Auto loans: a deadline looms

The Obama Administration is beginning to leak to the press their impending decision on loans to U.S. auto manufacturers. I am writing in parallel to explain how you might think about such a Presidential decision. There’s an obvious caveat that every President and each Administration are different, but I hope my explanation will at least give you a feel for how you could think about such a challenging policy decision.

I will begin today with some background, and a presentation of four basic options and their costs and benefits. I will follow up later by describing two different approaches to the issue, and then I will ask for your recommendation. We’re going to pretend you are an advisor to the President. You can pick Cabinet (Treasury, Commerce, Budget, Energy, Labor, Transportation, EPA) or a senior White House staffer.

U.S. auto manufacturers face a set of long-term challenges. Let’s divide them up into factors affecting their future revenues, their future costs, and their balance sheets.

(Note: “Detroit 3” = General Motors, Ford, and Chrysler)

Revenues

• The economic slowdown means fewer vehicles are being purchased from all auto manufacturers, foreign and domestic.
• Even apart from the economic slowdown, U.S. auto manufacturers have been losing market share over time.
• This is in part because they made a bet on light trucks versus smaller cars. This product mix doesn’t work when gas prices are high. Think of the proliferation of SUV’s in the past 10 years. (Note that this was in part the fault of U.S. government policies. SUV’s are technically light trucks, and so they qualify for lower fuel economy requirements.)

Costs & productivity

• The Detroit 3’s ongoing labor costs are higher than those of foreign-based firms. This is still true when you compare an American worker in a GM plant in Michigan, for instance, with an American worker in a Nissan plant in Mississippi.
• Productivity is lower in U.S. plants of U.S. firms than it is in U.S. plants of foreign-based firms. Some of this is because of the UAW contract that mandates certain inefficiencies. Some of it is poor management.
• The Detroit 3 have huge dealer networks that are costly to the manufacturers. These dealer franchises are often protected by state laws that make it hard for the manufacturers to make these networks smaller and more efficient.
• Auto manufacturers face a burdensome and unpredictable legislative and regulatory environment.

Balance sheets

• The Detroit 3 have enormous legacy costs from their retirees. Past UAW contracts provided generous benefits that continue to burden these firms. This drains profits (when they earn them) away from productivity-enhancing investments.

I have found that different people emphasize the above points differently. The manufacturers tend to stress the economic slowdown point. The Wall Street Journal editorial page likes to focus on the costs of CAFE and government regulation. Conservatives in Congress and on the outside tend to emphasize the legacy retiree costs, and the ongoing labor costs.

The Detroit 3 must overcome these challenges to survive and be profitable in the long run. GM and Chrysler, however, face a much more immediate problem. They are out of cash, and no private lender will loan them funds. They pay their suppliers on a monthly schedule, due in the first few days of a month. GM and Chrysler were going to be unable to pay their suppliers in full in early January of this year. If you cannot pay your suppliers and if they will not extend you credit, then you cannot get the parts you need to make cars and trucks, and you shut down. Ford seems to be in better shape, at least in terms of short-term cash flow.

In late December, after more than a month of wrangling with the Congress, President Bush authorized $24.9 B of three month loans to be made to GM, Chrysler, and their financing companies in late December, using funds from the $700 B pot at Treasury known as the TARP: Troubled Assets Relief Program. (If you want to dive in deep, you can find the gory details of the loans to GM, Chrysler, GMAC, and Chrysler Financial on the Treasury website.)

A March 31 deadline looms for GM and Chrysler. The Obama Administration faces its own March 31 deadline, which it can unilaterally extend to no later than April 30. So sometime within the next five weeks (at most), the President must make a decision about the fate of General Motors and Chrysler. It is, however, quite possible that GM and/or Chrysler will need funds before the end of April, which would force the President’s hand earlier.

According to the terms of the loan (bottom of page 6 for the GM term sheet),

On or before March 31, 2009, the Company shall submit to the President’s designee a written certification and report …

If the President’s Designee has not issued the Plan Completion Certification by March 31, 2009 or such later date (not to exceed 30 days after March 31, 2009) as the President’s designee may specify, the maturity of the Loan shall be automatically accelerated …

The President has four basic options:

1. Extend the term of the current loan and loan additional taxpayer funds, using more TARP money.
2. Same as option (1), but only if a firm files for bankruptcy. This is called debtor-in-possession (DIP) financing. If a firm does not file for bankruptcy, allow the December loans to be called, in which case the firm will go bankrupt anyway.
3. Allow the loan to be called and provide no additional funds.
4. Punt to Congress. Refuse to spend additional TARP money, and tell Congress that if they want the companies to survive, they should appropriate new funds.

In part two I’ll discuss the pros and cons of each option.

Parts three and four will compare the Bush and Obama approaches to this problem. Part five will ask you to make a recommendation to the President.