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.