Is what’s good for GM good for the country?

Abstract: A modified Chapter 11 bankruptcy funded with DIP financing from the U.S. government would balance avoiding an economically painful GM liquidation with the need to restructure the firm to minimize distortions to the economy.

General Motors is about to drive off of a cliff with the U.S. economy riding shotgun – unless Washington intervenes with a well-crafted policy intervention. The GM debate has focused on the two extremes of a spectrum of options. One extreme allows private markets to work without government interference. The other demands government-provided financial assistance. Neither extreme is attractive.

Pure market solutions: an invitation to pro-cyclical downward spirals

Without intervention, GM will declare bankruptcy. When pundits urge no intervention, they probably assume a Chapter 11 bankruptcy. Chapter 11 restructures debts, changes contracts, and modifies strategy. Supervised by a Federal judge, it is politically insulated and a known, existing process. Unfortunately, it is not available to GM because of the lack of debtor-in-possession (DIP) loans at manageable interest rates. DIP loans provide cash necessary for the restructuring. Without DIP loans, Chapter 11 will not work for GM. DIP lenders are unlikely to lend to GM for three important reasons: (1) lack of available funds at banks due to the economic crisis, (2) GM’s inability, even with restructuring, to generate profits or cash flow anytime soon, and (3) assets worth little in a liquidation.

With the Chapter 11 door closed and without government intervention, GM would be forced to file a Chapter 7 (liquidation) bankruptcy. This liquidation process, where GM would shut down all operations and sell its assets, would be an economic nightmare. With constrained available capital and unattractive alternative uses, assets would command low prices. Layoffs of automotive and related workers could approach three million, pushing the unemployment rate towards 10%. Suppliers would lead a wave of bankruptcies ensnaring businesses nationwide. Financial institutions would be weakened by bad loans and credit default swap payments. The Pension Benefit Guaranty Corporation would assume GM’s pensions (which appear funded prior to the financial meltdown, save for Delphi's obligations). Amidst the turmoil, consumer confidence would plunge. It is not difficult to envision an economic meltdown that must be avoided.

Bailouts: distorting economic incentives

While less dramatic, injecting taxpayer capital – no strings attached – has its own faults. Bailouts add to already huge U.S. deficits, reduce the need to make painful restructuring decisions, halt the process of creative destruction, and undermine U.S. calls for other countries to liberalize. Wealth would be transferred from taxpayers to equity or debt holders, retirees, employees and/or customers, depending on structure. With precedent set, every U.S. business would go hat in hand to Washington for their own subsidy. Without meaningful restructuring, a GM bailout would avert economic disaster but come at significant cost to the long-term health of the U.S. economy.

Efficiently restructuring GM requires relying on market forces that will result in necessary economic losses for different stakeholders. Equity holders recover nothing, bondholders face significant losses, suppliers lose business, and employees – whether unionized or not – face layoffs and lower compensation. Unions must rethink work rules, VEBA arrangements, and the Job Bank, while the management that isn’t fired faces reduced compensation and perks. Taxpayers lose wealth to bailout the industry. It is important that these groups face some costs to minimize the moral hazard in subsequent years. While losses are important to the overall functioning of creative destruction through bankruptcy, each group will engage in political maneuvering to avoid these costs by leveraging political power and the threat of liquidation or strikes.

The balancing act

Policy-makers must realize that neither extreme is without substantial cost. A policy solution must balance limiting “collateral damage” to the U.S.’s citizens and economy with the market forces that could shape GM into a competitive company. Limiting collateral damage requires avoiding liquidation at all cost. But how to balance avoiding economic catastrophe on one hand and forcing restructuring on the other? Pure market mechanisms are indifferent to political forces but force restructuring. Policy makers avert economic disaster but cannot overcome political pressure to sufficiently restructure. Conditional DIP financing provided by the government for a Chapter 11 bankruptcy could balance these two aspects.

Attractiveness of Chapter 11 restructurings

Chapter 11 is attractive because it is an established procedure and relies largely on the market mechanism of creditors acting in self interest to achieve efficient outcomes. With Chapter 11, politicians would have difficulty interfering and creditors would act in their own self interests to maximize returns. Managers would not be fired due to political pressure, but rather only if the creditors thought someone else would do a better job. Union contracts would not be renegotiated on the basis of delivering votes in the next election, but on the basis of economic negotiations. This market mechanism would pervade nearly all decisions, with two importation exceptions.

First, DIP loan specifics – size and interest rate – are typically determined by competitive market forces that do not exist in this scenario. Therefore, a substitute must be found to determine loan size and rate. A third party restructuring firm could develop the restructuring plan in coordination with auto company management. By paying that firm based on the return on capital, the incentives would be to minimize both the amount and duration of capital deployed.

Second, a systematic risk regulator would be required to avoid decisions that maximize GM’s returns but threaten the wider industry. An ideal regulator would be from the Federal Reserve, a non-partisan, politically insulated institution that is already tapped to be the systematic risk regulator in a new Treasury proposal. This regulator would ensure that no actions taken by the bankruptcy court would undermine the broader economy. For instance, the regulator would be able to halt liquidations, require additional capital injections, or veto decisions that would cause waves of bankruptcies. This is the critical addition of a limit to the normal market forces that drive a bankruptcy proceeding.

In addition to the benefits described for the high probability that GM ended up in such a system, this mechanism also has the benefit of incentivizing parties to avoid bankruptcy. Currently, GM has a strong bargaining position to argue for a bailout: the alternative is economic disaster. However, if the government announces not that it will prevent a GM bankruptcy, but rather GM liquidation, management teams of GM and similar firms will be strongly incentivized to avoid filing for bankruptcy and the probability they are forced from their jobs.

Conclusion

Modified in these ways, a Chapter 11 bankruptcy system would provide the safeguards required to keep the economy from starting down a negative spiral while imposing the fewest distortions to the effective bankruptcy system already in place. It limits short-term dislocations by ensuring, via regulation, that a firm that is “too big to fail” does not create a procyclical economic decline while requiring painful restructuring that limits firms’ willingness to rely on government intervention.