Bad for GM, Bad for America

All this is bad for General Motors, but why is it bad for the country? The short answer is that bond traders are scared enough about the possibility that General Motors itself could wind up in Chapter 11 bankruptcy that they're buying insurance, but they're not scared enough to worry how good the insurance is.

If they want to insure a debt against default, big investors turn to a kind of derivative called a credit-default swap. (Derivatives are securities based on other securities -- derived from them, if you will.) Forget about the details -- they involve an investor who thinks default is relatively likely who then buys what amounts to insurance from another investor who thinks default is less likely. So that, for example, on April 6, a default swap on GMAC to insure $10 million of GMAC debt for five years costs $385,000.

A Good Barometer

This makes prices in the default swap market a good barometer of how likely investors think a default is. More likely, and the price of the insurance goes up. Less likely and it falls. Recently the credit-default-swap market has been pricing in a 50/50 chance that GM will go into bankruptcy some time in the next five years.

The insurance provided by the credit-default-swap market removes some of the worry about buying GM bonds. Oddly enough, that works to keep yields on those bonds lower than they might be. If you can insure against the bonds going bust, your risk is lower, and the yield should be lower, too. The existence of the derivative market for credit-default swaps -- where recently it cost 18.25% to insure GM bonds against default for five years -- has lowered the yield on the actual GM bond by lowering the risk of default.

On April 7, a General Motors bond due in January 2011 was priced at $73.50 per $100 of face value, a yield of 14.73%. That's a very nice yield, but, I'd argue, not what I'd expect for a company with a 50/50 chance of going bust before the bond matures. (The original coupon on this bond when it was issued was 7.2%.) And I'll bet that some of those bonds, thanks to credit-default swaps, have found their way into pretty conservative portfolios.