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Auto loans, part 2: options for the President

In part one of this series I reviewed some background and long-term problems facing the U.S. auto manufacturers. I pointed out that General Motors and Chrysler, and the Obama Administration, face a more immediate cash flow problem. The Obama Administration is in the midst of rolling out the President’s new game plan. I’d like to walk you through the options the President faces.

Now let’s examine the benefits and costs of each option. I will soon ask you to pick your own recommendation to President Obama.

Option 1: Extend the current loan and lend additional funds from TARP

Assume a loan cost of roughly $5 B per month for GM, Chrysler, and their finance companies combined. This could be off by a factor of two either way, and can easily vary from one month to the next as external pressures on the companies change their needs.

Likely short-term outcome: 99% chance GM and Chrysler continue operating for the duration of the loan.

Benefits

  • It avoids immediate failure and the associated job loss. If GM and Chrysler both were to enter a Chapter 7 bankruptcy and shut down operations permanently, we had estimated (back in December) total job loss of roughly 1.1 million jobs, heavily concentrated in Michigan and surrounding states. This would be a significant hit to an overall weak national economy, and would devastate the region. We further estimated that U.S. GDP would be 0.5 — 0.75 percentage points lower in 2009 as a result.
  • It buys the firms time to continue working to solve the above-described long-term problems. It also buys time to allow the economy to recover, with the hope that vehicle sales improve.
  • It buys the President and his team time to focus on implementing and selling their financial plan, passing their budget through Congress, and maybe asking Congress for additional TARP funds.

Costs

  • The taxpayer would be placing at risk more funds ( ?$5 B per month), in addition to the $25 B already loaned in December and January.
  • New loans would consume scarce TARP resources, which are needed for the banking sector (their original intended purpose).
  • The December loans require the firms to prove that they are “viable” to continue receiving funds beyond March 31st. By rewriting or extending these loans, the President risks taking a political hit for explicitly relaxing or delaying the viability requirement. By providing even more taxpayer funds, he exacerbates this risk.
  • By temporarily removing the threat of a bankruptcy filing, it may delay a deal among stakeholders (labor, dealers, suppliers, creditors, and management).
  • Each time the taxpayer injects funds, it reinforces the incentive for those stakeholders to negotiate with the government (both the Administration and, separately, with the Congress) rather than with management.
  • In a competitive market, management and equity holders are supposed to face the full downside risks of their failures. By insulating them from some of that downside, the government is creating a moral hazard for the future. This is the “bailout” point, applied to management and shareholders.
  • It is harder to say no to other industries and firms that request relief. The Obama Administration already said yes to certain auto suppliers, lending them $5 B of TARP funds [last week]. This is a slippery slope.
  • It is harder to justify saying no the next time. If you lend them funds for another three months, how do you justify saying no three months from now? Each extension and additional loan increases the chance of these becoming “zombie firms” — firms which can survive only by consuming an ongoing stream of taxpayer subsidies.

Option 2: Offer to extend the current loan, and lend additional funds, but only to help a firm that attempts a restructuring by filing for bankruptcy.

This is called “debtor-in-possession” financing, or DIP financing. The firm enters a Chapter 11 bankruptcy proceeding, and then someone shows up and provides the cash for them to continue operating. In this case, that someone would be the U.S. taxpayer, through the TARP.

Assume that, as a part of this option, some of the DIP financing goes to support a guarantee of service (from third party services, if necessary) for cars bought during restructuring. This should help address the bankruptcy purchase fear.

You should assume a significantly higher initial cost to the taxpayer: $20 B up front, and $100 B total over time, if GM and Chrysler both did this. When a firm enters bankruptcy, everybody wants cash up front for everything. So the taxpayer outlay of DIP-financing is equivalent to roughly 10-12 months of ongoing support in option 1.

Likely short-term outcome: GM files for bankruptcy and takes the DIP financing. Chrysler files for bankruptcy. Maybe they take the DIP financing, or maybe their primary shareholder, the private equity fund Cerberus Capital Management, liquidates them and sells off the valuable parts.

Possible medium-term outcomes: This is where it gets tricky. The bankruptcy restructuring process creates a greater likelihood of the firm reducing its costs dramatically, at the expense of other stakeholders: labor, creditors, and dealers would all take significant hits, because the bankruptcy judge can void their existing contracts. This improves the firms balance sheet, and can improve their cost structure.On the other hand, bankruptcy means the firm defaults on payments to suppliers, which may hurt their ability to get new supplies and increase their costs. In addition, the conventional wisdom is that the word “bankruptcy” in headlines will make it harder for that firm to sell cars, as customers will be (rightly) concerned that the firm may not exist to service their car in the future. It’s unclear how these factors would balance out: will the benefit of cost savings from reorganization and reductions in legacy costs outweigh higher supplier costs and lost sales?

We guessed that there would be a high probability of a Chapter 11 restructuring leading to a Chapter 7 liquidation. This is particularly true when aggregate vehicle sales are so low — sales in 2009 are down about 38% from a year ago. GM’s sales so far this year are down 51% compared to last year; Ford’s are down 45%, and Chrysler’s are down 49%.

If, instead a restructured firm emerges from Chapter 11, it probably has a higher probability of longer-term success than if it had not entered Chapter 11, because it was probably able to achieve greater cost savings and potential future productivity improvements.

Benefits

  • It may avoid immediate failure (liquidation) and the associated job loss.
  • It buys the President and his team time to focus on implementing and selling their financial plan, passing their budget through Congress, and maybe asking Congress for additional TARP funds.
  • If the firm survives Chapter 11 restructuring intact, it probably has a higher probability of being viable in the long run.
  • If the firm survives restructuring, the taxpayer has a higher probability of being repaid.
  • Equity holders face the full costs of the firm’s failure. No more moral hazard is created.

Costs

  • There is a fairly high probability that at least one of GM and Chrysler liquidate. Chrysler’s owners might choose to do so immediately. Either firm may find that their sales loss is so great that they cannot emerge from restructuring, especially beginning from an already low level of sales. If they liquidate, then a portion of the 1.1 million job loss happens, with consequent economic and political effects.
  • This is a bigger cash outlay from the taxpayer than under option 1, at least initially. If these are TARP funds, a $100 B outlay squeezes out an element of the Administration’s financial and housing plan. If not, it dramatically increases the likelihood that the Administration has to go to Congress for more funds.
  • The President would be blamed for “allowing the U.S. auto industry to go bankrupt,” even if the firm is in restructuring and trying to emerge from bankruptcy. The word “bankruptcy” has tremendous political power. The President’s team might try to shift the blame back to his predecessor, but the failure would have occurred on his watch. This would have a national impact on the rest of his agenda, and would have a severe regional political cost for the President, especially in Michigan and neighboring states. It would also likely force some Members of Congress of his own party to attack him publicly. It is easy to imagine midwestern Democrat Members voting no on the budget resolution in protest of a Presidential decision not to provide further aid.

Option 3: Allow the loan to be called and provide no additional funds.

Likely short-term outcome: GM and Chrysler file for bankruptcy no later than mid-April.

Likely medium-term outcome: GM and Chrysler likely liquidate.

Benefits

  • U.S. auto manufacturers succeed or fail based on their own merits, and are therefore on a level playing field with most other American firms. (I said “most.”)
  • There’s no additional direct cost to the taxpayer. There would be indirect costs from higher unemployment insurance payments, higher health insurance subsidies through “COBRA”, and lost income tax revenues.
  • There’ no more moral hazard. Investors and managers face the full costs of their actions and decisions (present and past).

Costs

  • Assume roughly 1.1 million lost jobs, beginning within weeks.
  • (Same as option 2, but more intensely): The President would be blamed for “allowing the U.S. auto industry to go bankrupt.” His team might try to shift the blame back to his predecessor, but the failure would have occurred on his watch. This has a national impact on the rest of his agenda, and would have a severe regional political cost for the President, especially in Michigan and neighboring states. It would also likely force some Members of Congress of his own party to attack him publicly. It is easy to imagine midwestern Democrat Members voting no on the budget resolution in protest of a Presidential decision not to provide further aid.

Option 4: Punt to Congress. Refuse to spend additional TARP money, and tell Congress that if they want the companies to survive, they should appropriate new funds.

Given that the December loans expire within a week, the practical implementation of this option is likely a combination of this with option 1: extend the December loans for, say, one additional month, and provide additional TARP funding to cover that month. But tell the Congress and the auto manufacturers that you will not lend any funds beyond that without a new law from Congress that explicitly appropriates those funds.

Likely short-term outcome: GM and Chrysler survive for as long as you provide your last short-term loan.

Likely medium-term outcome: Completely unknown.

Benefits

  • Some argue that TARP funds were never intended for this purpose, and that Congress has the power of the purse. This is a decision, they argue, that should be made by the Legislative branch, not the Executive branch. Your decision not to spend any more (beyond, say one additional month) of TARP funds returns both the policy and political responsibility “where it belongs.”

Costs

  • Reactions from Congress will be mixed.
    • Conservatives (not usually this President’s allies) will likely relish the opportunity to try to block or amend legislation. Environmental advocates may take a similar view.
    • Members from auto states, as well as the auto manufacturers themselves, will likely try to pressure you and the President to reverse this decision, “Just as a fallback, in case Congress does not act.” This pressure will come from friends of labor and management, as well as from investors and “the markets” generally.
  • You lose control of the outcome, which is highly uncertain. In past years, the smart money would have bet heavily on the firms getting additional relief, and that’s still probably a better than 50 percent chance. But in last Fall’s debate there were signs of bailout fatigue on both sides of the aisle, and the environmental advocates had powerful friends who were not sympathetic to the industry’s views.
  • You look like a wimp who is trying to duck responsibility.

Coming soon: parts 3 and 4, comparing the Bush and Obama approaches, and part 5, in which I pose some hard questions and ask you to make your recommendation to the President.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

By | 2017-05-23T19:08:18+00:00 Friday, 27 March 2009|