GM bankruptcy to cause derivatives market collapse?

Jim Jubak, a journalist for MSN Money, wrote an interesting article about a possible collapse of the derivates market triggered by a GM bankruptcy. An executive summary of the article is as follows:

GM bonds, given the impending doom of America's stupidest company, are trading at much lower YTM (yield to maturity, the total interest you receive if you hold the bond until the end) than they should be. The reasoning for this is simple - buyers of these nearly junk bonds are purchasing "insurance" on these bonds on the derivatives market. This means if GM defaults and can't pay, someone else will.

In theory, this seems like a good idea for both parties. If GM doesn't default, the party selling the insurance makes a nice premium and the buying party "locks in" their returns. The problem lies in the fact that certain "weak hands" are selling this insurace, meaning that in case of default by GM they won't be able to pay the "claim" on the insurance they sold.

This is analogous to a company selling you expensive health insurance, then disappearing when it comes time to pay the bill for your major heart surgery. The difference is that the insurance industry is highly regulated - the government goes to a lot of effort to make sure this doesn't happen because it's bad for both the insurance companies and the consumers. The derivative market is hardly regulated at all. Even if it were regulated, it is so complex that a team of PhD's couldn't determine if another party could possibly be a "weak hand" in the future.

This brings me back to something I read in one of Warren Buffet's letter to shareholders (pdf, pg 14) about derivatives. Bluntly, Buffet states "Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."

When Berkshire Hathaway purchased General Re, it had a huge book of derivatives. After failing to sell the derivatives division, Buffet decided to try to close it at massive expense. Buffet is a financial genius, perhaps one of the best financial minds of all time. He doesn't intentionally waste money. Ever. His decision to get out of the derivates market at incredible cost demonstrates his feelings about the danger of derivatives contracts.

General Motors lost around $11 billion dollars last year. GMAC, the credit portion of General Motors which was recently sold to Cerebus Capital Management, accounted for 97% of GM's profits in 2004. It earned $2.8 billion in 2005. Without GMAC, GM would have actually lost almost $14 billion dollars. General Motors is a rickety old car, loaded with more weight that it can handle trying to climb a steep mountain road - and they just sold their engine.

I believe a General Motors bankruptcy and restructuring is a 100% certainty at this point. I don't think there is any way for them to turn it around. People won't buy the junk cars sold by GM without a huge discount and good financing. GM doesn't seem to be in the business of selling cars anymore. They seem to be in the business of financing cars. Without a finance arm to provide the financing (and make money), they will lose even more money on every automobile sold.

At the most recent autoshow, I was SHOCKED at the incredible decline in quality of the GM products at the show. Panels didn't match, welds looked like they came out of a high school shop class, and even the plastic parts didn't seem to align. And these were the very best that GM had to offer. At least, I assume they wouldn't just pull a random car off the line to show to hundreds of thousands of people. I think GM is already cutting every corner it can.

When the GM bankruptcy hits, will it result in disaster for the derivatives market (and the US economy as a whole)? Or will Uncle Sam follow the "Too big to fail" philosophy and bail them out, a la Long Term Capital Management? I think either way, the US economy is in for a severe bludgeoning that will have repercussions for years to come.