Tuesday, October 9, 2012

Where should the bailout stop? And what to do about GM - Edward Altman and Thomas Philippon

The massive US Government bailout originally intended for the financial industry has now spread to the non-financial sector, and the government is considering bailing out car manufacturers. This is partly the fault of the financial bailout itself, which was badly designed and too generous to the financial industry. Unfortunately, history and political economy have taught us that ad-hoc government interventions to bail out industries are a recipe for long run economic stagnation. This does not mean, however, that the government should stay on the sidelines. We argue that government interventions should be based on a consistent set of principles because interventions without principles are almost guaranteed to be captured by interest groups, to become excessively politicized, and to be inefficient in the long run. We present four broad principles: • First, the market failure must be identified; • Second, the intervention should use efficient tools; • Third, the costs for the tax payers should be minimized; • And finally, government intervention should not create moral hazard. Based on these principles, there is indeed a case for government intervention in favor of GM, but this intervention should not be a give-away bailout. The market failure that we identify is the disappearance of the debtor-in-possession (DIP) market because of the financial crisis. This provides a rationale for government intervention (first principle). To be efficient, the reorganization should be thorough, and therefore lengthy. This is why it should take place under Chapter 11 of the Bankruptcy Code (second principle). To minimize the costs to the tax payers, the government should provide DIP financing (directly or through private financial institutions) because DIP loans are well protected (third principle). Finally, reorganization in Bankruptcy does not reward bad management and therefore minimizes moral hazard (fourth principle). We advocate a massive “DIP” loan to GM in bankruptcy. The current bailout plan would offer less of a breathing space to GM and imply more job cuts in the short run than our proposed bankruptcy/DIP financing plan. The DIP loan would allow the restructuring to take place over 18 to 24 months while the bailout would be barely sufficient to avoid liquidation in 2009. To further limit the ripple effects of GM’s bankruptcy, the government should also consider backstopping warranties and spare parts availability, even if the reorganization fails. Why the bailout would not work General Motors Corporation originally asked for a $12 billion loan and a $6 billion line of credit to provide the interim financing it said it needs to restructure the company. Under the revised bailout plan passed by the House, GM’s share was reduced to $10 billion. In addition, they plan to be offered a distressed exchange arrangement with their creditors to reduce the amount of debt by as much as $30 billion. Unfortunately, some form of traditional loan, for $10 billion or even more, is destined to fail in the current environment and will more than likely be followed by additional requests for more rescue funds or a bankruptcy petition once the initial loan has been exhausted. GM’s cash-burn of over $2 billion a month, will reduce its assets even further, and be exhausted three months based on current conditions. The global automobile industry, not just GM, is facing the likely prospect of an extended and severe economic recession. Many economists and financial forecasters expect the recession to last at least another two years with the likely prospect of the worst recession since World War II. In these conditions, making a bridge loan and offering a credit line to GM is essentially a waste of tax payer money. As we will show, even with a more generous bailout package than the one GM is likely to get, it still will very likely go bankrupt in a year or so. General Motors’ viability (including its 49% interest in GMAC) can be analyzed in the following way. We take its financial results as of the end of the third quarter of 2008 and estimate its fourth quarter’s operating performance by assuming it was no better, or worse, than that of the third quarter (more likely its fourth quarter’s results will actually be far worse). We also assume a $2 billion per month “cash-burn” for each month in the 4th quarter, as reported by the firm in many of its statements. We adjust its capital structure for the $30 billion reduction in debt and addition to equity based on its proposed massive equity for debt swap. Finally, we assume that GM will receive the $12 billion loan and then a $6 billion line of credit. Using the 5-variable Z-Score model, as of the end of the third quarter of 2008, GM’s Z-Score was -0.16, which places the firm clearly in the “D” (Default) bond-rating-equivalent category. Indeed, GM’s Z-Score fell and became negative for the first time as of June 2008 and was in the “D” default zone. The average Z-Score of a sample of hundreds of bankrupt firms in the recent past was -0.19. With the pro-forma financial profile as of 12/31/08, GM’s Z-Score improves slightly to -0.09, assuming the receipt of $12 billion in loans and to -0.03 assuming an increase of $18 billion in cash from the government. These scores are still much closer to a “D” rating equivalent than to a “CCC” rating. In conclusion, even with the generous assumptions as to Q4 operating results and carefully adhering to GM’s own proposed restructuring, GM is still a highly distressed company and likely to go bankrupt, probably with one year. The DIP solution We argue that a massive “DIP” loan to GM in bankruptcy will guarantee the firm’s continued existence over an anticipated 18-24 month restructuring period, and the government should also consider backstopping warranties and spare parts availability, even if the reorganization fails. This is far more reassuring than a band-aid $10-12 billion bailout that will not materially reduce the public’s uncertainly about a possible liquidation in 2009. In addition to the DIP support, bankruptcy status enhances the ability for management to renegotiate existing and legacy pension and health care claims, which is much more difficult outside the protective confines of the court system. Moreover, the savings alone on interest payments by GM/GMAC would be at least equal to the interest of about $3.5 - $5.0 billion a year to the government or its conduit on say a $40 - $50 billion DIP facility. The government could work with one or more conduit organizations, like JPMorgan Chase, Citi, Wells Fargo, Bank of America and GE, who are experienced in structuring and monitoring DIP loans. DIP loans can be increased over time, with appropriate fees, to sustain GM over the expected long and likely deep recession. We would also advise the US Treasury to encourage institutions that have received TARP subsidies to participate in the DIP loan directly as investors. What about job losses? One argument for bailing out GM is simply that the alternative is worse. If GM fails, its employees will become unemployed in the midst of a crisis where the labor market outlook is dismal, and many of its suppliers and dealerships are likely to be liquidated, creating further job losses and economic disruptions. There is indeed a strong case for helping GM’s employees, but bailing out GM is simply not the solution. First of all, either with the bailout or in bankruptcy, job cuts and reductions in dealerships will be necessary if the firm is to survive. In fact, the current bailout plan would probably offer less of a breathing space to GM and imply more job cuts in the short run than our proposed bankruptcy/DIP financing plan. As we explained earlier, the DIP loan would allow the restructuring to take place over 18 to 24 months while the bailout would be barely sufficient to avoid liquidation in 2009. In addition, the bailout money does not offer a sustainable solution for GM’s employees. What many employees of the car industry really need is to acquire new skills. Incidentally, a recession is not a bad time to invest in human capital. The money allocated to the proposed bailout would be better spent in vouchers for a massive training program for unemployed workers. This would not only alleviate their sufferings in the short term, but it would also provide them with a better chance of landing a stable job once the economy recovers. Our proposed solution would also limit the ripple effects of GM’s bankruptcy. The government could backstop warranties and spare parts availability, even if the reorganization fails. This would limit the impact on suppliers and dealerships. Let us also note that concerns about the impact of a bankruptcy on pension benefits are not valid since the well managed GM pension plan under General Motors Asset Management is over-funded (as of mid-December 2008). In any case, it would be far better for the country and the economy to “right-size” the auto business in the U.S. now and make it more competitive in the long run, rather than have it deteriorate further and sold off at a later date with even more lost jobs and cuts in pension/health care benefits. Czars and managers The management and boards of GM, Chrysler and, to a lesser extent Ford, have until recently been in a state of denial. They should now face up to the reality of their dismal outlook, file for bankruptcy, and request the DIP loan. And, if the terms of the loan require changing senior management, so be it. The option to bring in a professional turnaround team is one of the advantages of Chapter 11. Bailing out GM and Chrysler at the expense of tax payers will only encourage bad management in the future. The plan proposed by the House of Representatives and the White House calls for the appointment of a “car-czar” to oversee the restructuring. Unfortunately, since restructuring proposals will come from existing senior management, it will be difficult for the “czar”, whoever he or she is, to obtain the timely information required to make decisions so critical in a difficult restructuring. Chapter 11 was created precisely to deal with these issues. It would be wise to use it.

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