The risks of Ford’s equity tail wagging the credit dog
ft.com
By Tony Jackson
Published: September 4 2006 17:33 | Last updated: September 4 2006 17:33
These are grim times for the Ford Motor Company. Ever since announcing enormous losses six weeks ago, it has been issuing panic bulletins on a regular basis. The market reaction has been interesting: Ford's shares, bonds and credit default swaps have all shot up.
One or two commentators are uneasy about this. Let us grant, for the sake of argument, that the crisis justifies a one-third rise in the share price. Does it also justify a 20 per cent rise in Ford's bonds, and a drop in its CDS spreads from 930 basis points to 640? Could it be that, as one US newsletter puts it, the equity tail is wagging the credit market dog?
If that were so, the implications would reach well beyond Ford. One of the themes of this column is the convergence between different asset classes. That is partly driven by arbitrage trades set up by the more sophisticated kind of investor.
The risk here is twofold. The more sophisticated the trades, the more liable they are to go wrong. And if stocks, bonds and derivatives are all driven by the same data, we could have an awful lot of people scrambling for the exit when the data turn ugly.
Recall that very often, what is good news for equity holders is bad news for debt holders and vice versa. In Ford's case, investors seem enthused by the prospect of a shell-shocked management finally biting the bullet. And plant closures, for instance, might be good for earnings in the long run.
But they could be very bad for immediate cash flow, which is what concerns the debt holders. Partly because of restructuring costs, the rating agency Fitch now thinks Ford could have negative cash flow this year of more than $7bn.
But we should not overdo this. The closer a company is to bankruptcy, the more the interests of the debt and equity holders converge. If a cash-rich company hits trouble on the trading front, its shareholders might panic and the bondholders won't care. But if Ford goes bust, both share the pain.
Thus, one big issue for both parties is whether Ford will sell its profitable financing arm. That would be a powerful short-term fix. As the derivatives market tells us, that business is far more humbly rated at present than the financing arm of General Motors. That is because GM gave up majority control earlier this year. Ford still owns 100 per cent of its finance business, which is therefore contaminated by its troubles.
But let us return to the broader issue. How far can the equity tail wag the credit dog? When it comes to the CDSs, it would seem, not very far.
A company's CDSs are essentially priced off the relevant corporate bond. Theory says the return on the CDS should equal the yield on that bond, less a risk-free return say, the yield on a Treasury bond of the same duration.
Now, suppose the company's shares were to rise, pulling the CDSs up by more than the bond. That would create an arbitrage opportunity. The trick or so I am assured would be to buy both the bond and the CDS and short the Treasury, thus locking in an extra return for the duration of the contract.
I don't want to get into the complexities of that, merely to observe that the process is fairly automatic. Where it gets trickier and more subjective is when the equity gets priced off the credit.
This is once more characteristic of companies at risk of failure, where the value of the two should be driven by the same headlines. As I understand it, it involves using option theory to derive a value for the debt. Then you use that to come up with an ideal value for the equity. If the market price is below that, you go long of the equity and short of the debt. And very often the easy way to short the debt is to buy the CDS.
Where does all that leave us? On the one hand, the situation with Ford may be more rational than it looks. On the other, the complexities involved in a case like this are faintly worrying.
In particular, the people working the various kinds of trade can be remote from each other, and may not be aware of what the other lot are up to. If Ford were to go bust, the behaviour of investors might stop being quite so rational. For in some respects, they are working in the dark. |
