Home > Market Commentary > Are US Auto Manufacturers Too Big to Fail?

Are US Auto Manufacturers Too Big to Fail?

Posted by Joshy Madathil.

The automotive manufacturers have suffered as soaring energy prices, the collapsing housing market, and the crumbling banking industry have roiled the US economy.

Does it matter if large US automotive firms fail? 

General Motors, Chrysler, and Ford provide over 200,000 well-paying jobs in the US, and many other jobs in factories around the world. [1][2][3] Paying unemployment benefits would represent a significant cost for the US government.  Warranties of purchased vehicles would be worthless, and many dealers would end up with a surplus of vehicles that would be sold for a loss. These companies’ multi-billion dollar pension plans might also require intervention by the Federal Pension Benefit Guaranty Corporation if the automakers filed for Chapter 11 bankruptcy protection. [4]

The auto industry has posted sharp losses and has had several consecutive months of declines in sales.  In August of 2008, Ford’s sales dropped 26.6%, Chrysler’s 36%, and GM’s 20.4%. [5] GM has also forfeited the crown of market share leader, a title it held for an astounding 76 years, to Toyota. [6]  As difficult as it is to keep the US consumer from spending, high fuel costs, the rising threat of unemployment, and a sluggish economy has made it easier for the consumer to cut down to the bare necessities (see related MarketBlog post on Consumer Spending).

Moreover, the recent housing market debacle and meltdown among financial firms has raised consumers’ anxiety levels and made it difficult to justify the need for a new vehicle — especially with thoughts of home foreclosure and/or recession in the back of everyone’s mind.  Couple this with soaring gas prices and there’s a recipe for disaster brewing — American automakers have relied on the sales of high profit trucks and/or SUV’s to drive company earnings. [7]  Slowing sales in this sector were detrimental to Ford and GM and are reflected in their stock prices.  Ford’s stock is trading at a near 20-year low of $4.80, and General Motor’s hit a 53-year low of $9.38 during July of 2008. [8][9] 

Energy and oil prices have also affected the cost of the materials which go into producing vehicles.  In addition, gas prices have increased the overhead of transporting vehicles to dealers, which cuts into the bottom line and reduces overall profitability. [10] Funding the factory upgrades necessary to manufacture fuel efficient vehicles has become a difficult task for the auto industry. Finding this capital at an affordable rate is an issue for an industry in financial turmoil. [11] The credit crunch from the housing and banking crisis has led to widening credit spreads that increase the rates at which Ford and GM can access capital.  This affects Ford and GM more than the average firm because they are perceived as high risk (and rightly so) to investors who, in turn, demand appropriate returns for their investments. [12][13]

Widening Credit Spread

Widening Credit Spread

So how does a seemingly bankrupt corporation find the capital necessary to re-invent themselves?

The automakers have requested $25 billion in low interest loans (4% – 5%) from the government to help in the renovation and upgrade of current facilities. [14] The automotive industry has shown resilience in the past to overcome market downturns, as evidenced by the auto industry in the 1970’s.  In late 1979 Chrysler was in the midst of bankruptcy.  With the help of a federally-backed loan and the leadership of Lee Iacocca, Chrysler paid back the loans ahead of schedule and posted a $500 million profit by 1983. Through a strategy of consolidating suppliers, employee pay cuts, and the leadership of Iacocca during the process — who took a $1 annual salary during the downturn — Chrysler was able to regain its position in the market. [15][16]

There has been much debate over the question of whether a massive federal loan for the auto industry is justified.   If the industry’s downturn is likely to have a significantly negative impact on the US and global economy, then the government can and probably will step in with the requested support.  With the recent government takeover over of Fannie Mae and Freddie Mac, as well as a $700 billion package in the works to help the financial system, the Feds have shown that they will do what is necessary to maintain a stable economy. [17][18]  Without the necessary facility upgrades and strong leadership at the helm, the US auto industry will remain weak and will not see strong profitability until the US economy has stabilized.

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  1. September 29, 2008 at 4:41 am

    I would like our economists to comment on this blog. Specifically, I would like them to opine as to the applicability of Schumpeter’s theory of creative destruction and the prospects for the continued vitality of capitalism when the government intervenes – even for altruistic reasons – to prevent or at least mitigate the destruction of a firm(s) that has become unable to compete. What are the implications for entrepreneurs when the government props up declining corporations, whose failure would no doubt eventually, and perhaps after great pain to shareholders and wage earners, spawn a tremendously creative response? Would the bailout of GM and Ford simply amount to the “corporatism” that Schumpeter said would lead to the downfall of capitalism?

    Others have commented recently that, while the bailout of Chrysler was a success in the narrow sense that Chrysler survived and the government (i.e. taxpayers) got its (their) money back, it was a failure in the long run because it encouraged the other US automakers to continue with a flawed strategy. Had Chrysler been allowed to fail, so the argument goes, GM and Ford would have been forced to more carefully analyze their strategies and perhaps today would be more viable competitors.

    In all this debate about the importance of the US auto industry to the US economy (and it is important) no one should forget that we are working with a much different paradigm today than when Chrysler was bailed out. Today, the US auto industry includes virutally all of the foreign auto makers who have so successfully competed against the US companies. Their manufacturing and assembly plants are located all over the US. Most Japanese cars sold in the US are at least assembled in the US if not manufactured in the US. BMW has plants in the US as well. I do not believe that was the case when Chrysler was bailed out.

    Finally, we have heard a lot about moral hazard lately. We heard nothing (at least in my memory) of moral hazard when Chrysler was bailed out. But, certainly, if the commentators summarized immediately above are correct, there should have been more attention paid to moral hazard before the Chrysler deal went down. Economists, please put your oar in the water here. Thank you.

  2. Paul Byrne
    September 30, 2008 at 12:03 pm

    Prof. Haines describes the “Big Three” automakers as suffering from a “failure to compete.” But what exactly does that mean? It means that the consumers purchasing their cars value their cars at less than these automakers spend producing them. While a government subsidy of these companies allows them to continue producing and selling their cars, it neither increases the consumer valuation of these cars nor decreases the amount of resources society must sacrifice to produce the cars. In almost all cases government bailouts ultimately come down to shifting wealth from one group to another. In the case of a subsidy of “US” automakers, it amounts to the government forcing 100 million people to contribute to the production costs of Ford, GM and Chrysler automobiles whether or not they choose to buy these new cars. One solution to these automakers may be to raise prices to account for their higher costs of production. The problem is that too many loyal Ford, GM and Chrysler customers are unwilling to pay a premium for these vehicles.

    Schumpeter’s theory of creative destruction relates to examining what would happen if GM fails. The US consumers demand for cars will not change dramatically; instead GM consumers will switch to other car producers. This would allow the other producers to spread out their fixed costs over larger amount of automobiles and result in greater pricing power, improving the prospects of the remaining firms. It may also allow for the creation of other industries as workers and capital flow into other corners of the economy. Look at the demise of traditional newspapers. It is not an isolated implosion. It goes hand in hand with the explosion of internet news sites and blogs. The automobile industry itself was born out of the Detroit shipbuilding industry and the demise of Texas Instruments led to the creation of Intel.

    A common fallacy in looking at many policy decisions is in only examining one side of the cost-benefit equation. Every dollar that the government spends on a bailout MUST come from some other sector of the economy via taxes and decreased spending. So if the government spends $150 billion subsidizing one industry that $150 billion must come at the expense of other industries and for every job and product gained on one side of the equation there is often another job and product lost on the other side of the equation. The question then becomes whether the job/product lost is more valuable than the job/product gained. The unprofitability of the struggling industries would indicate that the loss of the subsidy exceeds the gains.

    As for the issue of moral hazard the implications are more straight forward. If a firm looks to make an investment in a technology that has a 70% probability of success and a NPV profit of $5 million and a 30% probability of failure resulting in a NPV loss of $6 million dollars the expected value of profits is $1.7 million and a risk neutral investor (or society) should undertake this investment. On the other hand if the investment has only a 40% probability of success and 60% probability of failure than the expected value of profits is -$1.6 million and a risk neutral investor (or society) should NOT undertake this investment. However, if the government agrees to cover 2/3rd of the expected $6 million loss in the event of the investment’s failure than in the second investment scenario the firm has a 40% probability of gaining $5 million and a 60% probability of losing only $1.98 million resulting in an expected gain to the firm of $812,000. So they make the investment, even though society is on average worse off by $-1.6 million. What about the government (taxpayers)? If the investment is successful they get $0 but if they investment fails (40% prob.) they lose $4.02 million for an expected loss of $-2.412 million. Hence the phrase “Private Profits and Public Losses.” This problem goes beyond simply shifting money from one group (taxpayers & non-risk taking investors) to other group (risk-taking investors.) It results in the economy taking risks where the potential losses outweigh any potential profits. And any bailout either ex-ante (before the investment takes place) or post-hoc (after the investment fails) results in an incentive to make bad bets.

    On a final note if you were an investment banker considering an investment in a company which described itself as incurring so much heavy losses that they were unable to find financing for their entry into an emerging market. A market in which their very profitable competitors have already successfully entered into even though the company requesting financing was years away from entering the market themselves. While no firm would ever even consider making this type of pitch to a group of potential investors, this is the exact pitch that the Big Three automakers made to Congress this past spring when asking for $500 million to develop a high capacity battery that Japanese producers are already deep into R&D. Investment and capital is most efficiently allocated when those weighing the gains and losses of an action are actually bearing the gains and losses themselves.

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