How Hedge Funds Play GM

"GMAC is a good asset to have and you're better off with it," he says. Even if the sale will inject $11 billion or $12 billion of cash, the company would have been better off finding cash somewhere else, through the sale of the mortgage and insurance operations, for instance.

"The stock will rally on the sale and lose its momentum later on," says another hedge fund manager. "That's because the sale won't be enough. Ultimately, GM will need more liquidity and people will realize that there is a deeper problem," says this manager.

Other managers play one part of the capital structure of GM against the other, in a strategy called capital arbitrage, specifically by buying the bonds and shorting the stock. Bondholders have a greater potential for recovery in a bankruptcy. By definition, if a bond gets paid less than par, it means that the stockholders will get nothing. Anyone short the stock would clean up.

Some who believe in the bankruptcy scenario are buying short-term debt hoping that nothing will happen in 2006 or 2007. The bond maturing in 2008 with a 6.375% interest rate is currently trading at 80 cents on a dollar. Reflecting this discount, the actual rate of return, or yield, on this bond is 18%. For a short-term maturity and such a high yield, many believe that the risk of owning this GM bond is well worth taking.

In addition, General Motors offers myriad convertible bonds. Most buyers of convertible bonds hedge their long position by shorting the stock. That again creates downward pressure on the common.

The convertible trade on GM is not for the faint of heart, though, as history shows.

"A ton of hedge funds have been involved in General Motors since last year, when a lot of people lost money investing long bonds/short equity when Kerkorian bought the equity when the bonds got downgraded," says a hedge fund manager. This event is called a short squeeze: People had to buy back the stock at a higher price than they had sold it at. It precipitated a crisis in the entire convertible arbitrage space last year, culminating in June.