The “B” word along with “GM” and “Chrysler” often appear in the same newspaper articles. Bankruptcy is failure. Bankruptcy is bad news. For now, let us define bankruptcy as a situation where an entity is in default with their debt obligations. When you see the “B” word again, just think of it as news that’s neither good nor bad. Think of it as just a piece of information.

Chapter 11

When you read about bankruptcy in the United States, you will probably see the term “Chapter 11” somewhere in the article. What exactly is Chapter 11? When an entity files for Chapter 11, it is actually under protection from its creditors and a complex restructuring process begins. The restructuring process attempts to fix the entity so that it will resurrect in a new form and “go back to business as usual”. It will involve creditors to forgive the entity’s debt, often exchanging for equity positions. It is not surprising that creditors that become shareholders reclaim a measly 20 cents on the dollar on the investments.

In the meantime, the entity could re-negotiate some other contracts that are outstanding. Chrysler was in constant talks with the Union to adjust their hourly wages to more competitive levels for example.

Bankruptcy proceedings can be a messy business as there are many parties of interest involved. The creditors will want a bigger share of the company. Workers will want to keep their wages and benefits. The Bankruptcy Court decides on what is fair or not. Otherwise, the process will never end.

Chapter 7

There is no need to write much about Chapter 7, though it is a term that is less heard of. This is when an entity’s assets are liquidated and paid out to its stakeholders according to the pecking order; you know, secured debt holders get first dip, then the unsecured debt holders, and then the shareholders. Each level would get something only if the level above has something left for them. For this reason, shareholders can be fairly sure that there is nothing left for them. After the liquidation process is complete, the entity is forever gone.

Bankruptcy and the Detroit Big Three

Chrysler has filed for bankruptcy, GM is not far away, and Ford says it has enough cash to burn for just another year. I think bankruptcy is actually helping Detroit to take the fast lane in getting out of its darkest days.

Chrysler and GM are or will soon be under Chapter 11 protection. This means that stakeholders believe they will benefit by turning the company around instead of dumping everything at fire sale price before they lost everything. Think of the Chapter 11 process as a student who is failing his classes in school, but the teachers believe that she still has the potential and imposes disciplinary actions on her. Chapter 7 is equivalent to expelling the student because she is hopeless.

Chapter 11 will definitely help Detroit migrate to the next automotive era, but this does not mean that they will shine like the stars that they once were. Detroit failed to realize that they had entered an era of innovative competition, especially in the arena of fuel efficiency. Toyota got a head start in Hybrid technology, and the Germans dominate in diesel. Unless they catch up very quickly, they will be making products that don’t stand out and will survive because they managed to cut costs from restructuring efforts. As discussed in my last article, innovation will drive the next winner and this company in Los Angeles has a very promising technology. The U.S. auto industry might shine again if L.A. meets Detroit in a productive way. They also need to establish a bigger presence in China where the auto industry is experiencing explosive growth.

Was it right to bailout the Big Three? What about the Banks?

In response to K’s comments, I agree with you that the laissez-faire approach would’ve saved the taxpayers a lot of money. If we are looking at the issue purely from a financial point of view, it is not hard to tell that the government is subsidizing Detroit and not investing in it. And yes, if the Big Three are out, the parts suppliers will go out of business and cause even more unemployment. The decision to bail them out is based a political decision, not a financial one.

If I were part of the think tank, I would not recommend bailing out the Big Three. If the patient is gravely ill and surgery is inevitable, operate on the patient. Why prescribe her with a few months of pain killers and then perform surgery that would have to be done anyway?

The financial industry is a different story. Ben Bernanke is counting on his quantitative easing plan to revive the economy and needs the banks around to do the work for him. Let’s say that all but one bank stayed afloat. The Fed could push the rates as low as they like, but it doesn’t mean that the only bank would follow suit because there is no competition. This happened in Canada when the banks refused to follow the Bank of Canada’s lead after the latter had cut its rate. The more banks there are, the stronger the Fed’s army.

These zombie banks still have value in them as vehicles to help circulate money in the economy. Once the economy stabilizes, the Fed can make the switch to a laissez-faire approach and let the market decide who can stay. By bailing out the banks (at least temporarily), the U.S. government is acting like a market player because they are pursuing their self interest of maximizing GDP and hence, their tax revenues.

In the end, you still can’t beat market forces.

Henry Ford would probably sigh and shake his head if he saw what was happening to the American auto industry.  The industry is not just about jobs but has long been a symbol of American prosperity.  It has served well in the past as an indicator of economic health in the pre-financial tsunami era.  With the Obama administration granting GM and Chrysler 60 and 30 days respectively to restructure, it would appear that much of what we know about the industry can only exist in our memories and museums. 

Car sales is a direct function of oil price

My friend PH explained to me why all levels of the industry, from salespeople that work on commission to management in Detroit, love to sell big cars.  Gas guzzling SUVs have a higher profit margin than the practical Chevrolet Cobalt, which is on GM’s line-up because they need to satisfy fuel efficiency and environmental regulations.  SUVs enjoyed a few years of popularity when Detroit thought they have proven the world wrong by thinking that Americans wanted small cars.  Detroit was right – for a while, until the price of oil kept rising and rising with almost no friction.  New buyers didn’t want SUVs and existing owners were eager to get rid of theirs.    

You know how the story unfolds.  Consumers switch to fuel efficient cars where the Japanese and more recently, the Koreans, dominate.  Toyota dethrones GM as the world’s number one car maker.  Oh, don’t forget, with the financial tsunami, there is a behavioural change that keeps executives in Detroit up every night; more and more people are taking the bus to work.   

The end of the U.S. auto industry or the beginning of a new era of leadership?

While I’m not a big fan of American cars, I would say that the U.S. has all of the ingredients that it needs to become a leader in the next auto age.  Some dinosaurs became extinct, but others evolved into crocodiles and alligators that are alive and well today.  Whether the Big Three can turn into crocodiles will depend on many variables such as consumer attitude towards cars, the pace of economic recovery and government policies.  Some things we can be certain of though.  We can be sure that the supply of oil is finite, and environmental regulations will only become stricter.   As we sober about economic woes, let us not forget about the hole in the ozone layer.

If we want the luxury of relying on a personal vehicle wherever we go like we did for the most part of the 20^th century, we need to power up our cars cheaply and in a manner that won’t stink up the environment.   Electric cars have the potential to address both of these questions.

Tesla Motors

Based in California, Tesla Motors designs and builds high performance electric cars.  If you still believe electric cars can only hold enough charge to take you to and from the grocery store at a maximum speed of 40km/h, it’s time you’re in for a little surprise.  Tesla Motors is already working on the prototype of their second product; the Type S.  Requiring only 45 minutes to recharge, the Type S can travel up to 500 km on a single charge and accelerate from 0-100km/h in 5.6 seconds.  Running on electricity presents significant savings to your wallet and to the environment (we already have the technology in place to dispose of batteries safely).  I suggest you visit their website at http://www.teslamotors.com  to learn more about this company and their products.  By the way, if you live in a house, you can consider buying a solar panel powered charger to power up your car.  The solar power charger gives you enough power to 80km/h a day, giving many commuters the opportunity to literally drive for free.

Obstacles to the path to the new era

While the future of electric cars is promising and exciting, there are obstacles that will slow us down to a new future or simply prevent us from getting there.  If you frequently drive long distance between towns, you will probably dismiss the idea of an electric car because you wouldn’t want to be left stranded in the middle of the road.  The good news is that it only takes five minutes to swap batteries.  This is about how much time you would spend pumping gas in your car.  The problem is that we have plenty of gas stations and we don’t have any battery swap stations unless companies (maybe even governments?) are willing to invest capital to develop such infrastructure.  The U.S. has tried for a very long time to cure its addiction to oil and the Obama administration has committed to spending on infrastructure.   Obama had said explicitly that he would invest in infrastructure to both stimulate the U.S. economy and make the U.S. less reliant on foreign oil.  The big question is whether the new infrastructure will be in favour of electricity or some other alternative energy like hydrogen or bio fuels.

Thanks everyone for their comments.  Many of you are in disbelief or disagreement that there's no or little risk of inflation with all of this money printed out of thin air.  I picked up the latest issue of The Economist magazine and year to year consumer prices have increased for most countries.  A few things to clarify:

As much focus is placed on America’s unemployment rate which is poised to hit 10% this year, investors with long term horizons are already taking their binoculars out to see what the world will be like in the post-crisis era.  Their main concern is whether all of the money that governments around the world have been pumping into the world economy will result in hyperinflation;  inflation that runs out of control.  Let’s first try to understand inflation a little better, and then we’ll look at whether the dynamics of the current environment are in favour of an era of high prices. 

Inflation – a bad name until now:

Inflation has gotten a lot of bad press in the past.  On the milder side, we have the oil shock that the U.S. experienced in the 1970’s.  In the 1920’s, the damage that inflation had inflicted on the Germans was simply ruthless.  It cost 60 German Marks to buy 1 U.S. dollar in 1921.  In two years time, it cost 4,200,000,000,000 Marks to buy 1 U.S. dollar. 

U.S. inflation in the month of February was positive after consecutive months of price decrease.  The market embraced this as “Some good news finally”.   So... what happened to inflation being the ultimate evil? 

Understanding Inflation:

Inflation does not cause any problems.  It is the result of our day to day economic activities; it is when supply cannot meet demand.  This can happen when consumers demand too much or when producers cannot supply enough.

Small doses of inflation are good for the economy and are necessary for economic growth.  Inflation gives businesses pricing power and when businesses make a profit, they hire more people who will end up buying more products and services.  Businesses then hire even more people and invest more in equipments to meet the additional demand.  This cycle needs to be sustained to keep the economy growing while ensuring that it doesn’t run too fast to avoid bubbles from forming.  Canada has a target inflation rate of 2%. 

On the other side of the coin, businesses will cut cost when prices fall to maintain a profit (or just to break even).  Layoffs are almost an inevitable part of cost cutting measures and when people lose their jobs, they consume less, prices will fall further, and the economy enters into a deflationary cycle.   Authorities will tell you that they would much rather battle inflation than deflation.  They can easily manage inflation with monetary policies such as raising interest rates, requiring banks to maintain higher reserves, etc. 

On the other hand, deflation, which is associated with economic contraction, cannot always be fixed by the simple act of pumping more money in the system.  Governments need to go out there and actually spend money to kick start an ailing economy.  Under stimulation will not work, and over stimulation will cause unwanted inflation.  Given the difficulty in finding the right balance, I argue that governments would rather err on the side of inflation and deal with it later than have deflation persist.  Inflation of 5% or even 10% will cause people to think twice before buying that BMW or going on vacation.  But, they will at least have enough to get by.  If people don’t have a job, it doesn’t matter how cheap things get.   

The Current Situation:

The Obama administration will be pumping U.S. $787 billion into the economy by means of tax cuts and expenditures.   U.S. GDP was valued at $14.26 trillion dollars in 2008 with an annualized drop of 6.2% in Q4.  Excluding multiplier effects, the package is worth only 5.5% of GDP.   In other words, the stimulus package can only undo some of the price fall over the past few months at best; no threat of inflation here.

Some take the signs of inflation in February as indication of the U.S. economy bottoming out.  While I also take it as good news, I also take caution not be overly optimistic and jump the gun on major purchases or investments.  Let’s borrow those binoculars from the long term investors and look back a couple of months.  From August 2008 to February 2009, prices actually dropped 5% for the urban consumer in the U.S.  The Inventory to Sales ratio was 1.25 in Jan. 2008 vs. 1.43 in Jan. 2009, suggesting that businesses are struggling to move inventory out of their warehouses.  In an economy where over 70% of GDP relies on consumer spending, we should be more concerned with the risk of falling into a price deflationary spiral than speculated hyperinflation that may not be any real threat in the end.   On a global scale, the G20 summit came up with a resolution to make $850 billion available to the IMF.  That money is worth only 1% of world GDP so again, it shouldn’t raise a red flag for inflation. 

The U.S. government has injected capital into financial institutions shot after shot.  With the unemployment rate flying like there’s no gravity, that money is not going to start circulating in the economy anytime soon.  People need to have income in order borrow.  When people have income, they will get loans to buy a house or a car; you don’t need to force them (in fact, you can’t force them).  It shouldn’t work the other way around where you let credit run loose in hopes of stimulating spending and create new jobs.  This is how we got into this mess in the first place.  We probably won’t see the loans market being very active until unemployment eases and by then, the banks will be much more stringent with their lending practices.  The same idea can be applied to U.S. government scooping up US$300 billion of bonds to help kick start the loans market.  It won’t work. 

The Outlook:

Oil prices have fallen to the $50 range and the CRB Index (measuring the price of commodities) has fallen by 31% year to year (I took the values as of Mar. 27).  With eager job seekers, businesses that face a shrinking market for their products are also seeing their costs come down.  As businesses that can’t compete throw in the white towel, surviving businesses will be presented with cheap raw materials, available labour and enough market share to make a profit (with low prices, you will need to rely on volume to generate enough revenue).  Once they make a profit, they will hire more people, who will spend more money, and we enter another boom cycle.

Don’t forget that this is not a cyclical recession but one that rewrites the rulebooks.  Export driven economies will no longer be able to rely on American consumers.  Americans will not spend beyond their means and may even start to save money again.  Whether we will reach the bottom and stay flat (aka an “L-shaped” recession) or bounce back up will largely depend on whether the next wave of consumers that many speculate is in China will be able to lead the way.  We cannot be certain of China’s ability to lead the next boom.  But, we can be sure that the risk of deflation is real, the risk of hyperinflation is only probable and distant, and with interest rates at historical lows, any inflation can easily be corrected. 

How does this relate to your investment portfolio?  I need some time to give it some thoughts and I’ll share them with you in my next article.

Stay tuned!

Hello!  Thanks for your questions.  Let me address them one by one:

My good friend KY asked me the other day about my thoughts on gold as potential investment.  He really got my intellectual engine running.  I took the time to do a little bit of research on gold, analyzed the current economic conditions, and I must say that I learned a thing or two about gold that I didn’t know before from this exercise.  KY, thanks for your question.  Talking to you is always a pleasure.

Here is a snapshot of some key information on the demand for gold in 2008:

·         Consumption of gold related to jewellery was about 58%   (2137.5 tonnes)

·         Industrial use made up about 25% (860.8 tonnes)

·         Various investments made up about 17% (660.3 tonnes)

Starting with the largest user, jewellery made up more than half of the demand for the world’s yellow metal last year.  We are not even through the first quarter of 2009 and worldwide consumer confidence seems to be still heading south.  When times are bad, it makes perfect sense for people to cut back on major purchases that are unnecessary.  Two years ago, you could’ve gotten away telling people that you had bought that gold bracelet because you needed it.  No one will buy that story today.  Today’s consumer mentality is to buy what you need and put everything else aside for that rainy day.  Things are not looking for the jewellery business.  As of February, India, one of the world largest markets for gold, has yet to import any gold. 

The industrial sector made up the second largest demand group for gold.  There are so many uses for gold in industrial production; I cannot cover every single one of them.  For simplicity’s sake, let’s look at electronic products.  Japan, the world’s second largest economy, relies heavily on exports for economic growth.  Sony, Panasonic, you name it, are key to Japan’s economy.  Japan’s exports fell by over 40%, a sign that manufacturers are cutting back on the consumption of gold. 

Finally, there is investor demand for gold.  While gold has many practical uses such as those mentioned above, gold also has a unique function and that is it can act as store of value.  Over the history of mankind, many empires have risen to power and later crumbled to pieces, taking their currencies with them.  Gold can act as store of value no matter what happens.  People have managed to protect themselves while fleeing their home country from war and from hyperinflation. 

Given that demand is weak in the first two groups, the price of gold could only continue to rise if there is sufficient investor demand.   Investors that look far into the future realize that 1970’s style inflation may be ahead of us and have already flocked to gold to hedge their risk.  (I will write about inflation in my next article, too much information to cram everything here)  This is the last pillar standing to support gold price in the foreseeable future.   If you are considering holding positions in gold to hedge inflation risk, keep in mind that:

·         Many investors have already jumped in the game ahead of you.  This means that the price of gold has already factored in anticipated inflation after the economy recovers.

·         If inflation doesn’t turn out to be as bad as we anticipate, this will put further pressure on the price of gold.

I also learned that the supply of gold is rather rigid.  In other words, you cannot just come up with new supply on demand.  The process of finding gold mines, setting up the equipment needed to mine the gold ore and refining, are projects that are both capital and time intensive.  If mining companies continue to expand their mining operations, the outlook on gold is sliding demand with more than ample supply. 

Personally, I believe that it is still better off staying on the sideline observing the market than jumping into it at this time.    If you still want to invest in gold, there are plenty of ETFs out there so gaining exposure is easy.  (You can go long or short on gold with these ETFs, it’s up to you)   We are amidst one of the greatest financial crises, meaning that great investment opportunities are in the making.  Patience will pay off. 

Hello!  Thanks for reading my first article and your feedback.  Some of you raised interesting questions (I appreciate your email.  It is also possible to post comments on my blog directly) and I'm combining them here so I can respond to them all at once: