What to Do About Detroit?
The latest chapter in the great bailout saga revolves around what should happen to the Big Three automakers. Specifically, what aid, if any, should the Federal Government provide to them since General Motors Corporation (GM) might run out of cash in a few months and Ford Motor Company (F - Analyst Report) and Chrysler (private) could quickly follow.
While it is hard to think of any managements that seem less deserving of help than those of the Big Three, the spillover effects to the rest of the economy could be huge if they went down. Perhaps as many as 2 million jobs could be lost at a time when unemployment is already skyrocketing (new unemployment claims were 542,000 -- the highest since 1992, and continuing claims were the highest since 1982 at over 4 million).
While in some senses the problems of the Big Three have been decades in the making, the timiing of the current crisis is due to the credit crunch. With financing cut off, there are simply not that many people who are able to pay for a new car in cash.
Theoretically, the situation the Big Three find themselves in is just what Chapter 11 bankruptcy is supposed to be there for. Some of the legacy costs could be addressed, contracts could be re-written, debt exchanged for new equity (existing shareholders wiped out) and new management put in place.
There are a few major problems with this approach. The first is that when you buy a car, you are in effect entering into a long-term relationship with the manufacturer. You want to be sure that the warranty will be honored and that spare parts will be available 4 or 5 years from now. If the company is in bankruptcy, there would be considerable uncertainty about that. Sales could dry up even faster than they have so far, and the Chapter 11 reorganization could quickly turn into a Chapter 7 liquidation. This would probably drag down the suppliers, who also supply the remaining automakers. Since all the automakers operate using just in time inventory systems, this could result in even the more financially healthy transplants being forced to shut down production.
The second problem is that there are probably a huge amount of credit default swaps (CDS) outstanding on GM and Ford. These would be triggered in the event of a Chapter 11 filing, and it would create even more havoc in the financial system. I have no idea where all those bodies are buried, and I suspect nobody else does. However, it is highly likely that the volume of CDS's is several times the size of the actual debt of the Big Three.
Also, there are probably a fair number of CDS's that have been written on the suppliers like TRW Corp. (TRW - Analyst Report) and Lear Corp. (LEA), which would most likely follow GM and Ford into bankruptcy court. In case you have not noticed, the banking and financial system is not in the best shape right now, and massive CDS triggers could just be the coup de grace for the whole system.
In effect, what needs to be done is a Chapter 11 that is not called a Chapter 11. Any federal loans should come with the sorts of strings that would approximate what would happen to the companies in the event they did go to court. For example, the government should get massive amounts of warrents, with an exercize price based on the current prices of the stocks, and they should be exercizable as long as any of the loan is outstanding.
In effect, this would wipe out the existing shareholders. Senior management (and not just the C-level but probably the top 500 or so people at each of the firms) would have to agree to major pay cuts (and don't even think about bonuses). The C-level folks should probably be replaced. The UAW would have to agree to major modifications to the existing contracts, and those modifications would have to include not only the pay and benefits of the current workers, but the pensions and health benefits of the retirees as well. Most likely, several divisions would have to be shut down and consolidated (i.e. meld Pontiac and Saturn into Chevy, Mercury into Ford, etc).
Read the full analyst report on GM
Read the full analyst report on F