Just Say No

As I write this, a bailout for the U.S. automakers is winding its way through Congress.  The House has approved it; the Senate looks like it might vote against it.  An auto bailout elicits fierce passions: some people have no sympathy to Detroit due to decades of mismanagement; others claim a car company failure will unleash a domino effect – plus, hey, it’s a helluva lot less money than those bankers got.

I have to admit, that I fall a little closer to the first camp.  I’m stunned that these giants have been able to mismanage themselves for so long.  Let’s be clear: this ‘crisis’ has been a long time coming.  Here’s an interesting opinion on how bizarre incentives caused them to lose focus on building the right set of cars.  In fact, there’s no longer “one cause” for their decline: they’ve allowed the cancer to spread all through their business (failure to innovate; focus on financial return, not the consumer; weak boards, etc.).

Chrysler and GM are facing two imminent realities: bankruptcy or bailout.  Bankruptcy is not such a bad option.  If they enter into a prepackaged bankruptcy they can restructure their operations and avoid a liquidation.  A breakup is almost certain (goodbye Pontiac), but there’s a decent underlying core business; the companies just need to get their cost structure and balance sheet back in line with their expected revenue/cash flow.

However, lots of people are saying that a bankruptcy would be a disaster.  It would lead to millions of jobs lost and a domino effect as suppliers shut down and in turn economically devastated the towns they were located in.

Unfortunately, either way, there are going to be a lot of job cuts, so neither scenario is going to avoid those.  More importantly, let’s test the domino hypothesis.  Imagine Chrysler is liquidated.  No more Dodge, so no more need for the suppliers.  So they go bankrupt and liquidate.

Except they don’t.  Some actually sell to other companies, so they don’t go bankrupt.  Some definitely do, but automotive manufacturing isn’t that big a piece of the economy, so they don’t really take anyone else down with them.

The big group that suffers in this scenario are the people who live in one factory towns where the local factory shuts down: those towns aren’t coming back.  However, it’s not clear that anything is going to sustain small towns, so we’re really just delaying the inevitable.  There’s a bit of a cold calculus here, but this is why we have social programs like job retraining and Social Security; to handle transitions like this.

Contrast this with the banking sector.  What happens when a bank fails?  Here’s a quote from the New Yorker, interviewing a Fed official:

“If Bear had failed,” the senior official went on, “all these money market funds, instead of getting their money back on Monday morning, would have found themselves with all kinds of illiquid collateral, including C.D.O.’s”-collateralized debt obligations-“and god knows what else. It would have caused a run on the entire market. That, in turn, would have made it impossible for other investment banks to fund themselves.”

Here’s the quote in English.  Trillions of dollars are held by money market funds.  They extend overnight loans to investment banks and businesses so that they can function (this is what most people don’t realize: most major corporations run on credit).  If a bank goes bankrupt, the money market fund is left with whatever collateral they bank posted – substantially less valuable, and a heckuva lot less liquid – than the cash they had before.

So what do they do?  They stop lending money overnight and instead buy Treasury Bills.  Check out The Giant Pool of Money to hear it direct from ServiceMaster’s CFO.

This means that one bank went bankrupt and nobody in the entire economy can borrow money.  Suddenly otherwise healthy companies start to go bankrupt or stop investing simply because no one will lend them money anymore at reasonable rates.

That’s a wildly different scenario from a GM or Chrysler bankruptcy.  It’s an example of a tightly coupled complex system: a failure can quickly spread through the system.  And that, in a nutshell, is why the banks are getting trillions of dollars whereas the automakers will be lucky to get a billion.  (And the bankers are also going to get a lot of regulation as people have realized that they were allowed to build a much too fragile, complex system).