General Motors and the Intellectual and Moral Bankruptcy of Wall Streetby
Karen De Coster and
Eric Englund As punctuated by General Motors’ second quarter (6/30/08) loss of $15.5 billion, General Motors is a company in financial distress. In its attempt to survive the current economic milieu, management has been looking to throw excess weight overboard to keep the company afloat. GM is trying to ditch its declining Hummer brand, and it has been rumored that Pontiac and Buick may be fire-sale material. [1] The company has been offering massive rebates on its trucks, along with 72-month, 0% financing in an attempt to unload its weighty inventory. In spite of this, along with sagging car sales, [2] a tightening credit market, junk-rated bonds, a doomed balance sheet, massive production cuts, [3] substantial layoffs, zooming gas prices, and eroding cash flow, Merrill Lynch analyst John Murphy had maintained a “buy” on GM with a target of $28 per share. Let’s step backwards a bit. On June 25, 2007, Wall Street powerhouse Morgan Stanley put out a “buy” recommendation with respect to General Motors’ common stock. Robert Barry, Morgan Stanley’s star analyst, proclaimed a 52-week target price of $42 per share. Less than five months later, on November 7, 2007, Wall Street analysts were stunned by General Motors’ staggering third-quarter (9/30/07) loss of $39 billion – one of the largest bookkeeping losses in history, which was mostly related to the writedown of deferred tax assets. Fifty-three weeks after Morgan Stanley’s buy recommendation, GM’s stock hit a 54-year low of $9.98 per share – on July 2, 2008, after Merrill Lynch’s recommendation had gone from a “buy” to “underperform” (i.e., sell) on that day. In one sweeping move overnight, Merrill Lynch analyst John Murphy cut his target price on GM by a whopping 75%, reducing the target price from $28 to $7. So how is it that GM suddenly went from respectability to mediocrity – in one analyst’s mind – overnight? In fact, why did it take until July 2008 to concede that GM was on life support? Wall Street, belatedly, is willing to acknowledge the fact that General Motors is teetering on the verge of bankruptcy. Accordingly, key questions come to the forefront. How did any stock analyst, worth his salt, get blindsided by the aforementioned $38.3 billion writedown of deferred tax assets? Are Wall Street’s Ivy League-educated MBAs able to comprehend advanced accounting and finance? Has rigorous security analysis, on Wall Street, been supplanted by self-serving cheerleading and inane platitudes with the objective of transferring wealth from the masses to the Wall Street elites? As Benjamin Graham and David L. Dodd so eloquently stated in their classic 1934 book Security Analysis, “The correct calculation of the asset values and their relationship to securities or creditors claims depends on the purposes of the analyst.” Therefore, to answer the above-posed questions is simple. Wall Street has little to do with disseminating competent securities analysis and advice to average “investors,” and has much to do with transferring wealth from Main Street to Wall Street – and, for the most powerful Wall Street brokerage houses, doing the bidding of the government’s Plunge Protection Team. For Wall Street analysts to claim “surprise” at GM’s massive deferred tax asset writedown, during fiscal year 2007, and to finally discuss (in mid-2008) General Motors’ financial condition in terms of a possible bankruptcy, indicate that low-level fluff is easily passed on to Main Street “investors” under the guise of serious analysis. At the very least, earnest auto industry analysts should have been sounding the negative-outlook alarm after General Motors published its December 31, 2006 annual report – yet Wall Street was shouting “buy, buy, buy.” One must wonder, again, if any of Wall Street’s analysts are even capable of reading a financial statement. If the answer is affirmative, then honest analysts would have drawn the same conclusion as Eric Englund did in his July 9, 2007 essay. Here is an excerpt:
With GM’s September 30, 2007 third-quarter writedown of $38.3 billion in deferred tax assets, GM’s financial condition – at fiscal year-end December 31, 2007 – validates Eric’s above-shown analysis. Accordingly, GM’s 12/31/07 as stated working capital and net worth positions stood at negative $10.2 billion and negative $37.1 billion, respectively. Then, at March 31, 2008 (GM’s most recent filing), the company’s financials reveal a negative net worth of $41 billion. To compound this company’s downward spiral, with the latest quarterly loss of $15.5 billion, GM’s net worth arguably stands at negative $56.5 billion. These are the financial indices of a company on the verge of bankruptcy. To put things into perspective, GM’s market capitalization stands at under $7.5 billion, which is among the lowest of the 30 firms in the Dow Jones Industrial Average. On the surface, it appears that Graham and Dodd’s invaluable book Security Analysis is unfamiliar to most securities analysts. If a financial analyst understood the nature of a deferred tax asset, and that such an asset is properly deemed an “intangible” asset, then the course of action to take is quite elementary. As Graham and Dodd stated, “It is customary to eliminate intangibles in the computation of the net asset value, or equity, per share of common stock.” In the case of General Motors, a competent analyst would not have been surprised by the massive writedown of deferred tax assets. After all, such an analyst would have already fully discounted the intangibles in order to derive a conservative financial condition. The fact that General Motors eventually wrote down these intangible assets merely reflects the financial picture that a principled financial analyst previously would have drawn. The point here is that GM is so unprofitable that its top-level management realized they had to come clean and write down the value of its deferred tax assets because it became completely unpredictable as to when the company would actually return to making a profit, and thus use that tax asset against any future tax liability it incurs. Essentially, GM is uncertain about its ability to generate profits in the near future, and correspondingly, its use of its tax shield is in doubt. According to accounting rules, GM must recognize the impairment of the tax asset, hence the write-off. This is a huge indicator of management's pessimism about the coming years. GM, in writing down its tax assets as it did, made a negative judgment about the uncertainty of future economic events and their outcome. In view of that, this is a company heading toward bankruptcy, and executive management is fully aware of how close they are to being unable to prolong the dog-and-pony show. So, just how savvy are some of Wall Street’s best and brightest analysts? Nine days before GM’s deferred tax asset writedown bombshell, UBS upgraded its rating of GM to a “buy.” On September 13, 2007, Citigroup initiated coverage and issued a buy recommendation. Other Wall Street heavyweights, in 2007, that had weighed in with “upgraded” opinions of GM included Banc of America Securities, Goldman Sachs, J.P. Morgan, Lehman Brothers, and Deutsche Securities. One must heed Graham and Dodd’s words as to what purpose is behind a securities analyst’s recommendation. But then again, Wall Street analysts long ago abandoned their roles of providing independent expertise, and instead turned to selling their firm’s investment banking services. Mark Reutter writes:
So now, with the two services – investment banking and stock analysis – conveniently commingled, and thus creating a huge conflict of interest, a dealmaker’s sales literature is passed off as serious and useful analysis of the financial markets, leading Main Street investors – who tend to follow these recommendations – seriously astray. Also ignored by Wall Street analysts was the banking community’s loss of confidence in General Motors. A strong indicator as to how nervous GM’s bankers were, pertaining to this automaker’s viability, emerged when General Motors’ banking syndicate amended GM’s line of credit on July 20, 2006. This borrowing facility went from a $5.6 billion unsecured line of credit down to a $4.6 billion line of credit, of which $4.48 billion was secured. This 97%-secured bank line had a termination date of 2011. This arrangement was described as being a "positive action toward additional financial flexibility." Positive for whom? This meant that the holders of the new loans, which were secured by collateral, had priority over GM’s unsecured bonds. A default on the loans before the bonds are paid off would mean that bondholders would be left high and dry. This caused another credit-rating cut to GM’s bonds, which were already junk. As of March 31, 2008, GM’s borrowing facility remained substantially the same. Nonetheless, this still begs the question as to whether or not Wall Street analysts read 10-Qs anymore? But the agony does not end there. Adding to GM’s plentiful wounds, S&P announced that effective after the close of trading on July 17, 2008, General Motors would be dropped from its flagship S&P 100 index. A vital component of the Index of Leading Indicators, there has been no comment from S&P as to why the purge occurred. Though a drop from the S&P is not unique, in an historical sense, the most important index of large-cap US stocks must not see an enduring future for General Motors. In addition to that news, market participants have little confidence in General Motors. The credit derivatives market has priced in a 75% probability that GM will default on its loans within the next five years, and a 25% chance that it will default within one year. Perhaps the next buzzword that journalists and Wall Street prophets of profit will swoon over will be "going concern." In financial accounting, "going concern" means that a company must be financially sound enough to continue operating as a business entity. A company's value, as conveyed by its balance sheet, must reflect the value of the company in the long-term (beyond one year). Management has a duty to act on the principles of going concern when preparing financial statements. They must assess whether or not there are any material items that create uncertainty about an entity’s ability to continue as a going concern for and beyond the foreseeable future. Material items that bring forth doubt about an entity’s viability must be disclosed in the financial statements. A company facing bankruptcy due to financial items that give rise to material uncertainties is not a going concern. Auditors who form an opinion on financial statements are not required to devise and conduct specific audit procedures to validate the going concern assumption. However, they are required to evaluate conditions and events that indicate the potential for going-concern problems. In 2001, when 257 publicly-traded companies went bankrupt, a survey of 202 of these companies revealed that only 48% of them had audit reports that included the auditor's explanatory paragraph expressing doubts about the company being a "going concern." This must be considered a mammoth failure for the audit-accounting industry as a whole. Considering all the significant factors driving GM’s financial deterioration, the buzz on the Internet contains occasional references about whether or not a “going concern” qualification should or will be issued to General Motors. Certainly, that is highly unlikely, since no public accounting firm is likely to accelerate the downfall of its premier client. [4] Considering GM’s shrinking profit margins, mounting debt load, and onerous legacy obligations, [5] there is not enough cash from operations [6] to pay the rising cost of its debt expense or invest in future operations. Thus we have continued to write about General Motors and the fact that it operates on the verge of insolvency. The trend for GM has been the build-up of negative equity, negative working capital, insurmountable losses, and previously, its only profits were coming from its finance arm until it sold a majority stake in GMAC. In a world of $4 + gasoline, GM is now caught with an impractical product mix dominated by pickup trucks and SUVs. A well-capitalized automaker could see its way through these difficult economic conditions and take the appropriate time and steps to develop a more suitable lineup of automobiles. However, General Motors’ fragile balance sheet will not see this automaker through to better times. GM will have to declare bankruptcy and Wall Street, as usual, will absolve itself of such a self-serving clustering of buy recommendations pertaining to General Motors’ common stock. You can be certain that the big brokerage houses were offloading their own GM stock (and for those well-connected clients) to the poor saps on Main Street who trusted Wall Street’s analysts. And thus the deception and the wealth transfer continue. References
Notes
[1] GM CEO Rick Wagoner claims (as of July 25, 2008) that only Hummer is on the block, and no other brands will be eliminated or sold. [2] Auto sales in the US are at a 16-year low. GM’s sales fell 26% in July. The devaluation of the US dollar makes GM’s Saab brand costly to import and sell here in the US. Sales of Saab were down 29% in the first half of 2008. [3] For Q2 2008 (2nd quarter), GM’s vehicle production dropped to 835,000, down 27% from the previous year. [4] A public accounting firm is unlikely to want to be responsible for lowering stockholders’ and creditors’ confidence in a company, especially a venerated giant like General Motors. The New York State Society of CPAs states, “The fear is that a going-concern opinion can hasten the demise of an already troubled company, reduce a loan officer’s willingness to grant a line of credit to that troubled company, or increase the point spread that would be charged if that company were granted a loan. Auditors are placed at the center of a moral and ethical dilemma: whether to issue a going-concern opinion and risk escalating the financial distress of their client, or not issue a going-concern opinion and risk not informing interested parties of the possible failure of the company.” But the purpose of a financial audit is to add credibility to management’s implied assertions that its financial statements fairly represent its financial performance and position to its shareholders. Thus the code of silence on “going concern” issues is both contradictory and dishonest. [5] Roger Lowenstein writes, “After falling $20 billion behind on its pension earlier this decade, G.M. doggedly put money into its plan to catch up. It has also agreed to invest more than $30 billion in a fund to cover future health-care expenses. But these efforts have starved its business.” Unfortunately, he follows that comment with a call for the government to take care of social insurance so that the automakers can concentrate on manufacturing cars.
August 5, 2008 Karen De Coster is a Certified Public Accountant and has an MA in Economics. She formerly worked as a financial analyst in the auto industry, and now works in the securities industry. Send her mail. See her website and her blog. Eric Englund has an MBA from Boise State University and works as a branch office manager in the surety industry in Oregon. He is the publisher of The Hyperinflation Survival Guide by Dr. Gerald Swanson. Send him mail. Copyright © 2008 Karen De Coster and Eric Englund
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