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Detroit's Perfect Storm Sets Sales Up For Bailout

2157 words - 9 pages

Detroit’s Perfect Storm sets Sales up for Bailout
By Jeffrey Adik
Copyright © November 2008 Jeffrey Adik
Intraduce, LLC | All Rights Reserved

The domestic automotive crisis embodies the perfect storm. The gale-forces our economy now faces are the result of a lengthy series of events that have effectively frozen consumer lending and generated an extraordinary global lack of trust across all investor categories. Attempts by the international market to hedge the crisis, through US currency devaluation, have only accelerated problems. The doubling of fuel prices had an immediate impact on the US consumer goods market, perhaps most visible in the automotive industry. This dramatically ...view middle of the document...

While this should help to ease U.S. gasoline and consumer goods prices, and inspire demand again, it leaves the auto industry facing a significant crisis, and on the verge of causing a much deeper economic meltdown. Here is the reality that we are facing:
1. Reduced spending has caused a rapidly-depreciating, growing inventory of new vehicles.
2. Consumers can not actually buy vehicles, since the banks are not actually lending.
3. As the recession deepens and sees investment reduced, new layoffs will further drop demand.
4. Even if consumers were buying, many have permanently changed preference and refuse to be burned again with a return of high fuel prices.
5. Still on the industry books is the massive (3-4 year) inventory of lease vehicles gradually entering the used vehicle market. Prices may be 20-40% below their booked value by the time they enter for resale. This completely undermines the industry’s broader (non-current) asset values.

Although it is assumed the issues are large, it is not entirely clear in the general market how deep these problems are seated. The industry itself, of course, should be fully aware and has been lobbying as hard as possible for immediate relief. The window of time available to avoid catastrophe is quickly disappearing, as cash is growing scarce and forthcoming earning reports will soon show the naked truth of their asset devaluation.

Unsurprisingly, significant controversy surrounds the bailout the industry is seeking. First, it is unclear how a US auto industry bankruptcy would impact the country. To bring some clarity to the severity of the situation, I ask you to consider the banking multiplier.

Banking Basics: In the U.S., every dollar deposited in the bank requires only $0.10 to be retained. This is what is known as a 10% ‘reserve requirement’. The bank actually extends the remaining $0.90 to the market as credit. Recognize, however, that the money quickly comes back to the bank, and when it does the bank will of course lend out 90%, holding on to that 10% reserve requirement. This has just provided another $0.81 to the markets. Of course, this process continues, and what you get eventually is a 10 times multiple of whatever capital has entered into the bank, in the broader market. This approach dramatically facilitates commerce, and when things run smoothly we see enormous benefits.

Why this is important: The debt held by the Detroit three is only stated publicly on GM & Ford’s books. GM has $170B in debt, with Ford showing a larger $240B. Chrysler, although privately held, has generally seen half the average of GM & Ford’s financials, or another cool $100B. Consider that the auto industry defaults and seeks protection from its $510B sum debt total ($170B + $240B + $100B = $510B). Given the nature of the 10x banking multiplier, a catastrophe of this magnitude will have a $5.1 trillion impact on the financial markets. To give a sense of scale, imagine that...

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