America’s two largest auto giants, Ford and General Motors, are on a collision course with bankruptcy. Yet most American investors don’t seem to care.

Instead, they’re buying up big Dow stocks like American Express, AT&T, Citigroup, DuPont, General Electric, Hewlett-Packard, Merck, JP Morgan Chase and Microsoft.

Or they’re loading up on Dow companies like Coca Cola, Johnson & Johnson, McDonalds, Pfizer, Procter & Gamble and Wal-Mart.

Some are even bidding up the shares in the auto companies themselves. That’s how General Motors has managed to recover from $19 per share in April to as high as $33.64 on Thursday. That’s how Ford also rose from just over $6 per share in July to as high as $9.48 on September 13.

It’s a classic case of complacency despite overwhelming evidence of darker clouds.

Look. Ford is forecasting a pre-tax loss of nearly $6 billion in its manufacturing operations this year. And when you include its restructuring costs, the total projected loss could reach a whopping $9 billion.

On top of that, don’t forget GM’s $10.5 billion loss last year and its $3.4 billion loss in the second quarter of this year.

Heck, even with an overdose of Ambien, it would be tough to miss the fact that Detroit is drowning in a sea of red ink.

Wall Street’s Rating Agencies
May Be Tired and Drowsy.
But They Also See The
Handwriting on the Wall.

Standard & Poors rates the credit of both Ford and General Motors a single B, four steps below S&P’s highest junk bond rating of BB+.

Moody’s rates Ford B3, five steps down from its highest junk bond grade.

And Moody’s rates General Motors Caa1, buried six steps under top-rated junk.

According to Moody’s, that means General Motors offers “very poor financial security” with “present elements of danger with regard to financial capacity.”

Plus, even these extremely low ratings may be understating the likelihood of bankruptcy because ...

S&P’s and Moody’s Credit Ratings
Can Be Biased in Favor of the
Companies They Rate!

The widespread complacency in America today is not entirely the fault of investors. Quite to the contrary, it stems largely from a single four-letter word that’s deeply ingrained among many of those supposedly serving as America’s corporate watchdogs: BIAS.

When analysts at a rating agency like Standard & Poors say a company’s credit is secure, it may actually be borderline junk.

When they says it’s close to junk, it may actually be in financial trouble.

And when they admit a company’s finances are questionable, it may actually be a lot closer to bankruptcy than you think.

Where does the bias come from? I explained the fundamental reasons in a press release nearly four years ago:

• The rating agencies are generally paid substantial fees for their ratings by the rated companies.
  
  
• The rating agencies derive most of their revenues from the rated companies — not from investors.
  
  
• When some of the rating agencies do issue a rating without charging a fee, it can actually be a kind of blackmail — to get the companies to pay for a rating which is often more favorable.
  
  
• Plus, two of the top three rating agencies give the rated company the right to suppress publication of an initial rating that’s unfavorable.

My conclusion today is the same as it was four years ago:

 

“There is a very real concern that the conflicts pose danger both to the safety of investors and the stability of our financial system. This is the same type of conflict of interest that has already undermined the objectivity of research at investment banking firms and the integrity of the nation’s accounting system.”

If you’re wondering how this situation could be remedied, take a look at my Statement to the Securities and Exchange Commission.

But don’t hold your breath.

Indeed, the same conflicts-of-interest issue was hotly debated a decade and a half ago. That’s when Executive Life, Mutual Benefit Life and a half dozen other major life insurers went bust, entrapping six million policyholders — all despite “excellent” grades from the established Wall Street rating agencies.

 

In response, Congress asked the GAO to undertake a comprehensive study of the rating agencies. But virtually nothing changed.

This issue was hotly debated again ten years later. That’s when 19 major U.S. corporations went bankrupt, while still boasting “buy” and “hold” ratings from 50 of America’s largest brokerage and investment banking firms. (For the evidence, see my presentation to the National Press Club.)

 

In response, Wall Street grudgingly consented to reforms. But at S&P, Moody’s and other major Wall Street rating agencies, virtually nothing changed.

The issue came up a third time when most of America’s top auditing firms — Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers — almost universally failed to warn of accounting irregularities. In fact, they gave “a clean bill of health” to 93.9% of public companies that were subsequently involved in accounting problems. (My presentation to the U.S. Senate provides the back-up.)

 

Again, we saw reforms. But still, at S&P, Moody’s and other major agencies, virtually nothing changed.

End result ...

Most Investors Probably Won’t Learn
That GM and Ford Are Going Bankrupt
Until It’s Too Late to Run for Cover

Make no mistake: You’re watching one of America’s most successful, most iconic industries — generating $700 billion in annual sales and employing 3.4 million people — unravel before your very eyes.

It’s a horror story, played out in four acts.

Act 1
The Horror Story of
Rapidly Declining Sales

American cars are too big, too expensive, and too costly to maintain.

This is now widely recognized. But don’t expect the recognition alone to solve the problem anytime soon. Instead of fixing what ails them, automakers have tried every trick in the book — hefty rebates, employee pricing, zero-percent financing — to lure buyers into their showrooms.

And yet, despite the aggressive discounting, all three of Detroit’s major automakers have recently announced huge drops in sales — GM’s down 22.2 percent in July ... Ford’s down 35.2 percent ... Chrysler’s down 37 percent. And the numbers are roughly twice as bad for SUVs and small trucks.

No wonder Ford cancelled production of its massive Excursion SUV! No wonder GM canned the Hummer H1!

Above all, though, the most dreaded ailment in Detroit is this: The sick, sinking feeling that comes from the rapid loss of market share to foreign competitors.

Reason: Once they lose market share, it’s awfully tough to gain it back, even when gas prices temporarily decline.

The dire reality: For the first time ever, foreign-based auto brands are now capturing more than 50 percent of U.S. sales to consumers.

Act 2
The Horror Story for Auto
Workers and Their Towns

Ford plans to slash its North American workforce by a staggering 29 percent, from 130,000 workers now to 92,000 by 2008.

And this is coming on the heels of GM’s plan to eliminate 60,000 jobs over the next several years, including buy-outs for 34,410 hourly workers.

For people nearing retirement, generous buy-outs are like a big bonus. But for young workers in their 20s or 30s, accepting the buy-out means leaving with no job ... no pension ... no health benefits ... and often no future.

Moreover, every job at a U.S. auto factory supports several other jobs at nearby businesses. So each 10,000 jobs eliminated in autos could mean 20,000, 30,000 or more job losses in related industries.

This is hitting communities — from St. Louis and Atlanta to Batavia, Ohio and Wixom, Michigan — like a ton of bricks.

Flint, Michigan, for example, has seen its automobile factory jobs plunge from a peak of 80,000 to fewer than 3,000 today. And after adjusting for inflation, median income in Michigan has declined 14.9% over the past six years: It was $53,989 in 1999. Last year, it was just $45,933.

Hardest hit of all: 40- and 50-year olds who have been with Detroit auto makers for 20 years or more. They’re usually too young to qualify for pension benefits but too old to easily find a new job.

Worse, even when their pensions finally mature, there’s little assurance they’ll get their money. As an illustration, look what happened to employees at Delphi, the nation’s largest auto parts maker and previously a GM subsidiary:

 

Delphi filed for bankruptcy one year ago with nearly 180,000 employees. They thought they could at least count on their pension. But they were soon shocked to discover that their pension plan was underfunded by a whopping $10.8 billion. Adding insult to injury, the government’s Pension Benefit Guaranty Corporation (PBGC) said it would cover only $4.1 billion — 38 cents on the dollar!

But Delphi’s shortfall pales in comparison to GM’s and Ford’s with commitments for pensions and other post-employment benefits adding up to a staggering $94 billion, according to government estimates. That alone is NINE times GM’s huge loss of last year.

And complacent U.S. investors think all this is fine and dandy?

Act 3
The Horror Story
For Shareholders

Parents and grandparents used to give away shares in Ford, GM or Chrysler — as a practical lesson in the merits of long-term investing or as a nice ticket to a secure future.

No more! Despite the recent rallies, the long-term charts of Detroit’s big three auto stocks look about as reliable as the stock trends in a dot.com.

Look at what’s happened:

Since its peak in 2000, GM’s stock has plummeted from $94.63 a share to as low as $18.33 — a loss of 80.6%.

Ford has fallen even more, diving 83.8% from a peak of $37.30 to $6.06 in July of this year.

Meanwhile, DaimlerChrysler is down by “only” 57.7% — from $108.63 to $45.98 per share.

Total losses to investors from peak to trough: A staggering $170 billion just in these three companies alone.

Act 4
Horror Story
For the Future

Remember when Big Steel was at the pinnacle of American industry? Remember when Big Steel towered over Wall Street and Washington, exerting great clout?

But then, massive debt and the inability to change with the shifting demands of the world economy began to torpedo one steel company after another.

Result: In all, some 30 U.S. steel makers — including the biggest — went bankrupt.

My view: Anyone who thinks this can’t happen to Detroit needs to wake up and smell the coffee.

What to Do

First, if you own GM or Ford stocks or bonds, what are you waiting for? It doesn’t matter what you paid for them. Take advantage of the mini rally we’ve seen in the shares recently, and get out.

Second, don’t fall for the next moment of euphoria coming to Wall Street — when the Dow makes new, all-time highs. If anything, use that moment and take advantage of this classic case of complacency to reduce your exposure.

Third, build cash. And as before, keep most of your cash in U.S. Treasury bills or a Treasury-only money market fund.

Fourth, to protect yourself against a falling dollar and rising inflation, don’t veer from the gold, oil and other natural resource investments we’ve been recommending in our newsletters.

The International Monetary Fund (IMF) confirms that China has replaced the U.S. as the primary locomotive of the world economy. So as long as that continues, you can expect the demand for scarce resources to continue as well.

Fifth, turn these situations into a fast and reliable way to build your wealth for retirement ... or greatly boost your income in retirement. To get started right away with our recommendation going out Wednesday, see my latest report just posted on our website yesterday.

Good luck and God bless,

Martin