Is General Motors Lehman, AIG, or Bear Stearns?

Posted November 15, 2008

Government can do three things when faced with a sick company. Let them file for bankruptcy as we did with Lehman Brothers. Engineer a sale or a "tough love" restructuring as we did with Bear Stearns. Or invest money like we did with AIG. Which is appropriate for automakers?

Chrysler is a Lehman — the weak, homeless
orphan of the so-called "Big Three" auto makers. It is 80% owned by
a very large private equity firm, Cerebrus Capital who was paid $700 million to take it over from Daimler. Cerebrus buys and fixes bankrupt companies (Mervyns, Albertsons). Named after the multi-headed dog that guarded the gates of Hades, Cerebrus hired former VP Dan Quayle to serve as their global flack. Talk about a fixer upper.

Homilies from
Cerebrus about
being ahead of cash plan notwithstanding, the company is a corpse now
that GM has walked away from a chance to buy it. Who would buy a Chrysler and expect the company to live to honor the 50,000
mile warranty?

The second bail out model was AIG, which was and is a solid, profitable business that got into balance sheet troubles with
credit default swaps. From a bailout perspective, it was a much better use of tax dollars
because there is an excellent chance that the US investment
in AIG will pay itself back once the liquidity crisis unwinds.
It is a defensible
move that seems likely to save taxpayers money over 4-5 years.

Bear Stearns was the intermediate case — like AIG too big to die,
but in a lot more trouble. Its main advantage over Lehman was
timing — it got sick first — a lesson not lost on GM. Instead of a bailout, the government
guaranteed the loans necessary for JP Morgan to buy the company. Not clear
whether it will end up costing taxpayers money, but the bill was lower than the cost to the feds of a full failure of
a large investment bank.

The Bear Stearns "tough love" model is the right one for GM and maybe Ford except that there is no near term buyer. There is no buyer because the company, like Chrysler has more liabilities than assets, so a buyer demands to be paid to take it over. And the buyer should not be the US government.

How sick is GM? Well, they lost $38 billion last year and $20 billion in the first nine months of this year alone. Its stock price has dropped into the low single-digits from more than $30 a share a year ago. The company is burning $2 billion of cash a month. It's market cap is the same as Whole Foods, the upscale grocer that is 25 times smaller, but reasonably profitable. Over the past 42 years, its share of the US market has dropped from 53% to
20%. It saw year on year sales drop 45% last month. It burned through $14 billion of cash last quarter and will be out of money by Christmas. Now this miserable excuse of a company is spending the last of its cash in a massive PR effort aimed at Washington. But if getting government cash required CEO Rick Wagoner to step aside? Well no, he rules that out.

General Motors is a national embarrassment that deserves to die. GM is not too big to fail — it has failed. Indeed, the
company has been working hard to liquidate itself for decades. The company has frantically dropped car prices below cost in a desperate bid to attract customers, which of course means that the red ink will continue. One way or another, taxpayers are being asked to subsidize car purchases.

It is not easy to get this messed up, and GM is not easy to fix. Making
cars is a tough business in the best of times: a capital-intensive, design-intensive,
labor-intensive, distribution-intensive, brand-intensive, regulation-intensive business. Your
product has to be sexy, reliable, efficient, and safe at 80 mph.

GM is now tangled in a tar pit of unsustainable contracts, laws, and long term obligations that make bankruptcy not only inevitable, but desirable. It's just a question of how and when. GM has too many brands (Cadillac, Saab, Buick, Pontiac, GMC, Saturn, Chevrolet and
Hummer) compared with Toyota (three) and Honda (two). GM has about 7,000 dealers compared with Toyota (under 1,500) and Honda
(about 1,000). It would cost GM billions of dollars and many
years to reduce the number of dealers it has to a number near Toyota's because of state laws that protect dealers from change.

Wages are less of an issue than work rules and legacy costs. "Transplants", the manufacturers owned by Honda, Toyota, BMW, Nissan, and others employ 92,000 American workers at wages similar to GM's but with much lower benefit costs (about $45 vs $75 total hourly labor costs). GM supports more retirees than current workers and provides them with generous health benefits. It supports thousands of workers
in the moronic "jobs bank" program, which guarantees wages
and benefits for workers who "lose their jobs" (with the predictable and perverse result that some of the most senior workers clamor to be laid off!).

Less visible and in some ways harder to resolve, are the enormous amounts of property for unused facilities that GM owns or leases. It must support revenue bonds
for municipalities that issued them to build these facilities. On top of that lies a huge web of suppliers with contractual claims and a vested political interest in GM
staying what it is. This is a business that is built for bankruptcy. GM will restructure these obligations or die bellowing in the tar.The only question is what assets can be salvaged and what the bankruptcy will cost the rest of us.

The fantasy that GM can be retooled into an environmentally responsible car company is a complete delusion (indulged in most recently by Jeff Sachs, who should know better). Customers are only willing to buy fuel efficient cars from GM at a deep discount. The much vaunted Chevy Volt, GM's plug in hybrid, is expected to cost $40,000 and lose money on every car. It only has a chance because Congress will bribe taxpayers with a $7500 credit to buy one. The Volt will be an electric Chevy Cobalt — currently GM's best selling compact. The Cobalt sells for $4,192 less than a Honda Civic, based on average selling prices collected by Power Information Network over the past ten months. Translation: consumers paid Honda $3.22 billion more for Civics than they paid GM for Cobalts. We will have plug in hybrids. From Honda, Toyota, Nissan and other companies that spent decades figuring out how to make a business out of fuel efficient cars.

GM is either headed for traditional Chapter 11 bankruptcy or for a government restructuring. Bush is happy to see the former — and I am not persuaded that he is wrong. Barack Obama, having spent a year
campaigning in Michigan and Ohio, is not excited about GM failing in the middle of an economic crisis because the politics of a bankruptcy right now are daunting: a GM bankruptcy could send the U.S. jobless rate as high as
9.5 percent, up from a 14-year high of 6.5 percent in October,
and produce a recession comparable in length to that of 1980-82,
according to some analysts.

A more subtle argument is that Chapter 11 bankruptcy may not do for car companies what it is designed to do for the airlines and other businesses: give it time and protection to reorganize. The Economist put the case this way

Consumer surveys that suggest that 80-90% of prospective customers
would abandon the products of a car maker that had filed for bankruptcy
protection. When airlines went into Chapter 11, most of their
passengers stuck with them, reasoning they would be at least be in
business long enough for tickets bought for trips just a few weeks away
to be honoured.

Cars are different. A car is the most expensive purchase many
consumers make, and by buying a car they also enter into a long-term
contract. Buyers expect their 60,000-mile warranties to be honored,
parts to be kept supplied and their dealers not to have disappeared.
Used-car values are also a critical part of the deal. If the firm that
made the car has gone bust, it becomes virtually unsellable secondhand.

I wonder if this is true. I would much be more inclined to buy from a company that I knew had replaced its management and renegotiated its debt, supplier, and labor agreements than one I knew to be a ward of Congress. And the second paragraph confuses Chapter 11 (a restructuring of obligations) with Chapter 7 (liquidation).

But supposing that Washington
decides to help the auto industry, what might an intelligent bail-out look like? How do we
make sure that a perfectly good crisis does not go to waste?

To a first approximation, a bailout should aim to achieve a profound, bankruptcy-like restructuring. The government should
appoint an all-powerful receiver to radically restructure the
obligations of the business. This person (termed an "oversight czar" by the press) needs to have the
experience, power, and political independence to make painful decisions.

The receiver should not fund continued failure. As a widely-read column by the Wall St. Journal's former Detroit bureau chief noted, shareholders should be wiped out (mission nearly accomplished) and agreements with suppliers, cities, dealers, labor unions, and property owners invalidated. Senior management should be replaced and debt-holders should end up owning stock behind the taxpayers (and there is a good case that workers and retirees, unsecured creditors who will be forced to make deep wage and benefit concessions, should participate as shareholders as well). The goal here is not to create a Soviet-style state owned enterprise. The goal is to restructure a corporate behemoth without dragging the rest of the economy through the gates of Hades. This is not likely to be a pretty or a highly democratic process — bankruptcy seldom is.

In
exchange for public money, Democrats will impose the usual restrictions: below market executive pay, no dividend payments, etc. These restrictions are rarely helpful, even if they do make Congress feel better. They serve to increase capital costs and decrease the odds of long term success. For my money, any team that can salvage something from GM deserves to be well paid.

Fuel economy restrictions is also not helpful in part because new rules would not apply to companies not taking bailout money. If Congress wants fuel efficient cars, mandating average fuel efficiency is the wrong way to go about it. Smarter would be to require that all cars run on flex-fuel so that they can burn ethanol, whether from corn or produced by biotech companies (the cost of the conversion is less than $200 per car). Then tax gasoline. Start with a tax that keeps the pump price at $4/gallon. Bump the target price a dime per gallon each non-recessionary quarter until it hit $8 bucks
a gallon in a decade or so. No more imbecilic fights over CAFE (average fuel mileage) standards. Consumers would demand fuel efficient cars and petroleum-free fuel. Europe
did this many years ago and its cars and car companies are entering the recession in decent shape
– even Renault and Fiat. And in many countries gas is ten bucks a gallon on a good day.

Who has the skills to administer a such a restructuring (which may include a temporary public investment?) Maybe nobody, but I'd give the
job to Jerry York, former GM director, former CFO of Chrystler, and
former CFO of IBM, which he famously helped Lou Gerstner to turn around. York was
CEO of tech company Micro Warehouse and serves on the board of Apple.
He is a solid, unsentimental business guy who knows the company, having served on the GM board.

When the dust
settles, somebody is going to be meeting the demand that went to GM for $178 billion worth of cars (much of it overseas — where strangely, GM actually does a pretty good job and may have a future). Maybe it will be met by a much smaller, more focused GM that produces for developing markets. Maybe US demand will be met by the 18 thriving transplants owned by Nissan,
Honda, Toyota, Daimler, or BMW. Maybe Cerebrus wants to step
in, buy 10 good plants, and construct a new business with a rational
management and cost structure. These scenarios and more become available either with a federal receiver or via the bankruptcy courts.

Can car companies be fixed? Sure, we saw it happen right here in Silicon Valley. As I recount here,Toyota bought a failed GM plant without any assistance from taxpayers. In case you missed it:

During the 1970s, the Fremont GM plant resembled something out of Charles Dickens.
Parts were piled everywhere and seemingly randomly. The car chassis
stayed at ground level — so if your work was underneath the car, you
spent your shift flat on your back in a pit while cars passed overhead. The
lighting was lousy — the place could be dark at noon. UAW militancy
flourished to the point of comic opera — the Socialists Workers Party
(Trotskyites) hated the Communist Party USA (Stalinists) who hated the
Revolutionary Communist Party (Maoists). It goes without saying that
the cars sucked. Communist cars always do.

In 1982, GM closed the whole mess down. We held rallies, carried
signs, denounced the greedy corporate bastards, and sang old Wobbly
songs. For some reason these efforts did not persuade GM to reopen the
plant.

A couple of years after GM closed the plant, Toyota formed a joint venture with GM. The plant reopened as New
United Motors (NUMMI). Today more workers have better jobs making more and better cars in Fremont than when
it was a GM-owned plant. What did GM learn from the experience? Not much.

The Michigan congressional delegation and the UAW are not looking for this sort of tough love approach. They just want cash, thanks. Obama should offer very generous transition assistance
for tens of thousands of auto workers and others sure to be affected. Not everyone will need it, since some
plants will continue to operate. There is no reason for individual
workers to bear the brunt of this transition even if their collective
foolishness contributed to the problem.

Instead of tough love and transition pay, Obama will be lobbied heavily to simply write a check to GM. He just spent six months promising Michigan
the moon, he is rightly fond of Michigan governor Jennifer Granholm,
and has nontrivial political debts to the state.

But he is
President-elect of the US. GM would burn through its money in a heartbeat and be back for more. Congress would make auto loans deductible and enact other gimmicks to force taxpayers to subsidize a failed business. More fundamentally, if a Congressional delegation as reprehensible as
Michigan's can roll Obama, taxpayers will look elsewhere for political leadership.

Of course it is possible that Obama is doing the smart thing — advocating for the industry knowing that Congress will not act and the economic riptides will drag GM into bankruptcy court before his inauguration. If so, good for him.

At the moment, the Republican Party is like GM — a dying brand that has been repudiated by its customers. What Obama should prevent at all costs is having Nancy Pelosi and Barney Frank throw money at GM. They are already a gift to Republicans that keeps on giving. Their foolishness cannot revive failed companies — but it could easily renew the political fortunes of the Republican Party.