1st Feline Battalion

Yes, I’m gloating a little bit, although I refuse to accept “prophet” status. This is what I said back in July:

How many times have you heard rosy economists–likely after a dose of prozac, lithium, and thorazine–look at the camera and tell us that the worst of the credit crisis is over.

In fact, they are so FOS that they need an industrial enema.

General Motors is bankrupt. It’s not official yet, but the only question is whether it will be by the end of the year. That analysts are discussing GM and bankruptcy in the same sentence, conveys that the situation is dire.
Saudigroup Citigroup has written off at least $40 billion in assets. Ditto for Merrill Lynch.

The American taxpayer has financed JP Morgan’s buyout of Bear Stearns, which was effectively a Chapter 7 liquidation in disguise.

Countrywide was bought out by Bank of America at a fraction of her former capitalization. It remains to be seen of BoA made a wise move.

The Federal Reserve has sunk interest rates, thus foisting a backdoor tax on Americans to bail out those poor souls who were so gullible–in some cases criminally deceptive–to go for Adjustable Rate Mortgages (ARMs). This inflation of the money supply is why we are paying through the nose for gas, food, electricity, and even toilet paper.

Now we have Fannie Mae and Freddie Mac, on the verge of disaster. When the feds are discussing aloud options that are extreme–such as a federal takeover of Fannie and Freddie–then you know the situation is far worse than you are being told. If Fannie and Freddie go belly-up, it will be the Mother of All Bombs. If the feds bail them out, then we will be looking at an economic equivalent of nuclear winter in our lifetimes.

Could Sallie Mae be heading in the same direction?

Now we have both houses of Congress ramrodding a mortgage bailout bill through. Bush will sign it without hesitation. Paulson and Bernanke are all for it.

Our government has panicked, far more so than any administration has in my lifetime.

The question: do you believe a [substitute expletive of choice here] word they say?

Oh, and here is more:

In November 2005, I all but guaranteed it. Now, major credit analysts are accepting that there is an elephant–with a very large ass–in the room.

As a former systems engineer for EDS–when it was a subsidiary of General Motors–I am very saddened at the news. I have close friends who are retired from GM and receiving pension benefits. If GM files for bankruptcy, they will be among the casualties of the largest industrial bankruptcy in world history.

While the analysts are still trying to talk positive, they are merely playing the spin game: that they are even discussing the prospect of GM filing for bankruptcy protection means there is a high probability of it happening.

Analysts don’t just use such verbiage without a very strong factual basis. That Merrill Lynch would slash their target stock price for GM by 75%–out of nowhere–is very indicative of a very serious problem.

My prediction: GM will be in bankruptcy court by the end of the calendar year.

Of course, now we have Nancy Pelosi, calling on Bush to bail out the auto industry.

Maybe it’s the cynicism that comes with age, but I am not buying into the quarterly multibillion dollar loss by GM. Given the timing, one has to consider their interests in reporting dismal results, in order to make the case for their receipt of federal bailout money.

And if GM gets it, then Ford and Chrysler will get it, too.

On the other hand, it is hard reality that GM–irrespective of how much they are inflating their bad news–is in serious trouble. In its current condition, bankruptcy is a near-certainty within the next 6 months, and remains a possibility within the calendar year.

The corps of pundits–liberal and conservative alike–warn us that a GM bankruptcy would be the mother of all economic disasters for America. And it certainly would be painful for a number of reasons:

1. Retirees–many of whom are in poor health–would see their retirement checks get hammered if the pensions were offloaded to the Pension Benefit Guaranty Corporation (PBGC).
2. The economies of cities that depend on GM retirees–like Anderson, Indiana–would be severely impacted.
3. Companies that supply GM with raw materials and components, would be hit hard.
4. Banks that hold GM debt would be slammed.
5. Employees of GM–hourly and salaried alike–would suffer job losses and wage cuts, with little prospect of gaining a comparable job with similar income for the foreseeable future.

For those reasons, the punditocracy–and policy wonks–warn us that we need to bail out GM and possibly Ford and Chrysler (again).

Count me in the contrarian camp, and consider the following scenario….

(1) Let’s assume GM gets no bailout, and this forces them to bankruptcy court.

(2) Instead of allowing GM to offload their pension liabilities into the taxpayers, the judge (a) declares GM, as it exists, unable to continue as a going concern, (b) orders a Chapter 7 liquidation instead of a Chapter 11 reorganization, and (c) orders sufficient liquidation of assets to form a trust that covers retiree pension and health insurance (catastrophic care only), and provides a modest sum for non-retired employees with vested funds.

(3) The remaining assets are sold to third parties–possibly private capital groups, other auto makers, or even some combination of thereof. All executive management is fired. The old union-management agreement is declared null and void, as the old GM is defunct.

(4) The new owners of GM assets can now form a newly constituted entity that can compete with Toyota, Honda, Nissan, and Ford.

While the impact would still be ugly–GM would be reduced to about half of its former self–it would have the following advantages:

1. Retirees would get a reasonable degree of security at minimal cost to the PBGC.
2. GM would re-emerge in position to compete with Ford, Chrysler, Toyota, and Honda.
3. The whole dynamics of the Old Economy structure of GM–from pensions to the old union-management relationship to the engineering processes and the time to market–would be obliterated.
4. The new GM would be able to develop economy vehicles, as the profit margin would be sufficient to cover costs, as they would no longer be saddled by the sunk costs of the legacy corporation.

Would workers lose their jobs? Many certainly would. I’d also like to point out that, even if GM receives bailout money, they will have to eliminate many jobs.

Some might ask if it is possible that GM–if they receive bailout money–could get stuck with the condition that they neither eliminate their jobs nor cut employee wages. While governments can do that–Hoover tried this approach during the front end of the Great Depression–the downward pressure on wages will still overcome all efforts to inflate them.

The bigger losers will be those already unemployed, as a company that cannot fire people will not hire them either.

In a case like this, I’d suggest that–rather than resort to the reflexive approach of trying to bail out poorly-run companies–we ought to let such companies fail, have their assets bought out by others, and then reconstituted as competitive enterprises.

Still not pretty, but better than the alternatives.

I’ve been predicting a General Motors bankruptcy since 2005. (Actually longer than that, but that was the earliest point at which I mentioned it on this blog space.)

The reasons go far beyond the global economic crisis, or any current or impending recession. Take away those factors and you are still left with a devastating set of facts:

1. GM–now 100 years old–is an Old Economy corporation with an Old Economy cost structure. Without a radical reorganization–which almost never happens without a bankruptcy–GM will be stuck with that Old Economy cost structure for at least another generation.
2. GM’s competitors are New Economy corporations with New Economy cost structure.
3. GM management still operates with an Old Economy mindset.

What do I mean by Old Economy cost structure? I’m talking pensions and retiree health care costs. Pensions are financial obligations to employees that GM must fulfill, even after those employees are no longer with the company.

The competition, on the other hand, uses New Economy retirement packages–401(k) plans–the obligation to which ends when the employee separates from the company. 401(k) plans came to fruition with the Employee Retirement Income Security Act of 1974. With ERISA, companies began shifting to defined contribution plans, as opposed to pensions which are defined benefit plans.

There are a number of reasons why GM could not switch their pensions to 401(k) plans:

1. The UAW would have gone for the jugular, and probably would have won. They had far more strength in 1974 than they have today.
2. Switching current employees–especially those who had substantial degree of vestment with the company–from pensions to 401(k) plans would have required a large amount of capital. 
3. GM management was not known for financial creativity or the willingness to take risks and make bold proposals. In fact, their culture–and sheer size–discouraged managerial innovation and rewarded the “play it safe” mentality.  
4. Even if GM had switched their current employees to 401(k)s, they still would have had their retirees to cover. Switching them would not have been a realistic possibility.
5. Defined contribution plans–in the 1970s–were not as thought-out a concept as they are in 2008.

Fast-forward to 2008: the economy is arguably heading into Great Depression II. Even President-elect Barack Obama has had the mother of all “Holy [expletive]!” moments, as his tone has changed remarkably.

(Some of that is politicking, as Obama is trying to reduce expectations. Still, much of that is a case of him coming face-to-face with the reality that the economy is far worse than he ever imagined, and Bernanke and Paulson–who have been successful in their careers because they do not panic easiily–have clearly panicked.) 

Now, the entire auto industry–with the probable support of Obama–is seeking a bailout on par with the recent bailout of the banking industry.

The case for the bailout bears some mention, for several reasons:

1. Unless handled properly, any bankruptcy filings by GM, Ford, or Chrysler would overwhelm the Pension Benefit Guaranty Corporation.
2. Even if the PBGC picked up the pensions, the retirees would only get a fraction of what they are getting now. Many of them would be wiped out en masse. Cities–such as Anderson, Indiana–that depend on GM retirees would be crushed.
3. Any Big Three bankruptcies would cascade into other companies–components manufacturers and raw materials corporations.
4. No President, Congressman, or Senator wants to have the burden of dealing with an election season–the next of which is 2010–having to explain to voters why the largest industrial bankruptcy in world history happened on his watch.
5. Much–but not all–of the current crisis in the automotive industry is the playing out of consequences of government policies that extend back to the 1930s and 1940s.

Wage and price controls–implemented during World War II–prevented employers from offering higher salaries to compete for qualified workers. To find a way to compete, employers began offering health insurance and pension benefits in lieu of higher salaries.

Labor unions–strengthened by government policies during the Great Depression–began including health insurance and pension benefits in their negotiations with management. At the time, companies were more than happy to deal with health and pension matters equitably for several reasons: (a) life expectancies were lower, and therefore the actuarial impact of pensions and retiree health care was a not large one; (b) there were many ways corporations could get out of–or reduce–their pension obligations; (c) health insurance was largely inexpensive at the time; (d) there was little or no foreign competition in the auto industry. 

The United States emerged from World War II as the one of the only countries in Western Civilization with an industrial infrastructure unscathed by war. We were literally the only game in town, and GM was the biggest fish in the ocean. What was good for GM was good for America.

Today, the competitive landscape has become an order of magnitude more saturated. Toyota, Honda, Nissan, Hyundai, Volkswagen, Kia have all eroded the market shares of our Big Three. Even in Europe–where GM once was quite formidible–GM is losing a grip on its market share. This in spite of a falling dollar that would otherwise make American cars a good buy for Europeans.

Complicating matters, GM is restrained in its ability to innovate because–due to legacy costs–they must produce vehicles that can provide enough margin to cover those legacy costs. GM employee and retiree health care costs run close to $1,500 per vehicle sold.

That means they cannot produce a low-cost economy car that sells for $10,000, as they will incur a 15% tax for uncontrollable expenses that they will have to pay for the next 40 years. This is why they are relying on larger vehicles–Cadillac, Hummer, their many lines of trucks and SUVs–to bring in the money.

Now, we are left with two secnarios: a government bailout of the auto industry, or one or more bankruptcies of our major industrial giants.

Some pundits–and economists–will insist that a bailout is necessary, as a GM bankruptcy would be an economic WMD that would gravely impact our country.

I am not convinced of this, and Part 2 will be my reason, including an alternate possibility.