The Baseline Scenario

Surprise, surprise — GMAC needs more money. As you may recall, GMAC was the one institution that got a C- on the stress tests this spring that were impossible to fail. I imagine the analysts at the Fed really wanted to give it an F, but they couldn’t. In any case, it seems that GMAC is too big to fail, because of its importance to the auto industry. Yves Smith says, “The reason for more dough to GMAC is so GM and Chrysler can continue to finance auto purchases, not as a result of greater than expected losses on its existing portfolio. So this is cash for clunkers under another brand name.”

Again, not surprisingly, the government is treating the 50% ownership threshold as some sort of magic line. From the Times article:

“With all three helpings of federal aid, it is possible that the government could wind up owning at least half of the company. But GMAC and Treasury officials are discussing ways to structure the investment in a way that could limit the government’s ownership interests. One possible option would be to also ask some of its private preferred stockholders to convert their investments into common stock.”

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Back in December, when people actually had debates about whether or not Chrysler and GM would go bankrupt, one of the claims made by the anti-bankruptcy camp was that 80% of people would not buy a car from a bankrupt automaker. That number came from a CNW survey; here’s a summary from Motor Trend (hat tip Jane Hamsher):

A recent study from automotive market research firm CNW surveyed 6000 people intending to buy a new car within six months, and discovered that more than 80 percent of them would switch brands if the vehicle they wanted came from an automaker that went bankrupt. Breaking it down by company, Americans were more likely to abandon domestic automakers than foreign ones, with Chrysler faring the worst — a full 91 percent of buyers wouldn’t take home an Auburn Hills product if the company went bankrupt.

The theory was that bankruptcy would lead to an immediate collapse in sales which would lead to liquidation. (A later study, cited here, said that if the government were involved in the bankruptcy, the number of people who wouldn’t consider buying from GM would be 51%.)

This is what I said in December:

I strongly suspect that 80% is just a poorly worded and interpreted poll question. If you ask people in the abstract if they would buy cars from a bankrupt car company, of course they will say no. But in the real world, if the car they want is made by a bankrupt company, and they get a good deal, they will buy it. Just look at the November auto sales. GM was down 41%; Toyota, Honda, and Nissan were down 34%, 32%, and 42%, respectively. And everyone buying a car in November must have been aware that bankruptcy for GM was a serious possibility. (Besides, haven’t we been talking about a GM bankruptcy on and off for years?) Sure, bankruptcy will hurt sales a little. But 80% is just not credible.

Well, now we know. In May – during which Chrysler was in bankruptcy – Chrysler sales were down 47% from the year-ago period. Overall sales were down 34%, which means non-Chrysler sales were down around 33%. So as a crude estimate, if Chrysler were like the average automaker, for every 100 cars it sold last May, it would have sold 67 cars this May. Instead, it sold 53. That’s a 21% decrease – a lot less than the 91% predicted.

I’m not claiming I can predict auto sales better than other people – I know virtually nothing about auto sales. I’m just saying you shouldn’t rely on polls that ask people what they would do under some hypothetical scenario, since they don’t know what they would do.

By James Kwak

Those following the Chrysler bankruptcy know that the final holdouts are a set of Indiana pension funds, who have appealed the bankruptcy judge’s approval of the restructuring plan, attempting to force the company to explore other alternatives under a trustee who is independent of the government. They were lustily cheered on by The Wall Street Journal, elated to find good sturdy workingmen and -women willing to stand up to the Obama Administration and its “disdain for legal contracts,” and who could not be dismissed as speculators.

Well.

The pension funds in question bought the Chrysler debt in question last July for 43 cents on the dollar. (They stand to get 29 cents on the dollar in the restructuring.) I guess the difference between that and speculation is that “speculation” is something that bad people do; when pension funds by distressed debt, it’s called “investment.” I have no problem with pension funds buying modest amounts of risky investments, but they are taking the same risks that hedge funds are taking, and if they lose money on bad investments, that’s the fault of the pension fund managers.

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Many discussions of auto company economics include the assertion that SUVs and pickup trucks are more profitable than small cars, and so a shift from the former to the latter – as discussed by Felix Salmon, for example – will not be good for the auto companies, particularly GM and Chrysler (since they are in the news these days). I accept that as a historical statement, but I don’t understand why that is the case.

Textbook micro tells you that price equals marginal cost, so the gross margin on every product is zero; that’s clearly no help here. Profit margins should be higher in product segments with less competition, but basically every manufacturer makes a small, midsize, and large SUV, so I don’t think that’s the explanation.

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In the same post I discussed yesterday, Keith Hennessey cites the same NHTSA report – the Final Rule governing CAFE standards for model years 2011-15, issued in January 2008 – to make this point: “The proposal will have a trivial effect on global climate change.” (It’s point 5 in his post, and was also picked up by Alex Tabarrok in his endorsement.) Hennessey cites the NHTSA report accurately, but the report itself is misleading.

What does the report say? Look at Table VII-12 on page 624. There are three scenarios that we are concerned with: No Action (which Hennessey calls, and I will call, “Baseline”); Optimized (“Bush Plan”); and Total Costs Equal Total Benefits (“Obama Plan”). If you want to know why Optimized is Bush and TC = TB is Obama, see my previous post. In the year 2100, the projected carbon dioxide (“CO2″) concentration in the atmosphere, in parts per million, is:

• Baseline: 717.2
• Bush: 716.2
• Obama: 715.6

That’s pretty convincing – or is it?

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Note: There are two somewhat significant updates at the bottom, just before the Appendix.

CAFE stands for Corporate Average Fuel Economy – the average fuel efficiency that is calculated annually for every manufacturer that sells cars or light trucks in the U.S. and compared to standards set by the National Highway Traffic Safety Administration, part of the Department of Transportation. (If you want to know more about how CAFE is measured, see the Appendix to this post.) Yesterday, President Obama proposed new, higher CAFE standards for models years up through 2016, by which point aggregate efficiency should reach 35.5 miles per gallon. 

The typical conservative response to regulations like this is that they impose costs on the economy. In this case the main argument is that mandating higher fuel efficiency standards makes cars more expensive to produce; so car companies have to charge more for them; so fewer people will buy cars, and fewer people will be employed in the auto industry. I was planning to try to pre-empt this argument, but Keith Hennessey, former head of the National Economic Council under Bush II, beat me to the punch. His post summarizes some findings from a 900-page report produced by NHTSA in January 2008, when the Bush administration released the latest version of the CAFE standards. One of his main points, taken from that report, is that the Obama standards will cost 49,000 jobs. That’s relative to some baseline that I haven’t been able to identify, but it’s 38,000 jobs more than the Bush standards. The table is on page 586 of the long report; the Bush plan is “Optimized” and the Obama plan is “TC = TB.” Hennessey’s post has been picked up by Marginal Revolution (where I found it) and by The New York Times, so I decided I should stay up late and write a response.

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Keith Hennessey, the last head of the National Economic Council before Larry Summers, has a blog post out (hat tip Alex Tabarrok) reviewing yesterday’s announcement by the Obama administration on their proposed new CAFE (Corporate Average Fuel Economy) standards. It links to a very informative report that I’m still digesting. (I was planning a post on the economics of CAFE for today, but now I need to read part of that report.)

Update: I found a mistake in the way Hennessey used a table and I posted about it here. Hennessey graciously acknowledged the mistake, fixed it on his post, and left a comment here. So I decided to delete my criticism. I really should have sent him an email first, and I feel bad about that. 

By James Kwak

I was talking to an old friend last night about the Chrysler bankruptcy and, in particular, whether Chrysler (and Treasury, and the UAW) will be able to get around the order of priority of creditors in bankruptcy – which ordinarily would favor the senior secured lenders who are trying to block the proposed plan. I thought I would do a little research, but then (again via Calculated Risk) I found Steve Jakubowski’s analysis of precisely this issue, which apparently everyone on the Internet has already been linking to. It’s actually Part 3 of a series; you may want to start with Part 1.

My summary, for those who don’t like reading citations from court opinions: The issue with the “restructuring initiative” agreed-upon by Chrysler, the government, Fiat, and the UAW,  is that it only pays the senior secured creditors $2 billion in cash for $6.9 billion in secured debt; since secured creditors’ claims should come first, they argue they would get more from a liquidation. In particular, the VEBA created to fund retiree benefits is owed $8.5 billion; it is getting $4.6 billion debt and 55% of the equity in New Chrysler.

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This post was written by my friend Ilya Podolyako, an occasional contributor here and a third-year student (though not for much longer!) at the Yale Law School.

In the last couple of days, a few disparate news pieces attracted my interest. First, as I mentioned in my last post on industrial policy, an accelerating, worldwide decrease in consumer disposable incomes is beginning to percolate through the manufacturing sector. As a result, Caterpillar, DuPont, and United Technologies posted double-digit declines in sales. Second, reports surfaced that Fiat, Obama’s designated buyer for Chrysler LLC, was looking instead to purchase GM’s Opel division. Third, Sen. Diane Feinstein (D-CA) introduced a “cash-for-clunkers” bill that would provide a credit of up to $4500 toward the price of a fuel-efficient car for individuals or government-owned fleet operators who turn in a low-mpg “clunker.”

What do all these data points have to do with each other? In my mind, they highlight the need for a structured approach to the U.S. industrial sector. The current policies are completely random and occasionally conflicting, which is not surprising, considering that they are coming from different branches of government who seem reluctant to talk to each other. For example, the purpose of the Feinstein bill seems to be to support the auto industry by lowering the effective price of a new car while also boosting aggregate fuel efficiency. Presumably, these measures would help the ailing American automakers transition from making money on SUVs to making money on hybrids. Yet in this context, a government-financed sale of Chrysler to Fiat doesn’t make very much sense. If we are concerned about rescuing the American auto industry from the bottom up, why are we selling bits and pieces of this industry to foreign companies? Imagine if GM, Chrysler, and Ford did not exist – in this world, the government could surely find a better way of spending money to combat climate change than paying Toyota and Honda to chop 20% off the sale price of a new car. Just because other countries do it, doesn’t mean we should too.

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My Yale Law School colleague Ilya Podolyako comments on the Obama administration’s plan for the auto industry and the tension between public goals – preserving jobs, increasing fuel efficiency, etc. – and private goals – profitability.

By now, the dust seems to have settled around Obama’s rescue plan for two-thirds of the long-ago “Big 3″ (in 2007, Chrysler ranked 12th in the world in total auto sales; GM has ranked 2nd; Ford, which is not receiving government assistance, was 4th). The policy itself seems prudent enough. The President’s Task Force on the Auto Industry recognized that due to its small scale, reliance on light trucks, and objectively low product quality, Chrysler is not viable as a stand-alone company. On the other hand, General Motors has large economies of scale and makes certain well-received products (the report mentions the Chevy Malibu and Cadillac CTS by name, though one could add the Cavalier, Corvette, and Escalade to those lists), but faces exorbitant legacy costs for its nearly one million retirees and low margins on its fuel-efficient vehicles. Given this fact pattern, the plan does as good of a job as anyone could in offering a helping hand to iconic American manufacturers while preserving some incentives for efficient private-sector operation.

My problem with the restructuring proposal comes not from any one of its details, nor even its general spirit. At this point, I feel fairly neutral about heavy-handed government involvement in US industrial policy. Admittedly, I am from Michigan and really like cars (despite consistent problems, I keep driving Fords, though I am not sure why), so I have some emotional connection to the industry to balance against the gross, obvious inefficiency of pouring money into enterprises that, by their own admission, will at best break even by 2014. I also do believe that a GM bankruptcy would lead to the net loss of a significant number of jobs that would permanently cripple Michigan’s already desperate economy.

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Back in the early days of the Clinton administration, James Carville was credited with saying something like this:

I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 basball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

The story back then was that bond investors, by buying or selling Treasury bonds, could lower or raise the government’s cost of borrowing and interest rates across the economy, depending on how they felt about government policy.

Today bond investors have discovered a much more direct lever over government policy. I’ve already written about the importance of bondholders in dealing with the financial sector. This week we are seeing their power over the auto industry.

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Robert Siegel gave GM a priceless gift today: a feature segment on All Things Considered, with a bunch of softball questions and a paean to the Chevy Malibu (which was, to give credit where credit is due, the 2008 North American Car of the Year, which includes foreign imports). Then Bob Lutz, GM’s vice chairman, fumbled the gift and dropped it on the floor, where it smashed into a thousand pieces. When asked what it was like to operate using money borrowed from the federal government, he said:

I’ve never quite been in this situation before of getting a massive pay cut, no bonus, no longer allowed to stay in decent hotels, no corporate airplane. I have to stand in line at the Northwest counter. I’ve never quite experienced this before. I’ll let you know a year from now what it’s like.

At my old company, it was a point of pride to search on price-comparison sites for the cheapest hotels you could find. (I know the argument that it saves money for expensive execs to fly corporate jets rather than flying commercial, because at their hourly rates it’s not worth the time spent waiting in line. I think those arguments are bunk, because they assume that the ten minutes you spend waiting in line are ten minutes of work you will not do that day, while my experience is that in high-level positions the amount of work you do is a function of the amount of work you have to do, not the amount of time you have.)

It may be true, as Bob Lutz claims, that GM makes good cars again. (I happen to own and drive a GM car that I am very satisfied with, but it’s a Chevy Prizm, which may not count.) But GM’s brand reputation today is that it is out of touch, and stories like this don’t help.

I’m a little late to the GMAC bailout story, but after reading all the newspapers and blogs I usually read, there are still some things I don’t understand. I’m particularly confused about the announcement that GMAC will start lending to anyone with a credit score above 620, down from their previous minimum of 700. (The median credit score in the U.S. is 723.)

1. What is the relationship between GM and GMAC? I know that Cerberus owns 51% of GMAC and GM owns the other 49%. I also know that, in order to become a bank holding company, both were forced to reduce their ownership stakes. In any case, GMAC is an independent company that should not be run for the benefit of GM. Its obvious that GM benefits if GMAC reduces its lending standards. But how does GMAC benefit?

2. If a loan to someone with a credit score of 621 was a bad idea on Monday, why was it a good idea on Tuesday? The only theory I can think of under which this makes sense is that GMAC thinks that loans to people with credit scores of 621 are profitable, but they couldn’t get the capital cheaply enough until they got their government bailout money.

3. Who is going to pay the bill when these loans go bad? It looks to me like GMAC is making a big gamble by trying to pump up its lending volume with higher-risk borrowers, right in the middle of the worst recession since . . . 1981? the 1930s? (In any case, it won’t be able to get anything like the lending volume it used to have, simply because fewer people are buying cars.) Isn’t this a situation where a company is choosing a high-risk strategy because its only option is to watch its revenues shrink away to nothing because the demand for credit has plummeted? But if that’s the case, how smart is it to go chasing after high-risk borrowers because the low-risk ones are suddenly saving their money? And now that GMAC has gotten the Henry Paulson seal of approval (remember, TARP money was not supposed to go to unhealthy “banks”), I think there’s a fair chance they are counting on Treasury to bail them out of their next round of bad loans.

Of course, it could be said in GMAC’s defense that they are just doing what Congress wants them to do: take TARP money and use it to make loans more available to consumers. But this goes back to the fundamental schizophrenia of TARP: it was conceived to keep banks from failing, but most people think its purpose should be to increase credit. And in this case I suspect GMAC’s taxpayer money is being used to sell GM cars that people wouldn’t buy otherwise, and when it runs out GMAC will be back for more.

I’m probably misusing the word, but I just think it’s incredibly ironic that, thanks to the Senate Republicans who blocked the compromise worked out between the White House and the Democratic majority to extend short-term loans to the automakers, the Bush Administration has now reversed its position and is open to using TARP money to keep GM and possibly Chrysler alive. Who ever thought we would see the day that this administration would prop up the Big 3 – and who thought it would happen because they were forced into it from their right?

I admit – I have auto bailout fatigue. But given the amount of virtual ink that has been spilled on this topic here, I think I owe you a place where you can express your thoughts on the current plan.

The Times says we are close to a vote, although Senate Republicans may block it. Here is the draft bill. The news article says it would take the form of $15 billion in short-term emergency loans. Reading the bill itself, though, I can’t find the number “$15 billion” anywhere. This is what I read:

1. The President can appoint a person (or persons) to implement the bill, apparently colloquially known as the car czar.
2. Once the bill passes, the car czar can make bridge loans or lines of credit right now. Those loans can be for as much as is needed under the plans submitted to Congress last week.
3. The money is coming from “section 129 of division A of the Consolidated Security, Disaster Assistance, and Continuing Appropriations Act, 2009, relating to funding for the manufacture of advanced technology vehicles,” which I’m guessing is the pre-existing bill providing $25 billion in loans for R&D for fuel-efficient vehicles. That money will be then be replenished. It’s not clear whether this creates a $25 billion cap or not (how many times can the car czar draw on that money after it’s been replenished?).
4. The loans are at 5%, increasing to 9% after 5 years. The government also gets a warrant to buy up to 20% of the loan amount in stock, at a price equal to the average price during the 15 days prior to December 2.
5. The short-term loans are conditional on the government, the automakers, and all interested parties (including unions and creditors) being able to agree on a comprehensive, long-term restructuring plan by March 31, 2009. The car czar can extend this deadline by 30 days, but that’s it.
6. The car czar has a lot of power to monitor the auto companies and make sure they are meeting the targets of their restructuring plans; if they aren’t, he can call in the loans.
7. There are some other fun but peripheral provisions, like getting rid of corporate aircraft, dropping lawsuits against state greenhouse gas regulation, and executive compensation limitations.

The big point is #5 (in my list). In short, this isn’t a comprehensive bailout: it’s a bridge loan to buy time to come up with a comprehensive bailout. This is roughly what Simon predicted (although I can’t remember where). It enables the Bush administration to avoid having a car company fail on its watch, and enables the Democratic majority to say that they are doing something for the automakers, while deferring the hard questions. I assume that all of the controversial questions, like how big a concession the unions have to make, and whether or not it’s possible to force creditors to take equity in place of debt, will re-emerge over the next few months.

Of course, we may still have the live TV drama of not quite knowing if the Republicans will provide the needed votes, like we had with the first TARP vote. I would also be shocked to see President Bush sign a bill that requires car companies to drop their lawsuits against greenhouse gas regulation.

Let me know if I read the bill wrong.

Update: More from Felix Salmon on why it may be hard to get bondholders to agree to restructuring short of bankruptcy.