Sunday, February 26, 2012

Bailouts and Bankruptcies: What’s the Right Thing to Do?

I’ve started to wonder if this blog is still about LEADERSHIP – its original mission – or if it’s about cars. My last entry (Clint vs. Karl: Yeah, But What About the Cars?) focused on the validity of Chrysler’s claim in their "Halftime in America" ad on the Super Bowl. My assertion – that cars manufactured by the Big 3 are every bit as good as the foreign competition -- has since been borne out J.D. Power & Associates. Their most recent survey of the reliability of three year old cars ranked four American brands in the top 10 (Ford, Lincoln, Buick and Cadillac) and clearly observed that there are no more poor quality cars sold in America. Even those at the bottom of the survey’s list report very few problems and their reliability was not significantly different (statistically speaking) from those at the top of the list.


Most respondents to the posting told stories of cars they have owned for a long time, ranging from an ancient Land Rover Defender to a classic 68 Olds to a late model Chrysler 300C. Others lamented the fate of GM, a once great American manufacturing company.

One response, from my old friend Bob Cannan, stood out because it addressed the GM and Chrysler bankruptcies. While Bob conceded that the Chrysler ad was just that (an ad to sell cars), he continues to be disturbed by the government’s bailout of 2 of the Big 3.

“I think what I and others worry about is the idea that the American people, who understandably would mourn the loss of the American auto industry, will now come to believe that the ends have justified the means. The government, in other words, saved Chrysler and GM.” Said Bob. Going further, he protests:

“But this could have been done, and should have been done, by conventional bankruptcy.

“In conventional bankruptcy, a judge could have called all contracts into view, including the union’s. I’m sure that a restructured GM, emerging from the court of a skilled bankruptcy judge would have been much stronger than the one we see today. And the process would have been legal.

“Instead, the rights of bondholders and existing stockholders were violated. It’s grand larceny in my opinion. Repugnant. Reprehensible. The stock was distributed to the unions. Directly.”

For the most part, I agree with Bob. Indeed, I would take it a step further. The seeds for the current public expectation, that government will step in, were sown by the original Chrysler bailout in 1980. If Chrysler had been allowed to fail then, how much stronger might the rest of the industry have been in 2008? That bailout was the first step on the proverbial slippery slope.

That said, I think that the period of time between the Lehman bankruptcy and the GM bankruptcy -- a period of about 9 months -- was one of the most extraordinary of our lifetime. I believe it was George W. Bush who said, "I’ve abandoned free market principles to save the free market system." It's now easy to analyze the mistakes of the 9 month period in question. However, when we were in the middle of the storm, the fear of collapse dominated everyone's mentality.

What about the assertion that it was not legal?

We often hear that our nation is governed by the “rule of law”. The founders ensured that the elected legislature made the rules and not a sovereign. In the minds of many, “rule of law” conjures images of criminals going to jail. However, its most common application is the execution of contracts. In the case of GM and Chrysler, those contracts were loans, corporate bonds, supplier purchase orders and union agreements.

A Bankruptcy Court is not a court of law; it is a court of equity. In simple terms, the judge gets to decide what’s fair and equitable. It doesn’t matter what the contracts say. In a sense, they break the law by setting aside existing contracts.

In the GM bankruptcy, there was no commercial lender – bank, private equity fund, non-bank lender – who could or would step in to finance the company’s continuing operations. So, rather than let GM fail, presumably taking down much of the supply chain with it and putting hundreds of thousands of people out of work, the government stepped in as the Debtor in Possession (DIP). Were it not for their loan during the GM bankruptcy proceeding, GM would have ceased to operate. For most companies, that would have meant liquidation.

Would a willing buyer have stepped up to acquire the Buick Division or Cadillac? Not likely. Not then anyway.

More often than not, the DIP is also the ultimate buyer. And, the buyer’s desired outcome is usually the key factor in determining the final deal that is approved by the bankruptcy judge. So, the government structured the outcome.

When the government gets involved in business, the results get distorted. In this case, the distortion took the form of an allocation of a significant share of GM to the UAW. Believers in free market capitalism find this reprehensible as do I.

So, what do you think? If the government hadn’t stepped in to save GM and Chrysler, would the economy have collapsed? Moreover, was the GM bailout an example of extraordinary LEADERSHIP in a time of crisis or a nail in the coffin of the American free enterprise system?



13 comments:

  1. Excellent information.Keep sharing such great posts. Bankruptcy Leads

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  2. An interesting question.
    May I suggest you peruse the commentary of Judge Andrew Napolitano, a regular commentator on the FOX network, for which he was fired hours following his delivery. I believe he comes close to answering your question.

    Ted

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  3. Joseph Fatula • I'm going to stake out the middle between the libertarians and the progressives. The libertarians say bail outs are always bad and the progressive say they are always good because they save jobs.
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    Bailouts should be used sparingly and capital and the stakeholders need to pay a price for their errors.
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    For example bailing out the banks to prevent a greater problem (loss of deposits) made sense. Almost all of the money more or less is coming back. I forget the recovery rate.
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    The auto industry bailouts are a different story. They will *** cost *** the taxpayers money. Big money. Partial recovery only I forget the exact numbers and I don't think the story's over either.
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    I have an issue with the way they were done. It's one thing to make the union health funds whole with taxpayer money. That's a public policy decision. Instead--in effect--the federal government reportedly took money the bondholders would have recovered and gave it to the unions. I thought that was highly improper and against precedent. They had no authority to do this.
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    Of course this opinion may be demagogued as "you are just for the bondholders." No--the bondholders should not have come out worse than if GM and Chrysler had gone bankrupt. If the government had not intervened--that is what would have happened.

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  4. Robert Prodoehl • John, I thoroughly enjoy reading your posts and always look forward to your next entry.
    With respect to auto reliability, as with any topic, the source of your information can really sway your opinion. Although the JD Powers article supports your view that the domestic automakers are as good as the competition, the same JD Powers article had a link to the NY Times of October 25. 2011 with a very different headline: “Japanese Brands Dominate Consumer Reports Reliability Survey, While Ford Falls 10 Spots.” The lead paragraph of the story: “Taking the top nine spots in the magazine’s Annual Auto Reliability Survey, released on Tuesday afternoon, were Toyota’s youth-oriented Scion brand, which led the pack, followed by Lexus, Acura, Mazda, Honda, Toyota, Infiniti, Subaru and Nissan. Of the 91 Japanese models for which Consumer Reports had sufficient data, 96 percent received ratings of Average or Much Better than Average in predicted reliability. Ford, meanwhile, dropped 10 spots from last year, from its 10th place ranking to No. 20 out of 28 brands.”
    But that’s not the true focus of your comment today, so I’ll change gears. I truly believe that the government made the right decision with the information at hand and without the luxury of hindsight. The economy was in steep decline, Wall Street was collapsing…or so we believed…unemployment was skyrocketing, and the last thing the country could withstand was the loss of hundreds of thousands of more jobs directly or indirectly tied to the manufacturing of American automobiles. The Big 3 had to remain standing at the end of the day! It was right and justified, if for no other reason than to save all of those jobs…which in turn staved off a potential doubling of the unemployment rate and an economy spiraling out of control. It’s not the nature of the industry that matters to me…it is the sheer number of jobs tied to that industry. (A topic for one of your future blogs…why do we continue to support the tobacco industry in this country? We know the toll it takes in health and human life…and yet the industry continues to flourish …because of the JOBS it provides…)
    Although I happen to think that the bankruptcy process would have yielded an even stronger GM, I also believe that a long bankruptcy proceeding would have further damaged the economy and would have left us in a much deeper hole from which to dig. The bailout was the only option available if the goal was to keep them from sinking and pulling the rest of us down with them. Restructuring existing labor contracts would have been nice, but I think that would have protracted the process as well. So, as Bob pointed out, count me among those who believe that the end justified the means…at least in this case.

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  5. Robert, thanks for your comments. You take a pragmatic rather than dogmatic view which I support.

    As for JD Powers: what the mainstream media do not report is the method of determining the number of defects. The NY Times article to which you refer, published in October, was about the survey of new car owners. Owners reporting the number of defects include in their reporting those features that are merely disfunctional. So, Ford dropped 10 spots because they introduced new electronics not because something didn't work. In this example, they report defects in design not reliability. The 3 year survey, on the other hand, looks at reliability.

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  6. Joe Van Steen • It seems to me that there is an unrecognized and unaccounted for interdependence between the "societies" in which these mega-corporations operate, and the corporations. This is especially true "at scale." Allowing a small enterprise that operates in a major city to go bankrupt creates no great social issues outside the business (including employees, owners, creditors and customers). The labor market is not significantly impacted and other job opportunities are likely nearby (a relative term). The "owners" and "creditors" pay the price in loss of capital - which was a function of the risk involved in the investment. The customer needs to find another (more costly? less convenient?) place to acquire the product. But socially, the society in which the business operates is not itself threatened.

    Acting as though this equation between the company and society does not change as "scale" comes into play is nonsense. In fact, it's beyond nonsense. It's stupidity to think that a society should allow the level of massive disruption that can ensure from some of these failures and just sit by idle. The only thing dumber would have been to do just what we did - at least in the case of the banks. Bail them out, and then NOT do what we should have done in terms of regulation to ensure we won't have to do it again.

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  7. Joseph Fatula • In retrospect the one bailout which was *** not *** done but IMO probably should have been done was Lehman. They should have kept it on life support and wound it down in an orderly fashion. If the economy ever recovers from Lehman Brothers it will be a very long time. It might not ever recover. After Lehman went everything changed. It was like a heart attack to the financial services industry.
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    I know Bernanke said they did not have the legal authority to do so but the could have tried obtaining it. BTW--since when does legalities stop the government from doing some things. I digress but look at this ruling against church-related organizations that they must pay for morally objectionable products and services if they offer their employees health insurance.

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  8. John Calia • Joseph, I agree with your assertion that the government can do what it likes in most cases. They can always say, "so sue me". Lehman appears, in retrospect, to be the first domino; however, there was lots going on at the time -- not least of which were the failures of AIG and Fannie Mae. Imagine what might have happened had the government not stepped in to prevent those failures

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  9. Joseph Fatula • @John When Lehman went I'm not sure I understand exactly but they dragged others down with them. To some extent Freddie and Fannie. F&F had no one else to re-sell their securitized mortgages to perhaps.
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    Fair disclsoure: I'm a Republican--but for political and doctrinaire reasons most of them have philosophically turned seemingly against *** all *** bail-outs. Even when some may have supported bailouts in the past.
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    They blamed Bush for TARP for example. Very likely McCain too. McCain was leading until he decided to do what I thought was a statesmanlike thing and go to Washington to help. He suspended his campaign. When the house is on fire--it's all hands on deck. That's my philosophy.
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    Paulson and Bernanke went to Bush and pleaded for TARP. My question to my Republican friends was: "What would you have done?" Despite criticism leveled at both they are undeniably financial experts. Bush had some familiarity but of course lacked that expertise. I would have given them TARP. Many of my Republican friends would not have (more precisely most.)
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    Monday Morning Quarterbacking--some now say TARP was not needed. That's like saying why did you put that house fire out--it wouldn't have burned down the entire neighborhood. However--that's one reason we put fires out--the risk is *** always *** there.

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  10. Joseph, I recommend Andrew Ross Sorkin's book, Too Big to Fail, (which I haven't read) or the HBO Movie by the same name (which I have seen). I have heard many commentators including some of the principals express their admiration for the accuracy of the account.

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  11. Joseph Fatula • @John Thank you. The idea of "too big to fail" is also a subject in and of itself. It's a good argument for special regulations involving big institutions (not just business). Regulate, not over-regulate.
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    To digress a bit. With all due respect to those who live in California. This concept also applies to governments. Especially those that promise too much. CA's unfunded liabilties are reporteldy some huge figure which is some multiple of yearly state tax revenue.
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    For a while there was talk of having the US bail out California. Just fund the unfunded liabilities and add them to the national debt. Fortunately such talk didn't last (IMO) and now CA is claiming a small victory because their economy is slowly recovering and their latest deficit is less than expected.

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  12. @joseph, if California threatens to default on its bonds, the US will bail them out. 30 years ago, the US Government bailed out NYC. Of course, NY committed to an austerity budget to which it adhered and paid back the US loan ahead of schedule. I don't see CA going on the austerity budget.

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  13. Bryan Baquer • It was surely NOT leadership! When you have an individual under your command that is not meeting the standard, do we lower the standard or provide that individual a crutch? When providing the crutch, does that make the individual stronger and the unit stronger? I don't care to debate the quality of the American automobile industry. The issue is can ANY business/company provide a product or service that the public deems of value, and be responsible enough to meet their financial obligations? In the case of the auto industry, having the HUGE overhang of UAW obligations made the Big 3 uncompetitive. Why would it then be "reasonable" to (break the law, bend the law, disregard the law...take your pick), and re-direct the assets (the perceived value of the company) from the rightful owners, i.e.bondholders, and others that legally put their financial capital at risk (assuming that established securities and bankruptcy rules would apply), and give them as a gift, wrapped with a bow to the UAW? I guess it is because the UAW has such a terrific track record of managing the contributions (dues) of their members for their members health and retirement benefits. We are not creating a stronger country by continuing to lower standards and failing to require businesses and individuals to be strong enough to support themselves, ....without a crutch. We have a systemic problem. We need a leader that RECOGNIZES this problem first, before we can begin to formulate long and short term solutions.

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