GM’s Debt Crisis

If its bonds are junk, how are the cars?

Half a century ago, General Motors Chairman Charlie Wilson declared: “What was good for our country was good for General Motors, and vice versa.” This may still be true today, but in a much gloomier way. General Motors remains a giant economic force. Even though it has a relatively meek stock market profile (its market capitalization is only about $22 billion, less than half that of Google), the world’s largest automaker employs 325,000 people around the globe and last year reported revenue of $185 billion, good enough for third on the Fortune 500.

GM is a microcosm of some of the weaknesses afflicting the U.S. economy as a whole. Its health-care and retirement costs are rising. It makes more money from financial services than from manufacturing—GM’s General Motors Acceptance Corp. unit provides most of the firm’s profits. And it has a ton of debt: $290 billion as of Sept. 30, 2004. Of that pile, $30.1 billion rests on the automotive business, and $259.4 billion lies in the financing division. Both the United States and GM have been able to get through difficult times in recent years thanks to their ability to borrow oodles of money on favorable terms.

But here’s where the metaphor breaks down. Investors and credit-rating agencies have proven to be far less forgiving of General Motors than of the United States. And while the federal government continues to sell debt relatively cheaply, GM may soon find its ability to borrow on favorable terms sharply constrained—and at exactly the wrong time.

Corporations’ ability to borrow is limited in part by the credit ratings issued by agencies like Standard & Poor’s. (Here’s an explanation of how they work.) At S&P, the highest rating is AAA, followed by AA, A, and then BBB, with plus and minuses in between. Any long-term debt rated BB or below is “speculative”—aka “junk.”

In October, after GM reported third-quarter earnings,S&P downgraded the debt of both GM and GMAC to BBB-. Other credit-rating agencies, including Moody’s and Fitch, also downgraded the debt ratings of GM and GMAC. As a result, one of the nation’s most prodigious borrowers is now just barely hanging onto the lowest rung of the investment-grade ladder. One more drop—caused perhaps by a poor quarter or further erosion in GM’s domestic market share—and GM will be in junk territory.

“Junk bonds” earned a bad reputation because of their association with Michael Milken in the 1980s. But there’s no inherent shame—or even excess danger—in a junk rating for investors. The difference between the highest form of junk and the lowest form of “investment grade” is marginal. Many junk borrowers have turned out to be excellent long-term performers. And as an asset class, junk bonds have performed very well over the years. It turns out that the higher interest rate more than compensates investors for the higher risk of default.

But for an industrial titan like GM, a junk rating would be a huge comedown. And it could have significant consequences. A junk-rated GM will find itself with a smaller potential customer base for its debt, since many mutual funds and other institutional investors that are reliable purchasers of its bonds today are barred from owning junk bonds.

Borrowers with lower credit ratings have to pay more for money than do their better-rated peers. For companies with thin margins, the difference of a few basis points in lending costs can mean the difference between profits and losses. GM’s most recent quarterly report shows that in the first nine months of 2004, the automotive business earned a slim $776 million on massive revenues of $118.44 billion. Interest costs totaled $1.78 billion. GM’s financing and insurance operations earned $2.285 billion in the first nine months of 2004, during which they paid $6.78 billion in interest.

GM rolls over tens of billions of dollars in debt each year. If it borrows $30 billion next year, and the rate it pays for new debt rises 1 percent—which it certainly will if it drops to junk status—that translates into $300 million in additional interest costs. And since interest has to be paid first, higher interest costs mean less money for important things like executive compensation, investment in new plants, marketing, and developing hybrid engines.

The market can express some pretty brutal judgments about companies and their prospects through numbers. And right now GM is getting marked down all over the lot. GM disburses a fat 5 percent dividend of $2 per share, meaning it has to pay investors a lot of cash just to hold onto the stock. It is closing out the year with a “Red Tag Sale” that features cash rebates of up to $8,000, which means it has to pay drivers a lot of cash just to take GM cars off its hands. With the debt downgrades, GM is being forced to pay bondholders more just to carry its debt. And unlike the federal government, which shares many of GM’s problems, the car company can’t simply print money.