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How Hedge Funds Play GM

For professional investors, its rusty body is a wonderland.

General Motors

(GM) - Get General Motors Company Report

, whose fortunes have long been tied to the American working class, is a playground for the rich when it comes to its stock.

Despite its populist renown, GM has long been controlled by institutional investors. That's never been truer than now, as hedge funds specializing in distressed securities and so-called event-driven situations pile in with an increasingly complex palette of exotic wagers that embrace its common stock, convertible securities and bonds. While GM still boasts a high number of individual investors, they operate in a wonderland of esoteric gambles that could end up deciding the automaker's fate.

There is a lot to gamble on: Questions about whether GM can avoid bankruptcy, sell GMAC, and manage to avert a strike are all behind some kind of hedge fund trade.

Much of the trading involves GM's voluminous publicly traded debt, a breed of securities that is effectively out of reach to the average individual investor. In many cases, however, these trades are either hedged or coupled with positions in the common -- and unwary investors can easily find themselves being pulled around by the tail when one of them moves.

A lot of short-selling is in place, hedge fund managers note. About 15% of the company's float represents short interest, or bets that the stock will fall -- a pretty high figure. The short-interest ratio, as measured by the amount of short sales divided by the daily volume of shares, is only 5.51%, but this relatively low figure attests to the stock's high volume more than low short selling, says a hedge fund manager. He compares those numbers with another large-cap name,


(PEP) - Get PepsiCo, Inc. Report

, which has 1.7 billion of outstanding shares, 5.6 million of short shares and a daily volume of 4 million shares. The percentage of shorts is only 0.3% in the case of Pepsico and the short-interest ratio is 1.5%.

The bearish bets against GM's common stock reflect its declining fortunes and, to some degree, expectations that the company might one day face insolvency. GM has repeatedly distanced itself from such speculation, and has moved in recent months to cut employees, factories and benefits to conserve cash. Last month, GM halved its dividend and welcomed Jerome York, an adviser to major shareholder Kirk Kerkorian, to its board. Despite these actions, GM's credit has been downgraded further into junk territory and the sentiment remains bearish. The stock is down 43% over the last year.

"A lot of hedge funds assume that General Motors is going to be recapitalized," says Roy Ophir, a principal at hedge fund Brownstone Asset Management. A recapitalization is manna for distressed players, because their bonds often get restructured into equity on favorable terms.

General Motors' board is meeting Monday and reports have indicated it could agree to a sale of GMAC then. While bondholders should reap an immediate benefit, there's less agreement about the long-term impact on shareholders. One hedge fund manager believes a sale of GMAC is a net negative for owners, because it deprives GM of one of its last big sources of revenue.

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"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.

True, another short squeeze did not happen in January after Kerkorian rebuilt his position back to 9.9%. The stock barely moved then. But Kerkorian was merely replacing shares he sold a couple of months before. The trade could get interesting if Kerkorian tries to teach bears another lesson.

Finally, investors may be at risk due to the extremely high level of credit-derivative swaps written by managers to take long bond positions. Simply put, the writer of a credit-default swap offers credit protection to a buyer on the view that the bond is unlikely to default. If the bond does default, the writer will pay the value of the bond at par to the buyer. Such a bet is the equivalent of taking a long position on a bond without having to materially buy the bond. The writer of the derivative gets a premium for providing this guarantee to the buyer and that is the equivalent of being paid a coupon on the bond. On the other hand, buyers of credit-default swaps take the opposite view. They believe in the likelihood of a default. They have a bearish view. Their position is the equivalent of a short exposure on the bond.

Obviously, if too many people write credit-default swaps on GM and if the company does default, how will buyers of those derivative instruments get paid? That's the risk.

A manager estimates that the credit-default swaps on General Motors represent four times the value of the underlying debt. With a $121 billion debt for GM, such a derivative figure could be astonishingly high. "There will be a financial accident involving credit-default swaps in our future and it may well involve General Motors," says another hedge fund manager.

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