AIG Drives GM Bankrupt

General Motors is going bankrupt.

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By now everybody knows that GM will not survive without a bankruptcy reorganization. President Obama has said that he will expect (require?) the bankruptcy soon.

Why?

GM makes plenty of money. It uses various accounting practices to avoid reporting a profit from its annual sales. And these practices are normal, ordinary, and legal. There is nothing wrong with reporting their income the way that GM reports theirs.

But it does make them look a lot less profitable than they really are.

It is worth noting, also, that GM make most of their sales during certain months of the year. In the autumn when new models are released, the make money. And they make money during the summer when people are out driving about and feeling good and prosperous. They don't make much money in the dead of winter. And they don't make much money in the last weeks just before the new models are released.

During the times when GM's sales are high they make enough money to keep them going for the entire year. But it is real hard to use this revenue to meet their day to day costs for the whole year. The available cash is just too bumpy and unpredictable.

That is why they use short term loans - to provide a constant availability of cash for the operational use of the company.

Corporate bonds are a great instrument. They are bought and sold through well regulated markets and their values are expressed in terms we all know how to understand and use.

A bond is issued at a specific value, say $100. This is its par value. It is sold at a price which is less than its par value, for example $70. This is its discount value. At the end of the bond's term it is bought back at full par value. Corporations can also buy them back early at markdown rates based upon market conditions.

Discount values for corporate bonds fluctuate as rapidly and as sharply as pork bellies or any other commodity. Banks don't like corporate bonds because of the fluctuation in their discount values.

During the last several years, banks have been combining corporate bonds under the CDO (Collateralized Debt Obligation) umbrella. CDOs are virtually illiquid. Mostly you can buy or sell them only with the entity that created them. Banks love CDOs because they are stable in value.

How does AIG come into this picture?

CDOs have another neat feature for banks. You can insure the value of a CDO by buying a CDS (Credit Debt Swap). A CDS is an insurance account for the par value of a CDO.

This is like an insurance policy on your home if it offers "full replacement coverage" against disaster.

It is a smart idea to buy a CDS for each CDO you own.

AIG wrote most if not all of the CDSs for the CDOs that were derived from GM bonds.

How is this driving GM into bankruptcy?

Last year the US government bailed out GM from a short term cash flow crisis and gave them instructions to reorganize their debts.

The thinking was that all of the holders of General Motors' corporate bonds would be forced to take a markdown in the discount value of their bonds.

Finances are supposed to work like that.

But the holders of CDOs derived from GM corporate bonds were insured for their full par value by AIG CDSs. And all AIG CDSs were guaranteed by the US government for their full par value. Therefore the holders of these CDOs said, "No, we're not going to take any markdowns. We are insured for the full value."

As a result, GM could not force the discount value of their bonds down and they could not buy them back at a low market value rate.

When you can't pay your creditors off, they come to collect. This is what has happened to GM.

So think about this:

If AIG did not insure the value of the CDOs derived from GM bonds, their value and the value of GM bonds would naturally decline. And GM could buy them back at a lower rate, and preserve enough cash to continue to operate. But the United States has guaranteed the value of the CDSs issued by AIG against those CDOs, so their value cannot decline. As a result, GM has no takers when they offer to buy back their corporate bonds at a discount value less than they were initially sold.

That's why General Motors is being forced into bankruptcy.

This is a case where the US government should get out of the market.