General Motors Runs Over the Experts

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DETROIT
(AP) — Standard & Poor’s Ratings Services cut its corporate
credit ratings to junk status for both General Motors Corp. and
Ford Motor Co., a significant blow that will increase borrowing
costs and limit fund-raising options for the nation’s two biggest
automakers.

Shares
of both companies fell 5 percent or more after Thursday’s downgrades,
and the news sent the overall market lower.

~
New York Times (May 5, 2005)

All
of a sudden, without warning, the investment world is talking about
the looming crisis at General Motors. Its pension fund obligations
and health care obligations now appear to threaten the future of
the company.

The
decline of its stock price from $55 in January, 2004, to today’s
$30 range has revealed a loss of confidence in the company by investors.
To see this decline in action, click
here
.

I
have no objection to the experts’ pessimism regarding the future
of General Motors. I happen to share it, and have for years, precisely
because of the pension issue. What astounds me is that investors
and financial columnists have only just begun to regard the company’s
pension obligations as a significant factor in the future profitability
of the firm. Why now? Why not in 2003 or ten years ago?

The
United Auto Workers’ officers and GM’s senior managers decided decades
ago to agree to high pension and health benefits in exchange for
reduced increases in wages. Health care benefits are tax-free income
for workers. Even retired workers are covered. It seemed like a
low-risk deal for GM. Nobody thought about the price effects on
health care of Medicare.

The
health care market, like all markets, is a giant auction. If bidders
get their hands on more money, they will bid up prices. All over
America, workers are bidding health care prices. So are retirees.

A
DISASTER CALLED OPEB

Alan
Sloan, a financial columnist for Newsweek, has painted a
stark picture. He
begins with a description of how GM got into this pickle.

Lower
salaries meant that GM reported higher profits, which translated
into higher stock prices — and higher bonuses for executives.
Commitments for pensions and "other post-employment benefits"
— known as OPEB in the accounting biz — had little initial
impact on GM’s profit statement and didn’t count as obligations
on its balance sheet. So why not keep employees happy with generous
benefits? It was a free lunch. Besides, GM’s only major competitors
at the time, Ford and Chrysler, were making similar deals.

This
is the free lunch mentality: something for nothing. As with all
free lunches, people eat more than they normally would. The price
is right!

Now,
as we all can see, pension and health care obligations are eating
GM alive. The bill for the "free" lunch has come in
— and GM is having trouble paying the tab. In the past two
years, GM has put almost $30 billion into its pension funds and
a trust to cover its OPEB obligations. Yet these accounts are
still a combined $54 billion underwater.

Note
the phrase, "as we all can see." But nobody saw it until
about February, 2004. Sloan says the problem by then had been building
for over half a century.

GM
began its slide down the slippery slope in 1950, when it began
picking up costs for medical insurance, pensions and retiree benefits.
There was huge risk to GM in taking on these obligations —
but that didn’t show up as a cost or balance-sheet liability.
By 1973, the UAW says, GM was paying the entire health insurance
bill for its employees, survivors and retirees, and had agreed
to "30 and out" early retirement that granted workers
full pensions after 30 years on the job, regardless of age.

These
problems began to surface about 15 years ago because regulators
changed the accounting rules. In 1992, GM says, it took a $20
billion non-cash charge to recognize pension obligations. Evolving
rules then put OPEB on the balance sheet. Now, these obligations
— call it a combined $170 billion for U.S. operations —
are fully visible. And out-of-pocket costs for health care are
eating GM alive.

I
report this because of the delay factor. This was all built in,
Sloan says. He is correct. It is why I counselled small businessmen
in the late 1970s not to set up health plans and pension plans for
their employees. The legal liability was too great, I warned them.
But I was almost alone in this view. Not now.

"DON’T
ARGUE WITH THE MARKET!"

We
are told that the stock market discounts the future rationally.
This means that the best and the brightest investors use their best
estimates to buy and sell. Today’s prices therefore include all
of the relevant information, as judged by experts who bought or
sold. Any unexpected price changes must come from new information
or new perceptions that had not operated before.

With
respect to GM, it’s "new information, no; new perception, yes."
The information was there for many years. All of a sudden, investors’
perception changed. Down went GM shares. Yet the basics had not
changed.

By
tying stock pricing theory to information, and by relegating changed
perceptions to the footnotes, economic commentators can then tell
us that good times are coming, that bad news will be more than offset
by good news. After all, isn’t the stock market rising? Anyway,
it’s not falling. "Don’t argue against the stock market!"

Here
is the reality of stock market pricing: seriously bad news is not
discounted until it threatens the survival of the company. Optimism
usually prevails among investors. Only toward the end of a bear
market does investor perception change.

With
respect to pensions and health care, optimism is government policy.
The government has assured us, year after year, that "pay as
you go" works just fine for Social Security and Medicare; smart
people believed the spiel. They carried the same attitude with them
when they looked at GM’s pension/health obligations. They refused
to factor in the estimated numbers.

At
the end of last year, GM says, its U.S. pension funds showed a
$3 billion surplus. GM’s pension accounting, which assumes that
the funds will earn an average of 9 percent a year on their assets,
is highly optimistic. But things are under control — as long
as GM stays solvent.

By
contrast, OPEB is out of control. At year-end, OPEB was $57 billion
in the hole, even though GM threw $9 billion into an OPEB trust
in 2004.

Consider
these numbers in relation to GM’s market capitalization of about
$17 billion.
The company is deeply in debt: around $300 billion.
It had to sell $17.6 billion in bonds in 2003 to meet its pension
obligations. Yet in January, 2004, its share value peaked. Optimism
still reigned supreme.

The
best and the brightest missed what should have been obvious. It
could happen again. Next time, it could happen to a lot more companies.
The worse the news out of Medicare, the less optimistic the outlook
of investors.

A
MINI-WELFARE STATE?

Political
columnist George Will has described the plight of GM as the common
plight of the welfare state, in an article, "The Latest welfare
state? It’s General Motors."

Who
knew? Speculation about which welfare state will be the first
to buckle under the strain of the pension and medical costs of
aging populations usually focuses on European nations with declining
birth rates and aging populations. Who knew the first to buckle
would be General Motors, with Ford not far behind?

GM
is a car and truck company — for the 74th consecutive
year, the world’s largest — and has revenues greater than
Arizona’s gross state product. But GM’s stock price is down 45
percent since a year ago; its market capitalization is smaller
than Harley Davidson’s. This is partly because GM is a welfare
state.

Will’s
angle is a nice touch. A journalist looks for a hook to snag readers,
and the current discussions about the demographic train crash of
the Western world’s retirement and medical programs serve as a convenient
hook. Statistically, it’s the same problem: the bills are coming
due, and there is no money set aside to pay them.

But
GM is not a state. It is run by profit-seeking managers on behalf
of profit-seeking investors by means of serving consumers who have
a choice to buy or not to buy. Why should GM’s managers and investors
make the same mistake as politicians?

For
politicians, it never was a mistake. It was a way to get each era’s
voters to hand more money over to the politicians, whose careers
would end long before the demographic day of reckoning arrived.
It involved hoodwinking the voters by promising them future goodies.
The voters who saw through the sham could not sell their shares.
There are no shares to sell. The system is compulsory. GM’s shareholders
can sell, and have.

The
problem is, the managers at GM seem to have acted in the same short-sighted,
self-interested way. So did a generation of investors in GM stock.
Yet we free market advocates like to believe that things are different
in free markets than in political affairs. Are we wrong? No. But
we have to understand how the system works.

The
problem has been building for a long time. The tax code has treated
the funding of future benefits as deductible expenses to a company,
but not taxable events for the employees. Labor unions saw the advantage.
They could claim victories in their negotiations with management.
This is true across the board, in company after company.

What
has been in it for senior management? Stock option profits. It is
legal for managers of American companies to reward themselves by
investing workers’ retirement money in corporate shares. This raises
the value of managers’ stock options. This is what Enron’s senior
managers did. It is a widespread practice.

Profit-seeking
people respond to incentives. The tax code has created incentives
for pension fund payments. The tax code has also provided incentives
for stock options: long-term capital gains, taxed at a lower rate
than salaries. Government-authorized accounting practices have added
to the illusion of future wealth: assumptions regarding estimated
future investment returns based on the post-1982 stock market boom-era.
GM expects to earn 9% per annum in its pension fund. How?

The
federal government has created business in its own image with respect
to pension funds. The bills are now coming due.

COST
PER CAR

The
cost of health care plans for GM workers is now over $5 billion
a year. This is now affecting GM’s ability to compete. Writes
Will:

GM
says health expenditures — $1,525 per car produced; there
is more health care than steel in a GM vehicle’s price tag —
are one of the main reasons it lost $1.1 billion in the first
quarter of 2005.

But
it’s not just GM.

Ford’s
profits fell 38 percent, and although Ford had forecast 2005 profits
of $1.4 billion to $1.7 billion, it now probably will have a year’s
loss of $100 million to $200 million. All this while Toyota’s
sales are up 23 percent this year, and Americans are buying cars
and light trucks at a rate that would produce 2005 sales almost
equal to the record of 17.4 million in 2000.

Foreign
auto companies are steadily eating into GM’s profits. GM’s market
share keeps dropping. So is the market share of the other members
of the Big Three.

In
1962 half the cars sold in America were made by GM. Now its market
share is roughly 25 percent. In 1999 the Big Three — GM,
Ford, Chrysler — had 71 percent market share. Their share
is now 58 percent and falling. Twenty-three percent of those working
for auto companies in North America now work for companies other
than the Big Three, up from 14.6 percent just five years ago.

The
number of Big Three employed workers has fallen by 134,000 since
2000.

Then
there is the issue of who should pay for these benefits. The free
market’s answer is clear: consumers. Their money determines what
should be produced. If consumers say, "No; your price is too
high," this leaves GM’s management with bills to pay and no
income to pay them.

When
the bills come due, those receiving them start looking for other
people to share the burden. The bills are coming due for GM.

GM
says its health care burdens, negotiated with the United Auto
Workers, put it at a $5 billion disadvantage against Toyota in
the United States because Japan’s government, not Japanese employers,
provides almost all health care in Japan. This reasoning could
produce a push by much of corporate America for the federal government
to assume more health care costs. This would be done in the name
of "leveling the playing field" to produce competitive
"fairness."

In
short, because taxpayers in Japan are required to pay for health
costs of Japanese auto workers, American firms want you and me to
dig a little deeper into our wallets and our futures, in the interest
of fairness.

It
doesn’t sound fair to me. I didn’t sign those long-term contracts
with GM’s workers. I didn’t lower my costs of production by making
promises instead of paying higher wages.

Then
there are GM’s retirees: "Health care for retirees and their
families — there are 2.6 of them for every active worker —
is 69 percent of GM’s health costs."

Up,
up, up go medical costs. Down, down, down go GM’s profits.

We
think of GM as an auto company. But its auto division is small potatoes.
About 80% of GM’s profits come from GMAC, its in-house loan company:
consumer credit and mortgages. It profited greatly during the mortgage
boom. But this source of profits has begun to taper off.

Now what?

CONCLUSION

This
report is about GM, insofar as GM is representative of a mindset.
Managers have treated GM as a career investment vehicle. Workers
have treated it as a rich uncle who will always be there with money.
Investors have treated GM as if the company were not subject to
the reality of long-term increases in medical care costs.

In
retrospect, the experts say all of this was visible years ago. But
the share price of GM indicates that nobody paid any attention until
it was too late.

This
is why I am not impressed by economists who assure the public that
Social Security/Medicare are not out of control, that there is time
to maneuver.

Nobody
in charge ever seems to maneuver until the investment vehicle goes
into a skid on an icy road in the mountains. Bad news is dismissed
as irrelevant. Statistical reality is deferred by investors until
they finally start unloading shares. Then there is not much that
the people in charge can do to solve the problem.

If
highly sophisticated investors are this nave about where their
money is being invested, why should we expect politicians to tell
us the truth about the looming insolvency of Social Security/Medicare?

May
7, 2005

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.freebooks.com.

Gary
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