This commentary is an email, so because of length it's in two parts. Any comments oughta follow Part 2. Anybody run across the comment, "Today, GM; tomorrow, GE."? While GM's plight is obviously egregious, it's a matter of degree, not style. Gary North's REALITY CHECK Issue 444 May 6, 2005 GENERAL MOTORS RUNS OVER THE EXPERTS DETROIT (AP) -- Standard & Poor's Ratings Services cut its corporate credit ratings to junk status for both General Motors Corp. and Ford Motor Co., a significant blow that will increase borrowing costs and limit fund-raising options for the nation's two biggest automakers. Shares of both companies fell 5 percent or more after Thursday's downgrades, and the news sent the overall market lower. "New York Times" (May 5, 2005) All of a sudden, without warning, the investment world is talking about the looming crisis at General Motors. Its pension fund obligations and health care obligations now appear to threaten the future of the company. The decline of its stock price from $55 in January, 2004, to today's $30 range has revealed a loss of confidence in the company by investors. To see this decline in action, click here: http://shurl.org/gm05 I have no objection to the experts' pessimism regarding the future of General Motors. I happen to share it, and have for years, precisely because of the pension issue. What astounds me is that investors and financial columnists have only just begun to regard the company's pension obligations as a significant factor in the future profitability of the firm. Why now? Why not in 2003 or ten years ago? The United Auto Workers' officers and GM's senior managers decided decades ago to agree to high pension and health benefits in exchange for reduced increases in wages. Health care benefits are tax-free income for workers. Even retired workers are covered. It seemed like a low-risk deal for GM. Nobody thought about the price effects on health care of Medicare. The health care market, like all markets, is a giant auction. If bidders get their hands on more money, they will bid up prices. All over America, workers are bidding health care prices. So are retirees. A DISASTER CALLED OPEB Alan Sloan, a financial columnist for "Newsweek," has painted a stark picture. He begins with a description of how GM got into this pickle. Lower salaries meant that GM reported higher profits, which translated into higher stock prices -- and higher bonuses for executives. Commitments for pensions and "other post-employment benefits" -- known as OPEB in the accounting biz -- had little initial impact on GM's profit statement and didn't count as obligations on its balance sheet. So why not keep employees happy with generous benefits? It was a free lunch. Besides, GM's only major competitors at the time, Ford and Chrysler, were making similar deals. This is the free lunch mentality: something for nothing. As with all free lunches, people eat more than they normally would. The price is right! Now, as we all can see, pension and health care obligations are eating GM alive. The bill for the "free" lunch has come in -- and GM is having trouble paying the tab. In the past two years, GM has put almost $30 billion into its pension funds and a trust to cover its OPEB obligations. Yet these accounts are still a combined $54 billion underwater. Note the phrase, "as we all can see." But nobody saw it until about February, 2004. Sloan says the problem by then had been building for over half a century. GM began its slide down the slippery slope in 1950, when it began picking up costs for medical insurance, pensions and retiree benefits. There was huge risk to GM in taking on these obligations -- but that didn't show up as a cost or balance-sheet liability. By 1973, the UAW says, GM was paying the entire health insurance bill for its employees, survivors and retirees, and had agreed to "30 and out" early retirement that granted workers full pensions after 30 years on the job, regardless of age. These problems began to surface about 15 years ago because regulators changed the accounting rules. In 1992, GM says, it took a $20 billion non-cash charge to recognize pension obligations. Evolving rules then put OPEB on the balance sheet. Now, these obligations -- call it a combined $170 billion for U.S. operations -- are fully visible. And out-of-pocket costs for health care are eating GM alive. I report this because of the delay factor. This was all built in, Sloan says. He is correct. It is why I counselled small businessmen in the late 1970s not to set up health plans and pension plans for their employees. The legal liability was too great, I warned them. But I was almost alone in this view. Not now. "DON'T ARGUE WITH THE MARKET!" We are told that the stock market discounts the future rationally. This means that the best and the brightest investors use their best estimates to buy and sell. Today's prices therefore include all of the relevant information, as judged by experts who bought or sold. Any unexpected price changes must come from new information or new perceptions that had not operated before. With respect to GM, it's "new information, no; new perception, yes." The information was there for many years. All of a sudden, investors' perception changed. Down went GM shares. Yet the basics had not changed. By tying stock pricing theory to information, and by relegating changed perceptions to the footnotes, economic commentators can then tell us that good times are coming, that bad news will be more than offset by good news. After all, isn't the stock market rising? Anyway, it's not falling. "Don't argue against the stock market!" Here is the reality of stock market pricing: seriously bad news is not discounted until it threatens the survival of the company. Optimism usually prevails among investors. Only toward the end of a bear market does investor perception change. With respect to pensions and health care, optimism is government policy. The government has assured us, year after year, that "pay as you go" works just fine for Social Security and Medicare, smart people believed the spiel. They carried the same attitude with them when they looked at GM's pension/health obligations. They refused to factor in the estimated numbers. At the end of last year, GM says, its U.S. pension funds showed a $3 billion surplus. GM's pension accounting, which assumes that the funds will earn an average of 9 percent a year on their assets, is highly optimistic. But things are under control -- as long as GM stays solvent. By contrast, OPEB is out of control. At year-end, OPEB was $57 billion in the hole, even though GM threw $9 billion into an OPEB trust in 2004. http://shurl.org/gmsloan Consider these numbers in relation to GM's market capitalization of about $17 billion. The company is deeply in debt: around $300 billion. (http://shurl.org/gmdebt) It had to sell $17.6 billion in bonds in 2003 to meet its pension obligations. Yet in January, 2004, its share value peaked. Optimism still reigned supreme. The best and the brightest missed what should have been obvious. It could happen again. Next time, it could happen to a lot more companies. The worse the news out of Medicare, the less optimistic the outlook of investors. End Part 1.