GM's CDO shockwave  

Alan Kohler has an update on progress on the great CDO / CDS sting (see here and here for previous installments), now closer to reality after the bankruptcy of GM - GM's CDO shockwave.

Whoops there goes another investment grade default. Well General Motors was investment grade up to 2005, so any synthetic CDOs written up to that point are now another step closer to “detachment” (ie, kaboom).

There have now been eight investment grade defaults (seven for CDOs written after 2005, not counting GM): Freddie Mac, Fannie Mae, Lehman Brothers, Chicago Tribune, three Icelandic banks.

Synthetic CDOs were first described here last year in A tsunami of hope or terror? (November 19, 2008). They are collateralised debt obligations not based on actual securitised mortgages, as non-synthetic ones are, but on credit default swaps created by listing 100 corporations in the contract and saying that if seven to nine of them default, all the money invested in the CDO is lost.

It’s a bit like demerit points on a driving licence: lose 12 points, licence gone.

The research head of Australian fixed interest firm FIIG Securities, Justin McCarthy, says very few of the CDOs include in their lists of 100 all eight of the investment grade defaults that have occurred so far.

But the older ones that had GM as one of the names are this morning one step closer to total loss. McCarthy says most of them would now have between one and three to go.

The NSW councils that bought these things have generally been trying to ignore the collapse in the market prices of their investments (down to 30 cents in the dollar and less) by saying they are holding them to maturity. Many seem to have even persuaded their auditors of this.

That just means when the defaults tick over to the magic number, the value of their investment goes immediately from 100 cents to zero.

And the big problem with the GM default this morning is not so much the big car maker itself, since it hasn’t been investment grade since 2005, but the effect of its bankruptcy on parts manufacturers, many of which are also listed on synthetic CDOs.

Clearly Barack Obama’s bailout plan is not designed to rescue the parts makers and thus avoid a cascading default of hundreds of billions in CDOs, sending charities, municipal councils and other investors to the wall.

We know that because it won’t achieve that – quite the reverse in fact. In order to get the government’s $US60 billion, GM must shut half a dozen factories, sack 20,000 workers and produce 10 million cars a year instead of 16 million, so the government’s acquisition of 60 per cent GM is unlikely to make any difference to whether parts makers, and therefore CDOs, live or die. Much the same goes for Chrysler (now 55 per cent government-owned). ...

So even if this year’s 'green shoots' turn into a full economic recovery, it is likely that most synthetic CDOs will go into total loss this year as a result of the self-inflicted problems of the automotive and newspaper industries.

As described last year, that would see a massive transfer of money from investors to the banking system.

Given the complex chain of derivative molecules that the financial system has become, it is now impossible to tell exactly where that money will end up. But we certainly know where it will come from: the investment accounts of thousands of charities, councils and high-net-worth investors around the world.

For those investors, 2009 is likely to be a calamity. As I argued last year, for the financial system it could be redemptive – their life insurance contracts will pay off.

Ironically, the non-investment-grade high-yield CDOs seem to be in better shape than the investment grade ones. That’s because they typically require a lot more names to default than seven to nine – usually between 30 and 40.

Nonetheless, many of these are on their last legs as well. There have been about 30 non-investment grade defaults in the US so far this year; by the time 2009 comes to a close it is likely that many CDOs, both investment grade and high yield, will have lost their licence, as it were.

There’s many places you can visit with your limited time on earth — the Turkish riviera, Finland’s Ice Hotel, Mt Fuji, Wobbie World — but everyone who wants to understand the last century and this one, should see Detroit.

Why? Because Detroit is the first modern urban ruin, the largest city that has simply been allowed to die. From the 1970s onwards, successive state and federal US governments allowed this once incredible city — home to some of the first skyscrapers, to an urban black culture that came north for jobs, of a prosperous working class — to choke and fall over.

Warsaw, Frankfurt, Coventry — cities bombed into non-existence were put back together by their nations, often brick-by-brick. Faced with the far less challenging circumstance of industry moving out, the US turned its back on a city that had been the arsenal of the allied effort in WW2.

It staggered, stumbled, tried to revive itself. Now with the bankruptcy of GM, it’s all over. From an urban population of two million in 1960, Detroit has fallen to around 650,000. With GM about to be consolidated, it will fall further — effectively below a level where it is really serviceable as an urban centre.

Your correspondent was there in 2006, and it was bad enough. In the centre of the city, whole rows of skyscrapers were boarded up — 20, 30 storey buildings, some pre-WW1. Whole blocks were vacant, tumble weeded, because it was cheaper to pull them down and avoid property taxes. Whole suburbs were empty, vines and creepers reclaiming the mansions of old auto execs. Because no one was there to squat them.

Geographers developed a new concept — “urban prairie” — as foxes and weasels not seen in the area for 300 years, reclaimed areas within 15 minutes walk of the city centre — around which you could walk for five minutes without seeing another human being, while the monorail, the “people mover” with perhaps three customers on the entire route, circled uselessly above, like stars round the head of a suddenly whacked cartoon character.

With GM’s bankruptcy arrangement, by dint of the failure of American capitalism, the US has transitioned into actual socialism — though it may be a temporary holding pattern. Ownership of GM and Chrysler is shared between the Federal government and the United Auto Workers Union, and explicitly or otherwise, they are now directing the core industrial enterprises of America, the company whose director once said “what’s good for General Motors is good for America”.

The bitter ironies of this are multiple. In the 1890s, after Marx’s death, Fred Engels pondered the possibility that socialism could occur without violent revolution. At some point he reflected, the contradictions of capitalism would become so great, its failure so obvious, that the capitalist class in sheer exhaustion and despair, would hand over the keys to the castle.

In the 1970s, Sweden developed a variant of this called the Meidner plan. The trade unions and the state would achieve full socialism by using public capital and pension plan money to buy up the shares of heavy industry on the stock market. A variant of the plan was a major part of the Whitlam government’s strategy, advocated most vociferously in minerals and energy by Rex Connor and his amanuensis one P.J. Keating. Wonder what happened to that bloke?

Bizarrely, the US has now implemented a variant of this to save its economy. One of the reasons the auto industry failed was because it was carrying so many social costs — because of the asinine system of employers bearing health care costs. In the fat years, the auto companies cut deals with the UAW guaranteeing health coverage for retired employees to death. When you add that to their hopeless refusal to design smaller, better cars, a disaster was inevitable.

Now here’s the really funny part. There’s one place where an overextended auto maker was allowed to fail, to be subject to market discipline. Which one? Saab. Where? Sweden, the country that Republicans — lining up at the stimulus trough — wave as the dire example of socialist unfreedom.

How did this happen? Though Sweden is not unexposed — especially due to its investments in former Soviet Baltic states — its private sector is leaner and more efficient because its social capital is so high. Poverty is at 4%, health is high, social costs are low. Businesses can operate efficiently because a stable social democratic civic order is in place.

Meanwhile, in the US, the right is spruiking as an alternative to GM etc, the Toyota plants in the south — with unionisation practically illegal, a lack of health and safety protection, and a relatively good wage dependent on a 56-hour overtime week. In five years, when Mexico has stabilised cities like Juarez and Nogales, those plants will disappear across the border in a single week, leaving nothing behind, not even Detroit-style ruins.

So let’s be clear. For decades we’ve been running an experiment — US style capitalism versus social democracy in Europe and Australia. And the experiment’s over. America failed. Social democracy delivers the greatest spread of prosperity, freedom, health, and stability. US capitalism delivers uncertainty, chaos, and collapse — which then has to be mopped up by full socialist measures.

And if you want a demonstration of that, go to Detroit and then its twin city, Windsor in Canada, just across the water — it too was dependent on the auto industry. But decades of government investment in education and new industries have guaranteed it as a viable living city. We should send schoolkids to these two cities to show them what works and what doesn’t. No other argument would be necessary. RIP Detroit and much more.