Bail Out the Detroit Auto Manufacturers? Posner's Comment

Becker has laid out the case for refusing to bail out GM, Ford, and Chrysler. It is a powerful case, and if the drop in auto sales that is driving these companies toward insolvency had occurred two years ago, there would be in my view no case, other than a political one, for a bailout. But in the current financial crisis, I believe a bailout is warranted, provided that the shareholders and managers of the companies are not allowed to profit from it. There are two types of corporate bankruptcy: liquidation and reorganization (Chapter 7 and Chapter 11 of the Bankruptcy Code, respectively). In a liquidation the bankrupt company closes down, lays off all its workers, and sells all its assets. That probably would not be the efficient solution to the problems of the Detroit automakers. They are still producing millions of motor vehicles per year, and if they suddenly ceased production entirely there would be a big shortage even though demand is way down. To put this another way, although at present the companies are probably losing money on virtually every vehicle they sell, at a lower level of production the price at which they sold their vehicles would exceed marginal cost. The alternative to liquidation--reorganization--can work well in normal times, as in the United Air Lines bankruptcy that Becker mentions. The reorganized business is able to borrow money because its post-bankruptcy borrowings ("debtor in possession" loans, as they are called) are given priority over its pre-bankruptcy debts, which are usually written down in bankruptcy, reducing the reorganized firm's debt costs and thereby enabling it to recover solvency. The debts that get written down can include health and pension benefits, which in the case of the auto companies continue to be a big drag on profitability. The major problems with allowing the automakers to be forced into bankruptcy within the next few months are three, all arising from the depression that the nation appears to be rapidly sinking into. The first problem is that the companies might have to liquidate, because they might be unable to attract the substantial post-bankruptcy loans that they would need to enable them to remain in business. The credit crunch--less politely the near insolvency of much of the banking industry--has made that industry unable or unwilling to make risky loans, and loans to the auto companies after they declared bankruptcy would be risky. Second, not only the size of the automakers, but peculiarities of the industry, would cause bankruptcy to greatly exacerbate the nation's already dire economic condition. In the very short term, the automakers would probably stop paying their suppliers, which would precipitate a number of the latter--already in perilous straits because of the plunge in the number of motor vehicles being produced--into bankruptcy. Many of the suppliers would probably liquidate, generating many layoffs. At the other end of the supply-distribution chain, consumers would be reluctant to buy cars or other motor vehicles manufactured by a bankrupt company because they would worry that the manufacturer's warranties would be unenforceable. So more dealerships would close, producing more bankruptcies, liquidations, and layoffs. With the demand for the vehicles made by the Detroit automakers further depressed and the supply-distribution chain in disarray, the liquidation of those companies would begin to loom as a real and imminent possibility. Liquidation of the automakers would produce an enormous number of layoffs up and down the chain of supply and distribution. Such prospects reinforce the unlikelihood that a reorganized industry could survive on debtor in possession loans. The likely psychological impact of a bankruptcy of the U.S.-owned auto industry should not be underestimated. Already consumers, rendered fearful by repeated misinformation from government officials concerning the gravity of the economic situation (including their reluctance to acknowledge that the nation was even in a “recession,” long after it was obvious to the man in the street that we were in something worse), are reducing their buying, precipitating big layoffs in the retail industry, which in turn reduce buying power, which in turn spurs more layoffs. This vicious cycle would be accelerated by the laying off of hundreds of thousands of workers in the automobile industry, including employees of suppliers and dealers as well as of the manufacturers. The U.S.-owned auto industry may be doomed; it may simply be unable to compete with foreign manufacturers (including foreign manufacturers that have factories in the U.S.); or a reorganization in bankruptcy may be the industry's eventual salvation. But the automakers should be kept out of the bankruptcy court until the depression bottoms out and the economy begins to grow again. (Recall that the government bailed out the airlines after 9/11, allowing United Air Lines to have an orderly bankruptcy reorganization beginning the following year and ending in 2006.) Any bailout, however, should come with strict conditions, to minimize the inevitable moral hazard effects of government bailouts of sick companies. The government should insist on being compensated by receipt of preferred stock in the companies, on the companies' ceasing to pay dividends, and on caps on executive compensation, including severance pay. A possible alternative would be for the government to refuse to bail out the industry but agree to provide the necessary debtor in possession loans to keep the auto companies from liquidating after they declare bankruptcy. But this would be a kind of bailout, and probably would not be sufficient to avert the shock effects that I have described.

Comments

[Anonymous]

Becker's post seems to be missing...

[Tom Rekdal]

There is a certain degree of unreality in this discussion, since the political costs of allowing the Big Three auto makers to go under are so high--particularly for the Democratic party--that some sort of bailout seems nearly inevitable.

But assuming, for the sake of argument, that we still have some choice in the matter, is a bailout really the least expensive alternative? I accept your assumption that any bankruptcy proceeding would probably lead to lquidation, that liquidation would expand unemployment up and down the production chain, and that any further undermining of consumer spending comes at a particularly undesirable time. But can we not use the money that would otherwise prop up a failing industry to expand unemployment insurance and retraining programs?

[Acton.]

I think the main problem with the bailout is another moral hazard problem. If the Big Three are bailed out, then why not any other company? If we're in a depression, and many more companies will see red on their books, then they are going to come to Washington to lobby for a bailout. They also have many employees at risk of getting laid off and suppliers at risk of getting disrupted. Detroit gets a bailout, why not them?

I'm scared about the sense of entitlement companies will erroneously have if Detroit gets a bailout.

[Mike Linksvayer]

[liquidation] probably would not be the efficient solution to the problems of the Detroit automakers. They are still producing millions of motor vehicles per year, and if they suddenly ceased production entirely there would be a big shortage even though demand is way down.

They aren't all going to liquidate simultaneously. After the first does, the other two will have much better prospects.

The solution is to let them fail as quickly as possible, so that one in fact does fail quickly.

[Dan]

Given that the dems will almost certainly bail out Detroit, I'd be interested in more discussion of what the best form of bailout will be.

It seems executive compensation is a tiny (but still important moral-hazard-wise) part of the problem.

So, what should we do? I don't know enough to really say, but some ideas would include:

Shift some health burden to the govt by wiping out the gold-plated health plans for those over 65 and have them use Medicare like the rest of us.

Force renegotiation of union contracts.

Supersede state laws that protect dealer networks and let the companies control what happens through the dealers.

Use preferred shares like the first bailout of AIG.

If they go into Ch 11, guarantee the warranties.

Fire the senior exec who got us into this mess.

[undergrad effort]

I am going to have to disagree with Professor Posner, ha although this is coming from an undergraduate, so hey—we can all take it with a grain of salt.

As I was reading the post (which I do every week, and want to thank Prof. Posner and Becker for taking the time to write, for what it’s worth), I had in mind the final option that Posner rejects—that the government would provide the necessary debtor in possession loans; if they were to make a such a guarantee, there would be a unique set of advantages contra the other two options (bail out or refusal to bail out): it would lend itself to the firm’s being able to restructure their corporate governance (particularly their egregiously unsustainable worker pensions &c.), it would prevent moral hazard (although the debts are “bailed out,” the firm still files for bankruptcy), and it would provide the confidence needed (by either a de facto or de jure guarantee of their immediate debts) to allow the firms to pull through. Frankly, all of this is purely pragmatic on my end—the business model GM, Ford, and Chrysler have put forward has seemed to be on a crash course with this point for years, and I think they should by all rights be allowed to fail; that said, it’s simply not a practical solution at this point given the current state of our economy, as Prof. Posner correctly noted.

[Patrick]

In the case of the auto-makers' bailout, it's a relief to have a national issue that is so straightforward: American cars tend to break down and fall apart therefore people are not buying them. If GM and Ford don't want to go out of business, they should start making decent cars. To bail them out would be to reward their terrible manufacturing standards.

[Redmund Sum]

One more time: Failure is an essential part of the success of the capitalistic system.

[Michael Burt]

A bailout does not rectify the fact that Detroit has manufacturing capacity X and the market demands Y

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[neilehat]

As for the idea of liqidating the "Auto Industry", this includes third and fourth tier business as well. Such as retailers, restaurants, child care, housing, mortgages, private loans , etc. As for the Auto Industry, one is looking at the loss of approx. 800,000 jobs, when one includes the tird and fourth tier business's one is at job losses of approx. 1.5 to 2 million. With this job loss comes a rolling snowball effect that spills over into the Public Sector in regards to taxes and the services that they provide, not too mention employment. So a failure to bail out the "Auto Industry" will only drive the Nation deeper into the Depression. Making it that much harder to recover. No bailout is an act of stupidity and gross irresponsibility.

It's like being on a sinking ship and someone in the Club Room says, "Don't use the lifeboats, because it's a "moral hazard" because if we do use them, then people won't learn to swim.

[Jeff]

I think that Posner is ignoring the political realities. Dems have a natural constituency, so they will press for a bail out. As we have seen with the TARP, once the government cookie jar is opened, no one has restraint. Only bankruptcy can bring the necessary discipline that needs to come to the auto business.

Barron's had a great article on the amount of private capital that has been wasted on this industry over the past several years. No need for the government to get in the mud too.

[Robert]

This is another case where moral hazard and political uncertainty play a role. If a bailout weren't a consideration, GM probably would have already filed for bankruptcy. If this had happened a few months ago, GM would have billions of dollars in its war chest (at 12/31/07, they had $26 billion in cash; even now they have $16 billion), and the need for DIP financing would be much less pressing.

Instead, the incentive is to maintain current operations, even though they are bleeding cash, while lobbying Washington for a bailout.

[hutch]

I feel like I'm missing something regarding liquidation. If GM, F go into bankruptcy and decides to liquidate, who buys the assets and what will they do with them? Posner talks about the shortage of cars, so it seems he assumes whoever buys the assets won't be producing cars. Will they use those assets in an amusement park or to harvest corn? If those assets do in fact have value and are purchased, I would think they are being used to produce cars, in which case there is no major shortage of cars and those who provide parts to those cars still employ people. For example, when those assets are sold, it's highly likely that Honda or Toyota will buy some (or all, but I doubt that) of those assets and begin producing cars. To produce cars, employees need to be hired.

So to me, any estimates of reduced employment throughout the auto industry are probably grossly overstated. Am I not seeing something?

[Hyun Uk]

I think the government do not offer bailout for auto manufactures in order to curb a bankrupcy. I need to reorganize auto industry. It is better chance to enhance thier price competiton because they solve the most severe problems that has influenced their profit for more than thirty years. Of course, auto industry is one of the most industries in America. Many people depend on them. However, I think if they pass the chance to improve their structure of cost, they face more problems. Some economists predict that about five car makers occupy almost all market share in the future. To be one of the five car makers, gorvennment should try to reorganize auto companies that are facing run out of cash.

[Hyun Uk]

I think the government do not offer bailout for auto manufactures in order to curb a bankrupcy. I need to reorganize auto industry. It is better chance to enhance thier price competiton because they solve the most severe problems that has influenced their profit for more than thirty years. Of course, auto industry is one of the most industries in America. Many people depend on them. However, I think if they pass the chance to improve their structure of cost, they face more problems. Some economists predict that about five car makers occupy almost all market share in the future. To be one of the five car makers, gorvennment should try to reorganize auto companies that are facing run out of cash.

[Hyun Uk]

I think the government do not offer bailout for auto manufactures in order to curb a bankrupcy. I need to reorganize auto industry. It is better chance to enhance thier price competiton because they solve the most severe problems that has influenced their profit for more than thirty years. Of course, auto industry is one of the most industries in America. Many people depend on them. However, I think if they pass the chance to improve their structure of cost, they face more problems. Some economists predict that about five car makers occupy almost all market share in the future. To be one of the five car makers, gorvennment should try to reorganize auto companies that are facing run out of cash.

[Hyun Uk]

I think the government do not offer bailout for auto manufactures in order to curb a bankrupcy. I need to reorganize auto industry. It is better chance to enhance thier price competiton because they solve the most severe problems that has influenced their profit for more than thirty years. Of course, auto industry is one of the most industries in America. Many people depend on them. However, I think if they pass the chance to improve their structure of cost, they face more problems. Some economists predict that about five car makers occupy almost all market share in the future. To be one of the five car makers, gorvennment should try to reorganize auto companies that are facing run out of cash.

[Luca]

To say that the U.S. auto industry is doomed by being unable to compete ignores the outstanding products that have recently rolled out of the Detroit: the Chevy Malibu, the Cadillac CTS, the Ford Flex, the Epsilon family of GM crossovers, the innovative new Chrysler minivan. The problem is not that American companies are unable to creat competitive products: Ford Europe is a dominant force across the entire continent for which it is named.

Saying that a company needs a temporary subsidy or loan so that it can become competitive is one of the oldest, most hacked arguments against free-market processes. I am not denying the potential for widespread creative destruction, but I feel that without that such a challenging time would forge a leaner, meaner, reinvented, rejuvenated domestic auto industry.

[Bill C.]

Dan makes an often overlooked point. Starting in the 1970s dealers have used state legislatures and even Congress to dictate down to the smallest detail the formerly contractual relationship between themselves and vehicle manufacturers, a state of affairs splendid for dealers but terrible for the consumer and ultimately for the companies and the economy. Foreign-owned manufacturers have to endure the same stultifying regulatory regime in the U.S., but for the reasons noted by Becker about their general competitiveness are better able, for now, to endure it. There should be no consideration of a bailout without preemption of state dealer-protection laws and rollback of the federal special-interest legislation (e.g. the Motor Vehicle Franchise Contract Arbitration Fairness Act).

[Dan S]

Seems to me that the big three are all different versions of the same FORD (Fix Or Repair Daily; Found On Road Dead). Chapter 11 first, then bail out the survivors. Let the UAW go fly a kite.

[Oliver]

Given the fact that current and past management have failed to respond to market needs, i.e. producing cheap fuel efficient cars which are reliable, why should equity and bond holders be rescued? They had their chance to sell the stock and bond. I would sugguest to let them all together go bankrupt and propose the debt holder a debt-to-equity swap. If the government keeps these dying giants artificially alive, nothing will really change. If bond-holders will eventually control the companies, at least there is some hope that they will be managed to produce the necessary cash flows to keep them alive and to force them to produce what the market can afford.

[DaveZ]

Bankrupcy Reorg would be more preferred in my mind. I would like to see the following: Cut the executive payouts (bonuses and stock options mostly - as defined historically). I would suggest that the Unions give up the fight against pay cuts and healthcare cuts including other benefits, adopt these changes within reason and as a measure of good faith on the part of the companies and thier union and non-union employees, let the the employees own a pience of the company. Next drastically cut the price of the car they are trying to sell ($3000 to $5000) to give the American People and the international markets a chance to help the company clear inventory.

[AYouthInTheWilderness]

As the undergrad points out, almost everyone agrees that Chapter 11 restructuring and govt DIP loans would be vastly preferable to a simple bailout. Yet, given the political reality and psychological impact, it won't happen.

So why don't we use some of this bailout money to educate or re-train the younger workers? We accomplish all objectives at once: creative destruction in the industry, productive reallocation of labor and a blunted pyschological shock since we are actually helping people move on. Plus, no more need for future bailouts. People are worried but if you let them know they will have assistance, it doesn't have to be so bad.

[neilehat]

The market has alreday cleared dozens of Auto Man'f. from the table. Such as:

Hupmobile, Desoto, Packard, Studebaker, Pierce Arrow, Tucker, Crosley, etc. etc.

As for the "Big Three", Chrysler ain't anymore, So there's really only the "Big Two" and that includes Toyota (whose profits all go overseas contibuting to the trade deficit) Which is how many trillions/year?

For those who seem to think that these companies only produce autos, think again. These companies are heavily involved in many more strategic industries which are vital to the wellbeing and security of the Nation and it's populous. To let them go down the tubes is to cut our own throats. But, from what I see here, must don't care about that, so long as their ideological perspective is preserved intact.

So who are the real economic traitors? Certainly not the Unions, or the Management, or the Government.