The Great Deformation

by David Stockman

To be sure, these GM suppliers, who were owed about $15 billion for parts and material, were not victims—they were enablers. They had taken a reckless risk in continuing to extend forty-five days of trade credit to GM, even though it was obvious that GM was burning cash so rapidly a crash landing was only a matter of time.

  In the White House’s simulacrum of a bankruptcy court, however, most suppliers got paid a hundred cents on the dollar. Their unsecured claims did not rank very high in the contractual hierarchy of creditors, but their lobbying ranks on K Street turned out to be nine-tenths of the law. Once again, the free market’s disciplinary mechanism, in the case of the regulation of trade credit, was given short shrift.

  As previously described, I had been the principal investor when the $4 billion auto supplier I had put together (on too much leverage) had been taken down a few years before the White House gravy train arrived in Detroit. But I had learned the reason why suppliers foolishly extended GM trade credit long after it was objectively bankrupt. Most of them, including my company, were up to their eyeballs in debt and had no choice except to “extend and pretend” in order to keep enough cash coming in to pay the interest bill.

  GM was therefore at the end of a destructive daisy chain of debt that encompassed the entire auto supply base. When the free market’s unsparing campaign to clean house was stopped cold on December 12, 2008, the Bush administration struck a more deadly blow at the vitals of free enterprise than simply granting GM a stay of execution until it could be officially bailed out by the statists who had won the election. In fact, a corollary effect of the bailout was the further evisceration of business credit discipline.

  While rarely acknowledged, trade credit is the first line of defense against unsound finance in the American business system. At the present time, there is about $2.5 trillion of trade credit outstanding; that is, payables owed to suppliers by their downstream customers. These debts among companies handily exceed the $1.8 trillion of bank loans and commercial paper owed by nonfinancial businesses.

  In the general scheme of business credit, suppliers are unsecured lenders while banks rank above them and are secured by liens on fixed and working capital. As a result of this junior status, suppliers ordinarily have powerful incentives to closely monitor the financial health of their customers, and generally do so with far better ground-level knowledge and insight into their customers’ circumstances and current industry conditions than do the commercial bankers.

  By refusing to ship on forty-five-day credit, suppliers can exert a powerful braking effect on the financial policies of their customers. Indeed, a “run” among trade creditors on a profligate customer like GM can ordinarily be every bit as swift, contagious, and devastating as a proverbial run on a retail bank. This natural mechanism of financial discipline on the free market has been greatly crippled, however, owing to the massive increase in credit market debt during the era of bubble finance.

  As previously indicated, nonfinancial business credit grew from $4.5 trillion to $11.5 trillion over the last eighteen years. Accordingly, as suppliers got deeper and deeper in debt to external lenders, their trade creditor’s trump card—refusal to ship on forty-five-day terms—lost its efficacy. They could no longer make this threat because they could not afford a disruption in the daily cash flow needed to service their heavy external debt. In a process that was subtle and incremental, therefore, the business credit system became an ever more fragile chain of debtors who could not afford to safeguard their own trade credit exposure.

  This breakdown of the business credit chain reached its epitome in the auto supply base that served GM and the other original equipment manufacturers (OEMs). During the fifteen years before Detroit’s crash landing in late 2008, the domestic auto space had become a playpen for Wall Street–based financial engineering, including M&A roll-ups, LBOs, and supplier division spin-offs from the Big Three OEMs. The consistent theme behind all of these maneuvers was to pile the debt higher and higher.

  The impact was especially insidious in the case of the huge upstream parts division spin-offs from the OEMs, all of which ended up in bankruptcy. The GM spin-off was called Delphi and its $30 billion in annual sales made it the largest auto supplier in the world.

  THE ELLIOT GANG AND PLUNDER OF DELPHI

  Delphi was comprised of the former parts divisions—radiators, axles, lighting, interiors—that had been spun out of GM in the late 1990s by investment bankers claiming it would make GM look more “focused” and “manageable.” In truth, Delphi was a dumping ground for $10 billion of GM’s debt, pension, and health-care obligations, as well as dozens of hopelessly unprofitable UAW plants and billions more of hidden liabilities such as parts warrantees.

  Not surprisingly, Delphi hit the wall early, entering Chapter 11 in the fall of 2005. That this spin-off company was intended all along to be a financial beast of burden for GM is evident in its reported financials for its prior six years of existence as an independent company. During that period its sales totaled $165 billion, mostly to GM, but it recorded a $6 billion cumulative net loss and generated negative operating free cash flow. Indeed, saddled with $60 per hour UAW labor costs against non-union competition at $15 per hour, it was kept alive only by an intra-industry Ponzi scheme: Delphi floated bad trade credit to GM and GM massively over-paid Delphi for parts.

  Needless to say, Delphi was an economic train wreck that had no prospect of honest rehabilitation, but under pressure from GM and the UAW it remained mired in bankruptcy court for the next four years. In the interim it continued to float billions of GM’s payables on the strength of its DIP facility, yet was ultimately able to emerge from Chapter 11 only because the White House auto task force saw fit to pump billions of taxpayer money into its corpse as part of the GM bailout.

  The first-order effect of this terrible abuse of state power, of course, was a few more $60 per hour UAW jobs in Saginaw, Michigan, and a few less $15 per hour non-union jobs in Tennessee and Alabama. But the real evil of the bailout lay in its rebuke to free market discipline and the powerful message conveyed by the White House fixers that failure in the market-place no longer mattered. Even complete zombies like Delphi could be spared, so long as crony capitalism was alive and well in Washington.

  The self-evident fact is that Delphi should have been liquidated, with its few viable operations auctioned off and its dozens of uncompetitive and obsolete UAW plants shuttered. The billions of trade credit it had foolishly extended to GM should have been written off, not paid in full by the taxpayers (with GM bailout funds). Yet this capricious assault on the free market was only one of the evils that came from the auto bailouts.

  After Delphi was unnecessarily resuscitated with what turned out to be $13 billion of taxpayer money, including $5 billion from TARP and $6 billion from the Pension Benefit Guaranty Corp.’s takeover of Delphi’s busted pensions, an even more obnoxious turn of events unfolded. A marauding band of hedge fund speculators were able to scalp an astounding $4 billion profit from a company that under the rules of the free market and bankruptcy law would never have seen the light of day after its original Chapter 11 filing. Indeed, just one of the investors, a so-called vulture fund named Elliot Capital, appears to have realized a 4,400 percent gain, or $1.3 billion, on its Delphi investment, which was taken public in an IPO in the fall of 2011.

  The particulars of this case, in fact, reek with the stench of crony capitalism. They powerfully illuminate how the Fed’s boom and bust cycling of the financial markets wantonly showers ill-gotten wealth on the 1 percent. According to the SEC filings, Elliot Capital picked up its Delphi position for $0.67 per share in the midst of the auto industry collapse and while both GM and Delphi were still in Chapter 11. It had the good fortune to sell stock to the public two years later at $22 per share.

  Perforce, what the filings do not disclose is that in the interim Elliot Capital and its confederates had gained control of the Delphi bankruptcy by buying up the so-called fulcrum securities for cents on the dollar. The
y then threatened to paralyze GM by not shipping certain irreplaceable precision-engineered parts like steering gears, where GM technically owned the tooling but it was physically hostage in Delphi plants.

  Needless to say, in a regular way bankruptcy a judge would have come down on the Elliot Gang like a ton of bricks for contempt; a tough judge might have even figuratively put them in shackles. But under the ad hoc rules of crony capitalism, the law counts for little and political hardball is the modus operandi. This meant that the hedge funds were literally able to strongarm the Obama White House into providing the $13 billion bailout to the Delphi estate. Even auto czar Steve Rattner, who was himself busily fleecing the taxpayers, described the hedge fund position as an “extortion demand by the Barbary pirates.”

  The winnings of the Elliot Gang are an obscene lesson in how crony capitalism and Fed money printing perverts the free market. Without the $13 billion fiscal transfer Delphi would never have emerged from bankruptcy; and without the flood of liquidity from the Eccles Building there would have been no frothy market on which to unload the Delphi IPO.

  As it happened, however, the other vultures in the Elliot Gang had a good feed, too. In particular a credit-oriented hedge fund and spin-off from Goldman Sachs called Silver Point gained a $900 million profit from the deal, and this was not an atypical result: it was one of the most adroit speculators in the busted loans and bonds of overleveraged train wrecks miraculously brought back to life by the Fed’s flood of fresh money.

  Another huge winner was John Paulson’s fund. This time its big short was against the American taxpayer and the gain was a reputed $2.6 billion. But the most egregious windfall was the $400 million gain racked up by Third Point Capital. This hedge fund is run by one Daniel Loeb who had been an Obama supporter in 2008, but had since noisily denounced the president for unfairly picking on the 1 percent.

  Given the history here this might have put an uninformed observer in mind of biting the hand that feeds you. Except Loeb didn’t stop with his supercilious but widely circulated critique of Obama’s purported “class war.” Instead, he held fund-raisers for Romney and contributed $500,000 to the GOP campaign.

  In so doing, Loeb helped clarify why crony capitalism is so noxious and pervasive. It turned out that another winner from the Elliot Gang’s 40X return on the carcass of Delphi was an allegedly passionate opponent of the GM bailout; that is, the author of a famously penned New York Times op-ed called “Let Detroit Go Bankrupt.”

  The ease with which the vultures made their billions from this crony capitalist raid on the US treasury is evident in Mitt Romney’s $15 million of Delphi winnings. Based on the timing of this saga, it appears they were obtained while Romney was on the chicken dinner circuit honing his anti–Big Government rhetoric for the upcoming presidential campaign. Call it the Detroit Job.

  It goes without saying that with friends like these the free market does not need any enemies. More importantly, under the financial repression and Wall Street–coddling policies of the Fed there is no free market left. Instead, it has been supplanted by a continuous and destructive cycle of boom and bust emanating from the monetary depredations of the state’s central banking branch.

  In the process of inflating stocks, leverage, and speculation to absurd heights, the Fed finally loses control, transforming the financial markets into economic killing fields. Yet in its panicked reflation maneuvers, it then fosters a vulture capitalist harvest of such magnitude as to be unthinkable on the free market. This is the absurd end game of Greenspan’s wealth effects monetary policy and specious claim that bubbles can’t be seen, but only left to burst. This is how recovery for the 1 percent happens.

  LEAR CORPORATION: PRODIGY OF BUBBLE FINANCE

  During 2009–2012 the vultures feasted gluttonously in the Fed’s killing fields. Indeed, the Delphi abomination was an endlessly repeated template, even within the smoldering ruins of automotive alley. Thus, the miraculous rebirth of Lear Corporation, the poster boy for the auto industry’s excursion into bubble finance, was still another case where riches were extracted from the wreckage. Its two-decade sojourn as a leveraged buyout, IPO, M&A machine and stock market wonder was virtually coterminous with the Greenspan bubble era. Thus, Lear Corporation first emerged as a $400 million sales LBO in 1988—with what appeared to be a unique growth model based on just-in-time seat assembly facilities located near auto assembly plants. In return for rapid sales growth from OEM “outsourcing” of seat assembly, Lear accepted razor-thin margins and extended a huge trade credit to the Big Three; that is, it absorbed their working capital and thereby never made any cash profits.

  Lear’s revenues skyrocketed from this maneuver, however, permitting it to go public in the early 1990s as a “growth company.” In addition to continued huge investments in OEM working capital via the expansion of its seat outsourcing business, it also undertook more than $5 billion of acquisitions to “roll up” suppliers of auto interiors and electronics during the next several years. Accordingly, its sales grew like Topsy from $2 billion in 1993 to $10 billion by 1998 and $17 billion by 2004. Not surprisingly, this stupendous growth absorbed every dime of the company’s internal cash flow plus a massive buildup of debt to make ends meet.

  At that point Lear had generated immense stock market enthusiasm, sporting a market cap of nearly $5 billion and a 10X return to original IPO investors. What it hadn’t generated, however, were profits. In fact, during the two decades between 1991 and 2008 Lear Corporation posted $200 billion of sales, but nearly $1 billion of cumulative net losses.

  Like so much else during the Greenspan bubbles, the hit-and-run punters who pumped up Lear’s market cap to a preposterous $5 billion were long gone when it became evident that the company was worth zero: the only possible valuation for a company that makes no GAAP net income over two decades. In fact, Lear Corporation was a giant wheel-spinning machine which borrowed $3.5 billion to fund acquisitions and open new plants to supply the Big Three. In return for virtually profitless sales it extended them upward of $4 billion of trade credit—borrowing against its own assets and cash flow as it did.

  Accordingly, when GM finally hit the wall, Lear became a bug on its windshield. Yet instead of undergoing the brutal downsizing and deep reorganization that its failed business model required, it went through a quick four-month rinse cycle in Chapter 11, only to reemerge largely intact and with its bad debts from GM paid in full by the White House auto task force.

  THE BIG FIX IN MOTOWN

  It did not take Wall Street speculators long to realize that both the industry and Lear Corporation would emerge quickly from bankruptcy, thanks to the fact that GM, Chrysler, GMAC, and many auto suppliers were being smeared with $80 billion in taxpayer money. So the fact that Lear went into Chapter 11 with $3.6 billion in debt and came out a few months later with only $900 million of debt completely obscures the real story; namely, that speculators made out like bandits from Lear’s faux bankruptcy.

  By early June 2009, the operational wheels at GM had ground nearly to a halt and Lear’s bonds had dropped to twenty-seven cents on the dollar according to trading services at the time. However, vulture speculators aggressively scooped up this so-called distressed debt because by then it was evident that the “fix” was in, and that the “carry cost” of holding a position in Lear’s busted bonds was virtually nothing under the Fed’s ZIRP policy. Moreover, there were plenty of good reasons to take a flyer notwithstanding the headline noise about the auto industry’s dire state.

  The heart of the matter was that the Obama White House had by then made it abundantly clear that there would be no house cleaning on Wall Street. The president’s desire to make an example of Citigroup by busting it up had been sabotaged by his own advisors. Likewise, Wall Street’s new viceroy in the Treasury Building, Secretary Tim Geithner, had already completed his phony “stress tests” that gave most of the big banks a clean bill of health.

  Accordingly, the Fed was free to juice the primary bond dealer
s with unlimited amounts of fresh cash via Treasury bond and GSE paper purchases in order to levitate financial markets. It was thus “risk on” again with respect to asset classes like junk bonds.

  Indeed, with each passing month after the March 2009 stock market bottom it became more evident that the Bernanke put was actually a relentless, turbocharged version of the Greenspan original. So there was enormous potential upside from leveraged speculation in Lear’s busted bonds and exceedingly limited downside given the rampant crony capitalism embodied in the auto task force.

  General Motors was Lear’s largest customer by far, as it was the UAW’s largest employer. So there was precious little chance that it would be shrunk down to “GM Lite” in the White House bankruptcy process or that Lear’s supply contracts would be cancelled. Most importantly, since the White House fixers had already made it clear that GM’s trade debts to Lear would be paid in full, the reorganized company did not need to fund itself with a large working capital revolver.

  This was crucial because it meant that Lear’s entire enterprise value could be wacked up among its pre-petition bank and bond lenders; that is, the available value could be captured by the vultures because its assets didn’t need to be pledged to a new working capital lender. Not by coincidence, therefore, Lear announced a “pre-pack” bankruptcy filing almost to the day—July 5, 2009—that GM exited its fast dash through Chapter 11. As is consistent with normal practice, this deal had already been cleared with the company’s principal creditors and provided for expected “recovery” rates for each class of creditor.

  In the case of bondholders it was about forty cents on the dollar, meaning that speculators were already well in the money. In fact, when Lear Corporation exited its quickie bankruptcy and its stock began trading on November 9, the package given to its bondholders was worth sixty cents on the dollar, meaning that speculators had doubled their money in about 150 days. But the real “fix” was just getting started.