In May of this year we published a comment entitled "Ford, GM and Health Care: Was Hillary Right?" which predicted a slow-motion financial collapse of the Big Two US automakers. The unhappy event would be sparked, we speculated, by the implosion of their two former parts making subsidiaries, Delphi Corp (NYSE:DPH) and Visteon Corp (NYSE:VC), under the weight of accumulated liabilities.

Our missive "made a lot of people nervous," to paraphrase one of our colleagues who makes a living in the bond market, but nothing new there. The job of a risk analyst is not to make people feel comfortable. Thus when a certain conservative business & financial daily subsequently solicited a contribution from us on this issue, the article was ultimately rejected for being too critical of the Bush Administration policy - or lack thereof - regarding Detroit's mounting financial woes.

Yet the announcement by DPH that it may need to file for bankruptcy, both because of current losses and long-term labor and benefit costs, seems to confirm our analysis. And what a lovely irony it is that DPH, and many other US companies such as Northwest Airlines (NYSE:NWB), are considering filing for court protection from creditors before the new Republican-crafted bankruptcy legislation goes into effect on October 17, 2005.

The news about DPH came when the parts manufacturer disclosed that it was drawing on existing bank credit lines, the sort of behavior often seen just before a company files for bankruptcy protection. This situation nicely illustrates the Basel II concept of Exposure at Default or "EAD," which consists of two parts, the amount currently drawn and an estimate of future draw downs of available but untapped credit. In the May 2005 BIS working paper on the Basel II framework, "Studies on the Validation of Internal Rating Systems," Japp W.B. Bos wrote that:

"When estimating EAD it is important to recognise that EAD, even more so than [Probability of Default] PD and [Loss Given Default] LGD depends on how the relationship between bank and client evolves in adverse circumstances, when the client may decide to draw unused commitments. What this means is that the realised EAD is to a large extent influenced by earlier decisions and commitments by the institution."

Even as DPH began to draw down the remaining $1.5 billion on its existing bank credit facilities, a line of banks already was formed to offer the company new debtor in possession or "DIP" financing in the event of a Chapter 11 filing. Since DPH's receivables are already pledged as collateral on the existing loans and the company's remaining unencumbered assets are few, it will be interesting to see what financial legerdemain is employed by the lenders to justify new money loans.

A summary of the business stress test for DPH from the IRA Corporate Monitor is shown below. Notice that the Corporate Monitor did not generate a Z-Score for DPH for 2004 because the required data inputs are so far outside normal parameters.

Source: IRA Corporate Monitor

The creditor banks of DPH and VC cannot trade their way out of the direct and indirect financial exposure they already have to the moribund domestic US auto makers and their suppliers, thus the only answer is to lend more and hope the industry will rebound. A cynic might say that the swelling ranks of the hedge fund maggotry will pick up the slack and take the commercial banks off the hook, but the banks have such high exposure to hedge funds that such a strategy is not likely to reduce the overall risk to the banking system.

Over the past century, the US auto industry has managed to bounce back from seeming oblivion time and again. Perhaps this is why several analysts deigned to upgrade their ratings on DPH and VC in recent weeks. But with Ford (NYSE:F) and General Motors (NYSE:GM) continuing their "employee pricing" sales incentives through Labor Day, this as the Japanese automakers raise prices and still take market share, does anyone truly believe that this story has a happy ending?

The immediate risk to the creditors of DPH and peers like VC may be measured using terms like EAD, but the larger risk to the entire US economy is a political issue best debated in Washington. Blinded by its neoliberal, world-is-flat perspective, the Bush Administration likes to pretend that it can ignore the impending collapse of the US auto industry, all the while talking about a strengthening economy. We wonder, though, when DPH and VC are both operating in receivership, the Bankruptcy Court voids labor agreements, pension plans and vendor contracts, and tens of thousands of US workers and suppliers have lost their livelihoods and investments, whether Washington still will pretend that there is no crisis in Detroit?

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