Ramifications of Auto Industry Bankruptcies

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Good morning, Chairman Cohen, Ranking Member Franks and membersof the committee. I am Daniel Ikenson, associate director of theCenter for Trade Policy Studies at the Cato Institute. Today, Iwould like to share some general concerns about the ramificationsof the auto industry bankruptcies. The views I express are my ownand should not be construed as representing any official positionsof the Cato Institute.

The Past Eight Months

On November 5, the morning after Election Day 2008, a report waspublished by the Center for Automotive Research, a Detroit-basedconsulting firm, warning that three million jobs were at stake inthe automotive sector unless the U.S. government acted withdispatch to ensure the continued operation of all of the Big Threeautomakers.1Detroit's media blitz was underway. And it was timed to remind thepresident-elect, as he contemplated his victory the morning after,of the contribution to his success of interests now seeking somehelp of their own.

The CAR report's projection of three million job losses waspredicated on some fantastical worst case scenario that if one ofthe Big Three were to go out of business and liquidate, numerousfirms in the auto supply chain would go under as well, bringingdown the remaining two auto producers, as well as all of theforeign nameplate U.S. producers and, subsequently, the rest of theparts supply chain. Oddly, the report gave no consideration to themore realistic scenario that one or two of the Detroit automakersmight turn to Chapter 11 reorganization.

The subsequent public relations effort to make the case forfederal assistance was pitched with an air of certitude andimmediacy that the only real alternative to massive federalassistance was liquidation and contagion. The crisis-mongering wasreminiscent of former-Treasury Secretary Henry Paulson's andFederal Reserve Board Chairman Ben Bernanke's insistence six weeksearlier that there was no time for Congress to think, only time forit to act on a financial sector bailout, lest the economy facefinancial ruin.

The mainstream media obliged the script, elevating theautomobile industry "crisis" to the top of the news cycle for thenext month, and helping to characterize the debate in thesimplistic, polarizing dichotomy of "Main Street versus WallStreet." The notion that some financial institutions took risks,lost big, and were rescued by Washington became the prevailingargument for bailing out the auto companies, and the specific factsabout viability and worthiness were tertiary.

But public opinion that was initially accommodating of thatcharacterization quickly changed when the CEOs of GM, Ford, andChrysler laid waste to months of public relations planning andmillions of dollars spent trying to cultivate a winning messagewhen they each arrived in Washington, tin cups in hand, aboardtheir own corporate jets. That fateful incident turned the mediaagainst Detroit and reminded Americans - or at least opened theirminds to the prospect - that the automakers were in dire straitsbecause of bad decisions made in the past and helped convince themthat a shake out, instead of a bailout, was the proper course ofaction.

Although legislation to provide funding to the automakers passedin the House of Representatives last December, the bill did notgarner enough support in the Senate, where it died. Prospects forany form of taxpayer bailout seemed remote and the proper course ofaction for GM and Chrysler, reorganization under Chapter 11,appeared imminent. An interventionist bullet, seemingly, had beendodged. But then, just days after then-Secretary Paulson claimedto have no authority to divert funds from the Troubled AssetsRelief Program to the auto companies, President Bush announced thathe would authorize bridge loans from the TARP of $9.4 billion and$4.0 billion to GM and Chrysler, respectively.

As the companies were incurring $6 billion of operating lossesper month at that time, it did not require a Ph.D. in finance torecognize that they would exhaust those funds in a matter of monthsand be back at the trough. And when they returned - as stipulatedin the terms of the loans - to present their revitalization plans,it was evident that central to those plans were billions moredollars in taxpayer assistance.

As President Obama was correct to conclude at that point, thecompanies had not produced viable business plans worthy ofcontinued financing. At that point, the president should havepointed the way toward the bankruptcy courts and moved on. Instead, he asserted a major role (and responsibility) for theadministration by choosing to facilitate the bankruptcy processesof both companies by brokering pre-bankruptcy deals with majorstakeholders. He even "influenced" the occasional personnel moveand operational decision.

Both companies entered and emerged from bankruptcy protection inshort order, restructured according to the plans crafted by theObama administration. This testimony discusses some of thepotential ramifications of the unusual bankruptcy processes andoutcomes.

Ramifications of the Auto Bankruptcies

The emergence of General Motors from bankruptcy on July 10marked the end of the first chapter of what is an evolvingcautionary tale about the triumph of politics over markets and therule of law. As the next chapter unfolds, some of the adverseconsequences of a gratuitously political bankruptcy process forboth GM and Chrysler are likely to become evident.

Bankruptcy was always the best option for GM and Chrysler. Butboth companies were resistant to filing for bankruptcy protection,allegedly because they were concerned that car buyers would eschewpurchasing from companies in bankruptcy. Though it is difficult tomake the case that car buyers would prefer to purchase fromcompanies in limbo, bouncing from one bailout prospect to next, itis likely that resistance to standalone Chapter 11 filings had moreto do with the kinds of changes an independent bankruptcy judgewould have required to meet the threshold of a viable "goingconcern." But after reassuring consumers that bankruptcy did notmean liquidation and that car warranties would be honoredregardless, President Obama escorted both companies into thebankruptcy process.

Indeed, the process should have begun long before then. Itshould have happened long before President Bush felt compelled tocircumvent the wishes of Congress and "lend" Chrysler and GM $13.4billion from the TARP allotment. It should have happened longbefore President Obama had the chance to promise billions more andassume a large role for the U.S. government in Chrysler's and GM'srestructuring and future operations. It should have happened longbefore President Obama created a huge moral hazard by strong-armingChrysler's and GM's preferred lenders into taking pennies on theirloan dollars, while giving preference to claimants of lesserpriority. It should have happened long before Ford, Toyota, Honda,BMW, Kia, and the rest of America's automobile industry wereimplicitly taxed by the government's insistence on preventing twofirms from exiting the market or otherwise reducing their presenceby restructuring in accordance with established bankruptcyprovisions. And it should have happened long before otherbusinesses in other industries started to get the idea that failureis the new success.

President Bush's extension of "loans" to Chrysler and GM, incircumvention of the wishes of Congress and in contravention of theexpress purpose of the Troubled Assets Relief Program to support"financial institutions," was the original policy sin. Withoutthose loans, both automakers likely would have sought protectionunder Chapter 11 of the bankruptcy code before the end of 2008. The duration of bankruptcy may have been longer than it ultimatelyturned out to be, but the outcomes might have been more in linewith the precedents and orthodoxy of established bankruptcy law,and consistent with expectation of how market economies aresupposed to function.

Instead, on account of President Obama's doubling down by takingresponsibility for crafting and ramming through the courts hisprepackaged "surgical" bankruptcies, the entire auto industry facesa precarious set of circumstances. Taxpayers are now majoritystakeholders in a company whose success depends on good stewardshipfrom a 536 CEOs with disparate political interests that are notnecessarily aligned with GM's business interests. Prospects thattaxpayers will be made whole for their $50 billion coercedinvestment are dimmer than prospects that the public outlay willgrow larger. As the Obama administration seeks to justify itswisdom in intervening, it will be tempted to use public policy andthe tax code to tip the scales further in favor of GM, whilehamstringing the competition.

Meanwhile, the United Autoworkers Union, typically moreconcerned about how corporate profits are carved up, rather thanattained, is majority owner of Chrysler.

Neither GM's nor Chrysler's management situation is particularlyconfidence-inspiring, which bodes ill for the companies' prospectsfor raising capital to make the kinds of investments policy makersare intent on thrusting upon them in the name of emissionsreduction. Prospects for raising capital in the form of debt havealready suffered from the Obama administration's poor treatment ofsecured debt holders. Not only will that temper demand for GM's andChrysler's debt, but for corporate debt across industries. Withthe economy still fragile and the number of bankruptcies stillincreasing, typically risk-averse preferred debt holders will bemore inclined to remain on the sidelines, which will bid up thecost of debt at a time of tight credit and exploding budgetdeficits. It's not a pretty picture.

As one bankruptcy expert attested before this committee, theObama administration's takeover of the bankruptcy process was a bitgratuitous.2 Theimplication that our bankruptcy laws are incapable of handlingreorganization of companies this large in a timely manner is atodds with historical experience.

But perhaps even more troubling in the case of GM are thefundamental conflicts inherent in simultaneously operating andregulating the same company. How will the administration andCongress balance law, compliance, policy, and the profit objectiveat the same time?

Conflicts between Profits and Policy

The Dealerships Issue

Support in Congress for legislation to compel the two automakersto restore contracts with dealerships slated for closure undertheir respective recovery plans affirms the views of skeptics: thepursuit of profits and political objectives often work at crosspurposes. What is good for the bottom line is often incompatiblewith political objectives and political objectives are oftenincompatible with the bottom line. When decision makers are onlyconcerned with one or the other, there is no problem. But whenbusiness operating decisions are also made or even just influencedby people who have politics to consider, something is going togive.

Notwithstanding the possibility that the choice of dealershipclosings was made arbitrarily, if not politically, the fact remainsthat the companies must cut costs to survive, and excessivedealership networks are an area that is ripe for cutting. Accordingthe GMs nominal CEO, Fritz Henderson, the planned distributorclosings will save GM about $100 in distribution costs per vehicle. That translates into a few hundred million dollars of savings peryear when factoring in the millions of units GM expects toproduce.3 That thecompanies face the specter of having to abandon those effortsbecause a majority of its 536 CEOs have political reasons for doingso bodes ill for the companies' prospects.

Not only does the dealership issue seriously elevate doubts thatpolitics will not infect operational decisions at GM in particular,but it portends highly erratic management as the president andCongress wrestle for primacy in formulating policy at this majoritytaxpayer-owned entity. And since the Constitution is silent on thematter of which branch furnishes the CEO of a nationalized company,we may be in for a long period of uncertainty and instability.

The dealership issue represents just one of many potentialconflicts on the horizon. We have already witnessed other clashesbetween what is right from a business perspective and what isimperative politically. The president's firing of Rick Wagoner andhis subsequent endorsement of Fritz Henderson to fill GM's CEOslot, as well as his role in influencing the selection of GM'sboard members, raises questions about the administration'smotivations. Is the president interested in filling key executivepositions with people who are best qualified to run a profitableenterprise or who might be more amenable to the administration'splans for converting the economy from a carbon-based to arenewables-based one?

Profits vs. Green Production

The conflicts inherent between the objectives of returning GM toprofitability and making it a showcase for green production shouldbe obvious. Returning GM to profitability will require higherrevenues and lower costs, neither of which is made easier byimposing more rigid CAFE standards on the automakers. To quote myCato colleague Alan Reynolds, "General Motors can survivebankruptcy far more easily than it can survive President BarackObama's ambitious fuel economy standards, which mandate that allnew vehicles average 35.5 miles per gallon by 2016."4

Fuel efficiency standards are particularly punitive towardautomakers that sell larger vehicles. The Big Three - GM and Fordin particular - have had their greatest success in the largervehicle market. Their pickup trucks, sport utility vehicles,luxury cars, and muscle cars all have higher profit margins thantheir small vehicle offerings. But to even be eligible to sell anadequate number of these vehicles and reach overall profit targets,they must sell a sufficient number of small cars to attain a fleetefficiency of 35.5 miles per gallon. In other words, to satisfyconsumer demand and realize profits on their most popular models,GM will have to sell - at low or no profit, or at a loss - asufficient number of high mileage vehicles that are not as popularas policymakers imagine them to be.

GM in particular is at a huge disadvantage vis-à-vis theforeign nameplate producers in the United States, who already haveloyal customers for their high-mileage vehicles. So Toyota andothers will be able to compete with greater maneuverability in themarket for large and luxury vehicles (where GM is mostcompetitive), while GM is forced to divert resources to cultivate askeptical market for its small cars.

Warren Brown, the Washington Post's auto expert,reviewed the Toyota Yaris S in his column this past Sunday. Although he is favorably disposed to the car, he writes: "[F]or allof its many virtues, the little Toyota Yaris is selling poorly inthis country, where its retail numbers are down 40.4 percent in thefirst six months of 2009."5 And then in a passage that speaksdirectly to policymakers obsessed with fuel efficiency standards,he writes: "But here is what for many of you will be ahard-to-swallow truth: Fuel-sippers such as the Yaris are sellingin numbers well below those of the Ford F-series and ChevroletSilverado picup trucks…We want cars such as the Yaris andFit when gasoline prices are high, or when gasoline is in shortsupply. But when gasoline is flowing at prices that make us smile,which it usually does in the United States, we'd much rather have aChevrolet Camarro SS with a 6.2-liter, 426-horsepower V-8 engine. Strange as it might seem in these hard times, Chevrolet isn'thaving any trouble selling that one."6

The lesson here is that forcing automaker to produce vehiclesthat Americans demand only when fuel prices are in the $4 dollarrange is not going to help GM or Chrysler. The direct and honestapproach to increasing demand for small vehicles - although I donot endorse it - is a national fuel surcharge that keeps the priceof gasoline relatively constant at high levels. That idea isunlikely to be very popular around the country.

Between the Congressional pushback over the dealerships issueand the insistence on higher fuel efficiency standards, we see theobjectives of two broad groups of policymakers: those who wantgreen production and treat the costs of that goal as immaterial,and those who want the auto companies to remain a jobs program,regardless of the imperative of shedding workers to become morecompetitive. Neither camp seems to understand or care very muchthat fulfillment of their objectives will only hamper recovery, atbest, if not drive the automakers out of existence.

Making the Taxpayers Whole

Let us not lose site of the fact that $65 billion in taxpayerfunds have been directed to GM and Chrysler over the past eightmonths - not as many zeroes on the end as seems to be required toget Washington's attention these days, but still a lot of money. Most Americans are not too pleased about having these "investments"made on their behalf. But Washington may be forgiven if thegovernment divests of these companies quickly, with large enoughprofits and returns on investment to help soothe the public'smisgivings.

In the case of GM, for taxpayers to get back their principal(without any interest or capital gain) the company will have to beworth $83 billion. That figure is derived by considering thattaxpayers have "invested" roughly $50 billion in GM, which isdeemed by the bankruptcy plan to be worth a 60 percent share in thecompany. And 60 percent of roughly $83 billion equals $50 billion. How likely is it that the value of GM will reach $83 billionanytime soon (barring dramatic inflation)?

At its historic high value in 2000, GM's worth (based on itsmarket capitalization) stood at $60 billion. Thus, the company'svalue must increase by 38 percent from it historic high, achievedin the heady days of 2000, when Americans were purchasing 16million vehicles per year, just to return principal to thetaxpayers. But U.S. demand projections for the next few years comein at around 10 million vehicles, which suggests that prospects forthe government divesting of GM profitably are extremely remote.

In fact, it is much more likely that the taxpayer investment inGM, directly or implicitly, will increase further, as theadministration and some in Congress have incentive to use policy(tax policy, trade policy, and regulations) to induce consumers topurchase GM products, to subsidize production and, indeed, tohamstring GM's competition. And this all raises the question ofwhat will happen to Ford and the other foreign nameplate producerswhen the lawmakers and administrators have a favorite horse in therace. Ford is relatively healthy now, but continued support for GMand Chrysler could well drive Ford to the trough, too. At somepoint, Ford's management might reckon that their closestcompetitors, who made terrible business decisions over the years,just got their debts erased and their downsides covered. Why nottravel down that path, if things get too tough? That calculation,if it is ever made, presents the specter of another taxpayerbailout to the tunes of tens of billions of dollars, and anothergovernment-run auto company.

The U.S. Auto Industry is Healthy

In 2008, the Big Three accounted for roughly 55% of U.S. lightvehicle production and 50% of U.S. sales. To speak of the U.S.automobile industry these days, one must include Honda, Toyota,Nissan, Kia, Hyundai, BMW - and other foreign nameplate producerswho manufacture vehicles in the U.S. They are the other half of theU.S. auto industry. They employ American workers, pay U.S. taxes,support other U.S. businesses, contribute to local charities, havegenuine stakes in their local communities and face the samecontracting demand for automobiles as do GM, Chrysler, and Ford. The important difference is that these companies have a bettertrack record of making products Americans want to consume.

If GM or Chrysler or Ford went belly up and liquidated, peoplewould lose their jobs. But the sky would not fall. In fact, thatoutcome would ultimately improve prospects for the firms andworkers that remain in the industry. That is precisely whathappened with the U.S. steel industry, which responded to waningfortunes and dozens of bankruptcies earlier in the decade byfinally allowing unproductive, inefficient mills to shutter.

Bailouts or forced subsidizations are clearly unfair totaxpayers, but they are also unfair to the successful firms in theindustry, who are implicitly taxed and burdened when theircompetition is subsidized. In a properly functioning marketeconomy, the better firms - the ones that are more innovative, moreefficient, and more popular among consumers - gain market share orincrease profits, while the lesser firms contract. This processensures that limited resources are used most productively and thatthe most successful firms lead us into the future.

Last November, one day before the CEOs of GM, Ford, and Chryslertold the Senate Banking Committee that their industry facedimminent collapse without an emergency infusion of $25 billion, anew automobile assembly plant opened for business in Greensburg,Indiana. Although the hearing on Capitol Hill received far moremedia coverage, the unveiling of Honda's latest facility in theAmerican heartland spoke volumes about the future of the U.S. carindustry.

There are plenty of healthy auto producers in the United States,all of whom are facing contracting demand. The ones that are bestequipped to survive the recession will emerge stronger. But weundermine the objective if Ford, Toyota, Kia, Honda, Volkswagen andall the others cannot compete on a level playing field with GM tocome up with the next generation of fuel-efficient cars.

Some Final Thoughts

The demise of these two iconic American automakers, Chrysler andGM, and the U.S. government's assumption of responsibility fortheir rehabilitation occasioned a direct appeal from PresidentObama to American economic "patriotism" a few months ago. Thepresident exclaimed, "If you are considering buying a car, I hopeit will be an American car." Ignoring, for the moment, theimpropriety of the U.S. president attempting to influencecommercial outcomes by endorsing particular products, even if onewere inclined to buy an American car, the tricky question remains:What constitutes an "American" car? Economist Matthew Slaughter,in a recent Wall Street Journal opinion-editorial, attempted toelucidate:

What exactly makes a car "American?" Does it mean a car made bya U.S.-headquartered company? If so, then it is important tounderstand that any future success of the Big Three will depend alot on their ability to make - and sell - cars outside the UnitedStates, not in it. A big reason Chrysler has fallen bankrupt is itsnarrow U.S. focus. It has not boosted revenues by penetratingfast-growing markets such as China, India and Eastern Europe. Norhas it lowered costs by restructuring to access talent andproduction beyond North America.7

However, the incredulous, angry reactions from American laborunions, their patrons in Congress, and rabble-rousing televisionand radio personalities to GM's since-reversed announcement thatits revitalization plans include shifting more production to Mexicoand China suggest that the above definition of an American car isnot universally embraced. For those who object to GM's plans, it isnot the company's bottom line that matters, but rather thecompany's capacity to create U.S. jobs and stimulate U.S. economicactivity. That GM might need to start making profits in order tocreate U.S. jobs and stimulate U.S. economic activity somehowdoesn't factor into the equation for these detractors. Instead, inzero-sum fashion, they see investment in foreign operations asantithetical to domestic job creation and economic growth.8

Perhaps, then, they would find Slaughter's alternativedefinition of an American car more accurate:

Or is an "American" car one made within U.S. borders? If so,then it is important to understand that America today has a robustautomobile industry thanks to insourcing. In 2006,foreign-headquartered multinationals engaged in making andwholesaling motor vehicles and parts employed 402,800 Americans -at an average annual compensation of $63,538 - 20% above thenational average. Amid the Big Three struggles of the pastgeneration, insourcing companies like Toyota, Honda and Mercedeshave greatly expanded automobile operations in the U.S. In fiscalyear 2008, Toyota assembled 1.66 million motor vehicles in NorthAmerica with production in seven U.S. states supported by researchand development in three more.9

But many Americans have rejected this definition of an Americancar as well. Ironically, the people who are most inclined to opposeoutsourcing and define it as "shipping jobs overseas" tend to bethe same people who criticize insourcing for shipping control ofU.S. assets overseas. Even though the top 10 selling models of carsand trucks in the United States in 2008 were all produced in theUnited States, by American and foreign nameplate producers, andeven though foreign nameplate producers employ hundreds ofthousands of American workers, pay local and national taxes,support local economies, reinvest part of their earnings in theirU.S. operations, and invest in other local businesses, the factthat corporate headquarters are located in Tokyo or Stuttgart orSeoul seems to hold sway.

At best, there is grudging acceptance of the possibility thatthese "insourcing" companies are part of the American manufacturinglandscape, but it is impossible to imagine that the U.S. governmentwould have ever rescued Toyota or Honda, if they had presented withfinancial prospects as dire as Chrysler's and GM's. Yet, as put inanother recent Wall Street Journal article:

Once you put down the flags and shut off all the television adswith their Heartland, apple-pie America imagery, the truth of thecar business is that it transcends national boundaries. A car ortruck sold by a "Detroit" auto maker such as GM, Ford or Chryslercould be less American - as defined by the government's standardsfor "domestic content" - than a car sold by Toyota, Honda or Nissan- all of which have substantial assembly and components operationsin the U.S.10

The automobile industry is one of many that "transcends nationalboundaries" and is only one example of why internationalcompetition can no longer be described as a contest between "our"producers and "their" producers. But the same holds for industriesthroughout the manufacturing sector. The fact is that thedistinction between what is and what isn't American has beenblurred by foreign direct investment, cross-ownership, equitytie-ins, and transnational supply chains.

It's time for U.S. economic policy to catch up to thatcommercial reality.


1David Cole, SeanMcAlinden, Kristin Dziczek, Debra Maranger Menk, "The Impact on theU.S. Economy of a Major Contraction of the Detroit ThreeAutomakers," Center for Automotive Research Memorandum, November 4,2008, available at http://www.cargroup.org/documents/FINALDetroitThreeContractionImpact_3__001.pdf

2 Testimony ofDavid A. Skeel, Jr., U.S. House of Representatives, JudiciaryCommittee hearing, May 21, 2009.

4 WSJ, July 2,2009

5 Warren Brown,"What We Say We Want, Not What We Really Want," WashingtonPost, p. G12, July 19, 2009

6 Ibid.

7 Matt Slaughter,Wall Street Journal, May 7, 2009

8 For the record,the empirical evidence supports a positive relationship between thegrowth of a company's foreign operations and the growth of itsdomestic operations. Following is an excerpt from Daniel T.Griswold, "'Shipping Jobs Overseas' or Reaching New Customers? WhyCongress Should not Tax Reinvested Earnings Abroad," CatoInstitute Free Trade Bulletin No. 36, January 13, 2009: "Investingabroad is not about 'shipping jobs overseas.' There is no evidencethat expanding employment at U.S.- owned affiliates comes at theexpense of overall employment by parent companies back home in theUnited States. In fact, the evidence and experience of U.S.multinational companies points in the opposite direction: foreignand domestic operations tend to compliment each other and expandtogether. A successful company operating in a favorable businessclimate will tend to expand employment at both its domestic andoverseas operations. More activity and sales abroad often requirethe hiring of more managers, accountants, lawyers, engineers, andproduction workers at the parent company."

9 Slaughter.

10 Joseph B.White, "What is an American Car?" Wall Street Journal,January 26, 2009.

Daniel J. Ikenson

Subcommittee on Commercial and Administrative Law
Committee on Judiciary
United States House of Representatives