Monday, November 24, 2008

Three circles of economic hell after a Big Three bankruptcy

As auto industry Armegeddon approaches, many are crying "let 'em eat coke." Let the Big Three go through bankruptcy hell and rise from the ashes, cleansed of their legacy labor costs, like the steel industry. Or keep on truckin' through bankruptcy, like the airlines.

Today, three separate sources brought home to me, in very different ways, the likely cataclysmic effects of auto industry failure.

1. On the Times op-ed page, former energy secretary Spencer Abraham argues that the airline and steel industry analogies are flawed. Bankrutpcy for an automaker will mean liquidation because
To purchase a car is to make a multiyear commitment: the buyer must have confidence that the manufacturer will survive to provide parts and service under warranty. With a declaration of bankruptcy, that confidence evaporates. Eighty percent of consumers would not even consider buying a car or truck from a bankrupt manufacturer, one recent survey indicates. So once a bankruptcy proceeding got started, the company’s revenue would plummet, leading it to hemorrhage cash to cover its high fixed costs.
No revenue means no DIP financing and no rebirth. Abraham ticks off the knock-on effects: a "cascade" of bankruptcies among parts makers, a squeeze on surviving automakers as suppliers fear to extend credit, liquidation of the Big 3, three million jobs gone in the first year, new burdens on government healthcare and pension guarantee services, enormous credit strains on banks holding auto loans.

2. Also into today's Times, Zachery Kouwe and Louise Story lay out the multiple levels of the financial sector's exposure to auto industry debt: $100 billion that the automakers owe directly to banks and bondholders; another $47 billion in loans to Big 3 affiliates backed by auto leases and loans; billions loaned to Cerberus in its leveraged buyout of Chrysler; untold billions more to parts suppliers, dealerships, and of course increasingly distressed consumers.

3. Finally, in today's FT, Wolfgang Munchau reminds us that in the wake of a big 3 bankruptcy credit default swaps would once again prove themselves, in Warren Buffet's phrase, financial weapons of mass destruction:
Naturally, [a carmaker bankruptcy] would be bad for the US car industry itself. But it might be even worse for the banks, especially those that got involved with credit default swaps – probably the most dangerous financial products ever invented. CDSs are unregulated shadow insurance products that investors buy to protect themselves against default of corporate and sovereign bonds. Protection against a default by General Motors was among the most sought-after contracts.
Some have called for a "managed bankruptcy." Looks to me like a managed bailout, with all stakeholders giving up something in advance, would be a lot less risky.

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