Wednesday, March 11, 2009

“Too Big to Fail” or “Too Big to Save”? - Obama must bail out the US automakers

I was asked to write a position paper on whether to save the automakers or not. Generally, I'm not in favor of bailing any companies out, but our analysis revealed that President Barack Obama doesn't really have an alternative.  

“Too Big to Fail” or “Too Big to Save”? 
Obama must bail out the US automakers
By Ted Chan, Pooja Goradia and Sharon Cong Geng
MIT Sloan School of Management

President Barack Obama has no choice but to bail out the carmakers.  Allowing automakers to fail would be disastrous for the millions of people employed by the automakers, their suppliers and communities that service these makers.  According to 2005 federal reports, nearly 1.1 million Americans were directly employed in the auto making industry.  This does not include dealers and those who live in the communities who would likely lose their businesses as a result of the death of a Big 3 automaker.  In an unprecedented economic downturn, this move would be a mistake economically and politically for Mr. Obama.   Additionally, it was not that long ago these were competitive companies.  Their current struggles are due to the handicap of deferred compensation, lack of leverage with the unions and questionable management decisions over the past 10 years.  (Trade.gov, 2005)

Furthermore, cars can be made anywhere. The economic circumstances have not favored US manufacturing in recent years, however, that dynamic may change in the near future with the dollar likely to depreciate in the near future.

We advocate the new stimulus bill to only rescue US based automakers.  Firstly, workers hired by US based automakers outnumber those hired by foreign automakers. Secondly, foreign auto companies are in better shape because they not only have more efficient methods of production but also have lower costs by avoiding huge the burden of pension and health care obligations imposed by United Auto Workers (“UAW”).

The structure of bailout matters

There are several major issues that must be addressed in any automaker bailout.  Solving these problems will require multi-lateral compromise from all the stakeholders involved – automakers, employees and the government.  Any bailout must accomplish the following:

Build consumer confidence that these companies will not fail: An automaker bailout package should assure potential car buyers that none of the Big 3 will fail.  If a Big 3 automaker falls into bankruptcy, then it should be disbanded and sold for its assets because consumers will not buy from a company that may or may not be able to meet its service and warranty requirements.  

Avoiding moral hazard while providing brand reassurances: The bailout deal must assure that automakers do not act as if there is more funding again if they do not succeed.  Structure the bailout as debt that will be repaid but is not onerous to the company’s ongoing operations.  Setting milestones and operational goals on each company’s path to economic stability will ensure full transparency to the auto industry’s employees and serve to further build consumer trust.

Reduce labor costs: A limit on deferred retirement benefits such as health care is necessary – this transfers responsibility to future CEOs which eventually becomes unsustainable.  The UAW must be prepared to make sacrifices.  Decisions must be made on the present value of compensation packages.  The $73 average pay rate per hour is much higher compared to other carmakers.  (New York Times, 12/10/2008)  Also check out Greg Mankiw's post about the burden of health benefits on American companies.  

Consider merging or selling: The automakers are worth bailing out if they can become sustainable again.  It may be worth it to swallow the bitter medicine now if they cannot be saved.  As such, business strategies such as a Chrysler/GM merger, Chapter 11 reorganization, or helping GM consolidate its overlapping brands must be considered.  

Not just cheaper, but more flexible: The bailout package should include provisions from the union and government which make it easier for the automakers to reduce workforce and production to sustainable levels.  However, labor costs represent only about 10% of the cost of making a car, so this cannot be the only area of cost reduction.  In addition to some poor strategies and product development choices, American automakers suffered because it is difficult to reduce production and cost in a downturn with a unionized labor force and heavy capital investments into production infrastructure. 

No cap on executive pay, but a move towards incentives: These automakers need innovative leaders to guide them into the future.  They must be able to attract and compensate these leaders as any other American company would.  It would be preferable to pay these executives based on their ability to turn the ship around.  

Conclusion

In summary, a bailout package for the Big 3 involves a fundamental restructuring of each company’s current business models in order to become sustainable in the long term.  The underlying question remains as to whether the financial crisis sent these companies in a downward spiral or if their business practices would have eventually led to their current state. 

Sources

David Leonhardt,  “$73 an Hour: Adding It Up”, December 9, 2008, nytimes.com
http://www.nytimes.com/2008/12/10/business/economy/10leonhardt.html?_r=2&hp

Dave McCurdy, “Why the health of the auto industry matters to you”, November 12, 2008, grist.com  http://gristmill.grist.org/story/2008/11/11/125224/29

U.S. Department of Commerce, “U.S. Automotive Industry Employment Trends”, March 30, 2005 www.trade.gov/static/auto_reports_jobloss.pdf

“US Autos”, March 4, 2009, FT.com
http://www.ft.com/cms/s/1/65da5efa-085b-11de-8a33-0000779fd2ac.html


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