Day: December 19, 2008

The Madoff Economy..

/ Jim Luke

Courtesy of Paul Krugman.  He’s starting to get at the core issues.  I’ll discuss more in future posts, but for now ponder:

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s … had a corrupting effect on our society as a whole.

Let’s start with those paychecks. … The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money…, then invests the bulked-up total in high-yielding but risky assets… For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. … Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics… Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

Most of all, the vast riches … undermined our sense of reality and degraded our judgment. Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? … The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

I’m just sayin’…real reason Ford’s not taking FedGov $

/ Jim Luke

Ford’s talking about the future marketing benefits of not taking the Federal Govt bridge loans like Chrysler and GM.   Yeah, that’s true and possible – there probably could be a small market share gain to be had eventually by being the US automaker that “pulled itself up by it’s bootstraps”.

But there’s probably another reason.  Any FedGov loans involve reporting to the new “Car Czar”.  Right now that Car Czar will be SecTreasury Paulson.  Paulson’s an ex-banker (actually there are no ex-bankers –  once a banker, always a banker in thought).  Ford has a two-tier common stock structure.  One class for the family (can’t be sold outside) and one class for everyone else (read bankers, pension funds, and regular investors). The family class is a small $ portion of the company (sticks in my mind as around 5% -but don’t quote).  But the family class gets way more votes – effectively around 40%.  That’s how the family still controls the company.  Banks, pension funds, and others have long wanted to end the two-class stock system at Ford.  My guess is taking FedGov money would put it in jeopardy.  The family doesn’t want that to happen.  So Ford says no to govt $.  Fortunately for Ford and the family, they appear to have enough cash to do it.

Surprise: Bush sort of does the right thing for GM/Chrysler

/ Jim Luke

I’ll admit I’m surprised.  My inner cynic suspected the Bush administration would try a pre-packaged Ch. 11 bankruptcy for GM or Chrysler, or that they would dither and play Hamlet so long that the Chrysler, GM, or some big Tier 1 would end up in bankruptcy anyway for Christmas.

Instead, GM/Chrysler get their bridge loans.  See NYTimes (registration reqd) or FreePress.

The good side is that the package includes restrictions and a March 31 deadline that will enable the companies to play hardball with their debt holders (especially the banks), as well as dealers and the union.  The union has already shown a willingness to help & play,  but contrary to what some Republican Senators and Wall Streeters believe, the problem now isn’t so much the union contract as the debt-laden capital structure.  The banks haven’t shown a willingness to play yet.  Maybe now they will.  With the fed gov money getting priority over all other debt, a fed gov decision in late March that the restructuring hasn’t happened will greatly raise the risks for current debt holders.  The balance of power in the game of chicken between firm and banks just changed.

The downside is the timing and amounts. See the FreePress.  It seems Bush/Paulson want to tempt fate.  There’s no slack here folks.  That’s tight.  If the economy takes another surprise hit in the next 40 days, this might not work.

Industry Matters: Why Chap 11 Bankruptcy Won’t Help GM

/ Jim Luke

The NFL should watch out.  Armchair quarterbacking while watching football on TV is being challenged by a new couch potato activity: armchair management. It seems that nationwide people, pundits, Wall Street analysts, and even U.S. Senators have the solution for GM and the U.S.-headquartered auto industry:  file chapter 11 bankruptcy and “re-structure”.  It worked for airlines and others they say!

No! say the defenders (?) of the Big 3.  A Chapter 11 bankruptcy would immediately turn into a Chapter 7 liquidation because customers won’t buy cars from a bankrupt automaker.

NOTE for Students: “Chapter 7” and “Chapter 11” are different parts of the U.S. bankruptcy code.  In ch.7, a firm is liquidated – it shuts down operations, all the assets are sold, the creditors are paid what money is left, and the company is no more – it is a “late company” in Monty Python parlance.  In ch.11, a firm is allowed to continue to operate and the court protects it against claims from earlier creditors. The court then negotiates/forces the creditors to take less then than what’s owed them.  The court can also tear-up an re-write union/employee contracts. Eventually, the firm “emerges” from ch. 11 as a financially restructured company.

The truth, like always, is more complex than these simple soundbites.  In my opinion, chap 11 bankruptcy is not a viable option for the Big 3, but the reasons are more complex than just “customers won’t buy from a bankrupt automaker”.  Let’s look at why chap.11 won’t work and why a ch. 11 would quickly become ch.7 and a cascade that brings down other automakers.  But in fairness, we’ll also look at what benefits ch.11 would bring.

In addition to the customer reluctance argument, there are four other reasons why ch. 11 won’t work for autos, even though it “worked” for airlines and some others. All of them involve the economics of the auto industry as compared to other industries.  The auto industry has high hard fixed costs, it has a long product development cycle with large sunk costs, purchased components are a large part of value, and it’s a credit-based business.  Airlines and other firms that have successfully navigated ch.11 don’t have these characteristics.

  1. A significant number of customers won’t buy from a bankrupt automaker, unlike airlines.  It doesn’t matter if some customers, or even most customers, would continue to buy.  If you run a high fixed-cost business, any significant drop in volume will doom your operation and necessitate liquidating plants.   Despite what advocates of ch. 11 argue, it’s perfectly rational for consumers to fly a bankrupt airline and not buy a car from a bankrupt automaker.  A plane ticket is a service that’s delivered over a few hours.  I only need to know that the plane is safe (I know the FAA & insurance is watching) and that the airline won’t shut down during the time I’m flying.  That’s a risk most people will take since it’s low probability.    A car from a bankrupt automaker is a different thing.  I’m buying a large asset (second largest asset I’ll likely own).  My “investment” depends not only on whether I think the automaker will be there for parts in 2-3 years, but also whether future buyers of my used car will think the parts/service is available.  The safety (recalls) are dependent on the automaker, not the FAA or an insurance company.  In buying a car, I’m buying a relationship with the company & dealer for several years.  Yes, some car fanatics will buy anyway and maintain it themselves, but even if only 20-30% are scared off, it’s doomsday for the automaker.
  2. Autos have high “hard” fixed costs, unlike airlines.  In ch.11., it’s normal that sales volume declines somewhat.  For any business, the risk to profitability/viability of a sales decline depends on whether costs are fixed or variable.  High fixed costs = trouble when sales decline.  High variable costs mean costs come down with the sales decline.  I define a “hard” fixed cost as some cost that can’t change easily regardless of sales  volume.  A “soft” fixed cost is more like a step-cost.  Opportunities exist to lower the costs.  It’s fundamentally a question what size a “chunk” of capacity is. Airlines are often thought of as high fixed costs, but in reality they have soft, step-fixed costs.  An airline essentially has three major costs:  lease on the plane (hard fixed), the fuel for each flight, and the labor/maintenance.  Airlines can reduce costs in small chunks – if there aren’t enough tickets for the Chicago-Albuquerque flight, cancel it. You save the fuel costs and possibly some of the labor costs.  GM, on the other hand, can only realistically cancel an entire plant or a whole model line – these are permanent shutdowns.
  3. Autos have to plan ahead, airlines don’t. Under the best of conditions and the most flexible automakers, what’s on the showroom floor has been in planning, development, and production for at least two years.  To do a significant “re-structuring” requires planning ahead.  In airlines, reaction is a lot faster.  Witness how fast airlines adjusted to fuel cost changes in 2nd qtr 2008 or traffic declines in 4th qtr 2001.  Can’t do that easily with autos. In autos, if you start reducing costs today in 2008, you lower the cost of the car available in 2011.  2009’s costs are largely set already.
  4. Purchased components & the supplier network. A bankruptcy court can tear-up a union contract.  It can force a bond-holder or bank to write-off part of their investment and take a loss.  A bankruptcy court CANNOT FORCE a supplier to make and sell parts.  Without parts, no car. Without a car, no sales, and no automaker.  70% of the value of a car is parts/components purchased by the Big 3.  It’s not just a question of whether customers will buy from a bankrupt automaker, but also will a cash-strapped supplier sell and deliver parts to a bankrupt automaker.  There’s not much evidence to indicate they will.  What’s worse, is even if 95% of suppliers are willing, the 5% that might not can shut down the whole thing.  For most auto parts and components, the tooling is unique to each model.  It takes months, even years to switch the supplier of a particular part.  For an automaker to survive Ch. 11, ALL the suppliers need to be involved and taken care of.  Not likely to happen.  In airlines, on the other hand, the airline needs fuel.  If Exxon won’t sell it, BP can easily substitute. Different industry.
  5. Autos are built with credit, airlines fly on cash. An automobile is really a credit vehicle.  The automaker buys the parts on credit. The tier 1 supplier buys on credit.  The dealer buys on credit. The customer buys the car on credit.  Nobody gets paid until and unless the car gets sold and GMAC, FoMoCredit, the credit unions, the banks, etc deliver the money.  In chapter 11, the certainty and risk of being paid changes drastically for everybody.  A bankruptcy court can easily tear-up existing contracts, but it can’t force customers, suppliers, or dealers to enter new ones on credit.  A bankruptcy court also can’t supply credit.  And in the current 2008-09 environment, it appears the banks can’t/won’t either.  Airlines, however, pay cash or near cash for the only really large purchased production component:  fuel.  Customers also pay cash (or do their own financing with Visa/MC). Different industry.

A chapter 11 bankruptcy for automakers would have one positive effect.  It would make it easier and cheaper to break and re-negotiate the contracts with the dealer networks.  This would allow GM and Chrysler to skinny down the dealer network  –  a critical element for long-term survival.  Right now, this is a tough task because a patchwork of state laws and anti-trust court decisions makes it difficult for the automaker to unilaterally cut dealers.  Today, automakers have to essentially buy-out dealers with a $ carrot to get rid of them.  Presumably (I am not a lawyer), a federal bankruptcy court trumps state dealer franchise laws.  Again, even here, the contrast to airlines is stark.  Airlines don’t have to “buy-out” an airport or travel agency in order to stop doing business with them.

If the GM or Chrysler end up going chapter 11, I don’t see anyway that survival is possible in any practical form.  Instead, a chapter 11 will really be a chapter 7 with additional paperwork and attorney’s fees up front.  And a disorderly liquidation of any one of them, puts key Tier 1 suppliers at risk and the risks production at Ford, Toyota, Honda, Kia, Hyundai, etc.

Unfortunately, it seems that our economic policy leaders are touched with the Wall Street disease:  armchair management.  They don’t understand how the business works and don’t want to learn, but they want to prescribe management policy anyway.  I don’t have a problem with people (or their elected representatives) wanting to prudently put limitations on their investments (and that’s what the auto loans should be), but we need fact-based, intelligent analysis, not simplistic soundbite solutions that don’t won’t pass Econ 101 or Mgt 201.