduced by the debt-for-equity swaps, and if you end up with a positive number then you are viable. Not only are the projections going to be very subjective but the discount rate should be pretty high given the risks involved. The problem with a high discount rate is that losses in the near term cannot be offset by profits in the out years (the old "hockey stick" projections where you have near term losses and then a "sudden and dramatic" return to profitablility in the out years).