General Motors Runs
Over the Experts
by Gary North
by Gary North
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 naïve 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
Copyright © 2005
LewRockwell.com
Gary North Archives
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http://www.lewrockwell.com/north/north370.html
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