The Impact Of 2008 Financial Crisis

Published Date: 02 Nov 2017

Operations, Financing and Risk Management

Zi Fang

Executive Summary：

This report is commissioned to analyze the implication from the changes of General Motors (GM) during the 2008 financial crisis through quantitative and qualitative analysis on GM’s operations, financing and risk management.

The report draws attention to the fact that the insolvency of GM can be largely attributable to the U.S. financial crisis during which the company’s beta coefficient changed by 44%. In terms of operations, GM’s sales volume and profit margins reached the lowest point due to the impact of the crisis on car-loan availability and GM’s biased market strategy. Moreover, GM was in a financial strain during the crisis with the volatility of the stock price almost doubled in the periods of the crisis. In addition, under the global uncertainty, GM’s hedging decision is of great importance. Using regression and correlation analysis, the report measures the correlation between GM’s stock returns and selected foreign exchange rates which draws to the conclusion that Japanese Yen should be the companies most concern. For the purpose of forecasting, Moving-Average model is applied to forecast Chinese Yen as China should be the GM’s future regional focus.

Key words: General Motors, 2008 financial crisis, operations and financing, risk management, quantitative analysis

Contents

Executive Summary…………………………………………………………..……2

Introduction…………………………………………………………………….4

Overview of the Financial Crisis with regards to General Motors………….4

U.S. Financial Crisis and GM’s Bankruptcy…………………………….4

The Linkage between the Financial Crisis and GM’ Liquidity Crisis….4

Quantitative Proof: Empirical Comparison of Beta Coefficient………..5

The Impact of financial crisis on the operations of General Motors…………6

3.1 Plummet in sales……………………………………………………………6

External: Changes in Car-loan Availability…………….…..6

Internal: Inappropriate Strategic Reaction…………………7

Empirical Comparison between GM and Major Competitors…………...8

3.3 Implications from the Financial Crisis on Operations……………………..9

Impact of the Credit Crunch on General Motors’ Financing…………….….10

Liquidity crisis: ……………………………………..……………………..10

External: Decreasing Bond Ratings……………………….10

Internal: Unhealthy Capital Structure…………………….11

Quantitative Proof: The Changes of Volatility in GM’s Stock Price……12

Financial Crisis, Euro-zone Uncertainty and Risk Management of GM……13

Passive Hedging Strategy…………………………………………………13

Quantitative Analysis: Regression Analysis…...........................................13

Recommendations Based on Regression Analysis………………………14

5.3.1 Foreign Currency Risks………………………………………….14

5.3.2 Commodity Price Risk and Interest Rate Risk………………….15

Future Regional Focus: China…………………………………………………16

Favorable Macroeconomic Environment……………………..…………..16

Forecast of CNY…………………………………………………………….16

.

Conclusion………………………………………………………………………17

Introduction

As far back as 1960s, General Motors Corporation had always ranked top in U.S. vehicle market shares and sales volume predominately due to its SUVs production lines. Nevertheless, GM went into insolvency during the 2008 financial crisis.

This report aims at analyzing how the 2008 financial crisis influenced the operations, financing and risk management of General Motors and eventually, led to the bankruptcy of General Motors. Through quantitative and qualitative analysis, it can be observed that GM’s operations and financing was severely affected by the crisis while the global uncertainty impacts the risk management of the company. In the last section of the report, a future regional focus is suggested with forecasting analysis.

Overview of the financial crisis with regards to General Motors

2.1 U.S. financial crisis and GM’s bankruptcy

The federal takeover of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers and the nationalization of AIG suggested that the financial crisis had spread from housing industry to the whole economy with estimated loss of trillions of dollars. Considering the aftermath of the 2008 financial crisis, it is justified to regard this as what Federal Reserve Chairman Ben Bernanke claimed "the worst financial crisis in modern history" (as cited by Wessel, January 14, 2010) and therefore it is often referred to as the Great Recession.

In October 2008, Consumer Price Index (CPI) presented the biggest monthly decline since 1947, among which transportation index, with a sharp 5.4% decrease, was the major contributor to this decline (Bureau of Labor Statistics, 2008). One of the "Detroit Three", General Motors, became the unfortunate victim of the Great Recession. As a result, the Obama government adopted the "good-bank/bad-bank" policy (The Economists, Apr 1st 2009) and organized Chapter 11 government-endorsed sale. This allowed a well-capitalized government-owned (60.8%) new corporation—General Motors Company--emerged with most of the profitable assets, left the Motors Liquidation Company( the old GM) with undesirable assets to be wound down(General Motors Company, July 06 2009). Demirgü-Kunt and Servén (2010) stated that during crisis government intervention like this is not rare and unprecedented although government should probably focus more on publishing more prudential financial regulations.

The linkage between the financial crisis and GM’ liquidity crisis:

One of the landmarks in 2008 financial crisis is "a complete evaporation of liquidity" of BNP Paribas (BBC News, August 7 2009), as it indicated one of the essential characteristics of the crisis—liquidity crisis.

In my opinion, out of all the defects exposed during this crisis, inadequate liquidity should be treated as one of the most severe flaws in corporation’s functioning due to the fact that available liquidity directly influences company’s ability to meet the short-term obligations. Therefore, without sufficient cash flow, any company is likely to be in distress.

In fact, the insolvency of GM can be largely attributable to its liquidity crisis. It can be clearly observed from Figure 1 that GM was in financial strain during the crisis.

Figure 1 Liquidity Status of General Motors(2003-2010)

Data source: Annual reports of GM

Quantitative proof: Empirical comparison of Beta coefficient

For the purpose of validating the link between the financial crisis and the General Motors, I chose Beta coefficient (Systematic Risk) as the indicator and Dow Jones Industrial Average (DJIA) as the stock market index.

Table 1(See Appendix A):

Before the crisis

(2001-2006)

During the crisis

(2007-2009)

After the crisis

(2010-2013)

Cov(R%,DJIA% [1] )

0.001691379

0.002514841

0.001278599

Var(DJIA)

0.001168488

0.002890954

0.000943722

1.447494463

0.869900164

1.354848

This suggests that if there is 1% change in the market risk during the financial crisis, the stock price of GM will change by 0.87%.From Table 1, it can be seen that the Beta of General Motors had been more volatile during and after the financial crisis. However, with the onset of financial crisis, General Motors’s Beta changed by 44%, which indicates the huge impact of this crisis on GM.

Since linkage between GM and the financial crisis is validated, the following section aimed to analyze why the financial crisis led to this structure break. From my perspective, the financial crisis influenced GM’s liquidity from three aspects: operations, financing and risk management. It is because of the influence of the financial crisis that pushed GM into insolvency.

The Impact of Financial Crisis on the Operations of General Motors

3.1 Plummet in Sales:

Rick Wagoner, the former GM chairman and chief executive officer expressed causal relationship between the economic downturn and the Company fatal bankruptcy with his testimony "what exposes us to failure now is the global financial crisis which has severely restricted credit availability, and reduced industry sales" to the Congress(Wagoner, November 18, 2008).

3.1.1 External: Changes in Car-loan Availability

The availability of car-loans is substantially important for GM’s sales volume. During 2005 and 2007, the easy car-loan environment mitigated the negative impacts of volatile oil prices. Relaxed lending standards and proliferated lax underwritten regulations encouraged consumer to finance their vehicles with home equity loans, with 30% of new sales in California made with home equity debt and 11.77% nationwide in 2007 (Dash, May 27, 2008). Jesse Toprak, an industry analyst ( as cited in Valdes-Dapena, May 2 2012), stated that anyone, at that time, is entitled to car loans with no serious consideration of their credit history. From the data presented by TransUnit, 4 million U.S. citizens finance their cars (GOGOI, Mar 29th 2012).

However, the credit crunch limited the home equity extractions and restricted the availability of car loans to the consumers which can be reflected in Figure 2 where the prime rate plunged during the crisis.

Figure 2: Fluctuations in prime rate from 2001 to 2012

Data Source: Data release program, Board of Governors of the Federal Reserve

In the second half of 2008, due to subprime mortgage crisis, financial services such as Capital One and Wells Fargo, declined considerable amount of relatively riskier CAR loans requests and cut back their lending volumes on lending by almost 50% and 25% respectively, altogether resulting in a slump of 66.1% on the approval of subprime auto loan (KPMG, November 2008). Moreover, GMAC, the former financing arm of the Company, chose to limit its target clients to high-quality borrowers. This new standard is estimated to reject 60% of the potential buyers of GM’s cars (Scholtes, October 17, 2008).

Consequently, with decreased availability in home equity car loans, consumer was not willing and not competent to purchase new vehicles, especially the more expensive SUVs, which led to dramatic sales loss of GM (see figure 2).

Figure 3: Domestic Sales of General Motors (2000-2011)

Data source: Annual report of General Motors

Internal: Inappropriate Strategic Reaction to the Financial Crisis

During the crisis, GM still continuously leaned towards its extensive product line on SUVs which was admitted as a misstep later in the candid apology letter called GM's Commitment to the American People( as cited by Krolicki, 8 Dec 2008 ).

Under the impact of the financial crisis, the consumer confidence index inevitably dropped to the lowest number (59.8) since 1980, based on the UNIVERSITY OF MICHIGAN SURVEYS OF CONSUMERS ( as cited by Rand, June 3, 2008). According to the SpendingPulse report from MasterCard Advisor, their clients’ consumption on luxurious goods declined by 24.4% in December 2008(Rosenbloom, 3 December 2008), displaying a negative correlation between the prices and the sales. This is in accordance with the Figure 4 which illustrates that the Assemblies of light trucks, including SUVs, reached the lowest point during the 2008 Great Recession.

Figure 4: huge slump in light truck Assemblies during the crisis

Data Source: Data release program, Board of Governors of the Federal Reserve

3.2 Empirical Comparison between GM and Major Competitors

In order to prove that GM’s skew towards SUVs during the crisis one of the main reasons of its bankruptcy, I compare the market strategies and their effects between GM and major competitors.

Unlike GM, Toyota and Honda adjusted their product lines during the crisis. More specifically, Honda strengthened the image of its fuel-efficient hybrids under Civic and Accord to cater the needs of this fast growing market (Howie, 11 August 2008 ).

In the market of fuel efficient vehicles, Toyota achieved the status of Top Picks in Green car (Toyota Prius) in 2008(Valdes-Dapena, 26 Feb 2013 ).This cutting edge fuel efficient technology enabled Toyota to obtain a higher growth rate, sales revenue and profit margins than GM during the crisis(see figure 5,6,7).

Figure 5 Annual Growth Rates of Toyota and GM from 2003 to 2011

Figure 6: Sales Revenue of Toyota and GM(2003-2011)

Figure 7: Profit Margins of GM and Toyota(2003-2012)

Data source: Annual reports of GM and Toyota

The effectiveness of their updated light-vehicle focus can be proven from Figure 8, where the aggregate market share of Toyota, Honda and Hyundai-Kia climbed consistently in this period.

Figure 8: The market share of GM and aggregated market share of major foreign competitors in U.S. (2000-2012)

Data source: WARDSAUTO, U.S. vehicle sales market share by company for 1961-2012.Available: http://wardsauto.com/keydata/historical/UsaSa28summary

Implications from the Financial Crisis on Operations

The financial crisis doubtlessly traumatized GM’s sales volume and exposed flaws in its previous marketing strategy. In my opinion, GM should switch its focus to fuel efficient vehicles and sell off the loss-making brands. After the Chapter 11 restructure, the new GM made major adjustments in the corresponding aspects mentioned above:

First of all, the focus of the new GM focused more on development of energy efficiency technologies and published a fuel-efficient Chevrolet Volt(Annual Report,2010), complying with the global market demand trend.

Secondly, the new GM carried through an immense scale of brand reduction by means of spin-off and sell-off aiming at lower break-even point (Annual Report,2010). More importantly, this brand rationalization allowed the company to focus on its four core brands, which led to possibly better utilization of resources and higher car quality.

Impact of the credit crunch on General Motors’ Financing:

Liquidity crisis:

When the onset of the credit crunch increased the cost of loans and limited the access to debt for both individuals and corporations(Collinson, 9 August 2010), especially when the financial institutions which used to provide loans to GM were getting into trouble themselves, GM’s debt to equity ratio reached an unsustainable negative stage(See figure 12). This highly leveraged vulnerable capital structure pushed GM to the brink of insolvency.

Figure12: Debt to Equity ratio of General Motors from 2003 to 2012

Data source: Annual reports of GM

External: Decreasing Bond Ratings

Furthermore, GM’s debt rating was downgraded to the possible default level C in December 2008 (see Figure 12). These series of downgrading was because of GM’s financial performance decreased substantially during the Great Recession, according to Scott Sprinzen, an S&P credit analyst(Associated Press, 5 June 2005). This level of credit rating resulted in a weak fund-raising prospects for GM.

Figure 11: Decreasing credit rating of GM from 2001 to 2008

rating.png

Data source: Annual reports of GM

Internal: Unhealthy Capital Structure:

As mentioned above, financial crisis largely affected GM’s operations, resulting in a substantial decline in operating income (see Figure 9 ).

Figure 9: Operating Income of General Motors from 2005 to 2011

Data source: Annual reports of GM

This insufficient operating income naturally had an impact on its financing structures. For the purpose of evaluating GM’s capital structure, current ratio is used as the indicator of a company’s capacity to pay off its obligations. From Figure 10, it’s clear that GM’s current ratio was consistently below Toyota’s and the benchmark one before the crisis which indicates that its current assets are not sufficient to cover current liabilities.

Figure 10 : Current Ratios of Toyota and GM from 2005 to 2010

Data source: Annual reports of GM

Consequently, General Motors financed its operations mainly by short-term and long-term loans to cope with obligations including payments to suppliers. Therefore, the Company became increasingly reliant on short-term borrowing to compensate for the insufficient cash flows. Under this capital structure, GM is extremely sensitive to the fluctuations in costs of short-term debt.

Quantitative Proof: The Changes of Volatility in GM’s Stock Price

As suggested by Equation (1), GM’s stock price has always been more volatile than the market index. For the purpose of analyzing the relationship between the volatility of GM’s stock price and financial crisis, the standard deviation of the stock price in different time periods is presented in Table 2. It can be witnessed that the standard deviation of stock price during the financial crisis almost doubled.

Table 2: Standard deviation of the stock price of GM (see Appendix Table A)

Before crisis

(2001-2006)

During crisis

(2007-2009)

After crisis

(2010-2013)

Standard Deviation

of stock price

5.374586651

13.46213496

4.833861234

The Financial Crisis, Euro-zone Uncertainty and Risk Management of GM:

5.1 Passive Hedging Strategy

In general, GM selectively passive hedges against these three risks: commodity price risk, foreign exchange rate risk and interest rate risk. . For commodity risk and interest rate risk, derivative instruments such as forward contracts, options and interest rate swaps are used (Annual Report, 2008). For mitigating foreign exchange risk of foreign receivables and payables, similar methods are adapted. In the annual report of General Motors (2008), GM showed a translation loss of $1.6 billion due to foreign currency translation process in 2008.

5.2 Quantitative Analysis: Regression Analysis

In order to prove that GM’s risk management before and during the crisis is problematic, I conducted correlation analysis between the stock returns and selected exchange rates.

Table3: correlation analysis between GM and JPY, GBP, EUR

GM’s stock price

JPY

GBP

EUR

GM’s stock price

 1.000000

 0.237763

 0.060057

-0.031224

Data Source: Data release program, Board of Governors of the Federal Reserve

As indicated by the correlation analysis, compared with Euro and Pound, the stock price of GM is more correlated with Japanese Yen.

Additionally, I formed a regression and the results are presented as follows: [2] 3

Table 3:Regression analysis

Dependent Variable: MONGM

Method: Least Squares

Sample (adjusted): 2001M07 2013M01

Included observations: 124 after adjustments

Variable

Coefficient

Std. Error

t-Statistic

Prob.  

C

0.014918

0.053010

0.281426

0.7789

LAG6MONTB3

-0.076363

0.270447

-0.282358

0.7782

MONDJIA

0.867904

0.427321

2.031037

0.0446

LOGMONOILPRICE

-0.000362

0.000997

-0.362774

0.7175

MONJPY

-0.004825

1.178159

-0.004095

0.9967

MONGBP

0.951226

1.754711

0.542098

0.5888

MONEUR

-1.920095

1.744838

-1.100443

0.2735

DUMMY

-0.226209

0.120527

-1.876832

0.0632

DUMMY*LAG6MONTB3

0.167637

0.274546

0.610599

0.5427

DUMMY*MONEUR

1.594626

2.201298

0.724402

0.4703

DUMMY*MONGBP

-0.862387

2.188119

-0.394122

0.6942

DUMMY*MONJPY

2.475775

1.588389

1.558670

0.1219

DUMMY*LOGMONOILPRICE

0.001906

0.001548

1.231665

0.2207

F-statistic

2.288964

    Durbin-Watson stat

2.506807

Prob(F-statistic)

0.012156

Recommendations Based On Regression Analysis:

From the results of this regression, it is worth mentioning that GM’s stock price is considerably influenced by these three kinds of risks mentioned above based on the F-statistics.

5.3.1 Foreign Currency Risks

First of all, Note that the coefficient on the interaction term between the dummy and monthly change of Japanese yen is statistically significant at 10%. This suggests that during the crisis if Japanese yen appreciate by 1%, the stock price of GM will increase 2.47%, keeping all the other variables fixed. In addition, although the coefficient on the volatility of Euro and Pounds is not as significant as Yen, the fluctuations of Euro and Pounds still negatively influence the stock price of GM during the crisis.

Considering the correlation analysis, when it comes to hedging decision, it is the volatility of Japanese yen that caused most concerns due to the fact that the cost structure of GM’s major competitors such as Toyota and Honda are primarily denominated in yen.

5.3.2 Commodity Price Risk and Interest Rate Risk

As illustrated by Figure 13 and 14, the oil price and the interest rate fluctuated greatly in the periods of the Great Recession. Therefore, GM should minimize its exposure to these risks as well.

Figure 13: Unstable Oil Price from 2001 to 2012

Figure 14: Interest Rate Fluctuations from 2001 to 2012

Data Source: Data release program, Board of Governors of the Federal Reserve

6. Regional Focus: China

6.1 Favorable Macroeconomic Environment

From my point of view, GM should maintain its global presence and the future of GM lies in the BRICs, especially China.

On the one hand, as the car ownership in China is only 58 out of 1,000 people in 2010, which is less than 10% of that figure in other major developed countries, such as United Kingdom, United States and Germany(The World Bank), the potential market in China is still large.

On the other hand, the national saving rate (gross national saving as a percentage of GDP) of China is more than 50% since 2005, which is two-thirds higher than most of countries worldwide. Moreover, unlike the situation in US and Japan, its household savings contribute to nearly half of the total gross saving (Ma and Yi, June 2010). This consistently high saving rate indicates not only stable macroeconomic environment but strong citizen purchasing power as well, altogether creates a preferred target market for GM.

6.2 Forecast of CNY

The drawback of focusing on the foreign markets is company’s exposure to exchange rate volatility. For the purpose of forecasting the future exchange rate of Chinese Yuan, I chose the Moving-Average (MA-12) methods (Smith, J. d, 2012) using historical exchange rates and presented the results as follows.

Figure 15: Forecast of CNY: Moving Average (MA-12) Model

Data Source: Data release program, Board of Governors of the Federal Reserve

From the graph, in the near future, a appreciation of Yuan can be observed in light of the forecasting model. Moreover, according to the recent analysis from IDEA global(26 April 2011),it is justified to believe that there will be continuous pressure on Yuan which may possibly lead to further and faster appreciation based on the ongoing economic uncertainty in the Euro zone and U.S. As a dollar-denominated company, the future appreciation of the Chinese Yuan is undoubtedly good news for GM.

7. Conclusion:

This report demonstrated that 2008 financial crisis influenced GM’s operations, financing and risk management through means of regression analysis, empirical comparisons and correlation and volatility analysis. On the basis of this, in order to rebuild customer trust, some suggestions are provided. In terms of operations, GM should continue concentrating on the four core brand as well as widening its production portfolio with special regards to fuel-efficient vehicles. As for financing, a more healthy capital structure should be maintained for the benefit of future sustainability. Furthermore, effective hedging strategies should be adopted because of GM’s substantial foreign currency risk.

GM’s future is still at risk despite the fact that company’s revenue seems to boom after restructuring. In the future, the regional focus of GM ought to be China on the basis of macro-environment and the forecast of Chinese Yuan.

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