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November 15, 2008 GM Bailout - Part 2
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Yesterday, in a note to clients, I acknowledged that there are two sides to
the GM-bailout controversy; there are valid arguments for the government to
extend emergency credit to the Big Three, as there are for Washington to refuse
credit thereby forcing GM (and potentially Chrysler) to file for Chapter 11
bankruptcy protection. The debate goes on as the prospects of the provision of
credit by the lame-duck Congress seem to dim. Democratic leaders in Congress
have proposed $25 billion in emergency funding for the carmakers. A bail-out
would be in addition to the same amount in low-cost loans approved earlier to
help finance plants to build more fuel-efficient vehicles. However, Republican
lawmakers and the Bush administration have expressed reservations about the
package, preferring to speed up the disbursement of funds under the earlier
low-cost loan scheme. President Bush asked Congress to drop requirements that
those loans be used to help the industry retool to meet higher fuel-economy
standards, a step many Democrats oppose. The Republicans have enough votes to
block a deal in the Senate.
Under ordinary circumstances, most economists and free-market
small-government types (many Republicans and Conservatives) advocate unfettered
capitalism, allowing markets to work, which leads to the creative destruction
of companies that cannot compete. Adam Smith’s invisible hand of supply
and demand creates the flow of goods and services that customers want at the
prices they are willing to pay. But in Smith’s theoretical world, markets
are perfectly competitive—there are no barriers to entry, no government
constraints or interventions, and no sales taxes or quotas to prevent the
market from achieving the equilibrium price of goods, services and labour that
balances the forces of supply and demand. In this world, perfect competition
knows no national boundaries and customers have full information about the
products and services available to them and labour is perfectly mobile, seeking
the highest wage for services provided. As well, credit flows freely, the price
of which is also determined by the invisible hand of supply and demand.
Many deep thinkers and business practitioners believe that filing for
bankruptcy protection would allow GM to restructure and come out as a leaner,
meaner, more competitive company. These folks include executives like Jack
Welsh, former CEO of GE, and investors like hedge-fund manager William Ackman
and quite a few academic experts. For example, New York University business
professor Edward Altman, a long-time analyst of corporate bankruptcies, avers
the federal government should only put money into GM through a pre-planned
bankruptcy process that knocks out GM shareholders, rolls bondholders into
equity and renegotiates union labor contracts.
Professor Altman recommends the government provide financing to help GM only
after it files for protection from creditors. Espousing a common theme, he is
recently quoted in the New York Times as saying, “I do not think
putting more money into the failed business strategy at GM makes
sense.”
However, there are other very important considerations that refute the
bankruptcy option. But before I get to them, allow me to go off on a brief
tangent regarding the current crisis and why it was so avidly ignored or denied
until it nearly took down the financial system and the global economy.
The Wrong Theory
These are not ordinary times. With the ongoing credit crisis it has become
glaringly obvious that the perfectly competitive market of Adam Smith is great
in theory, but does not exist in the real world. As economist John Maynard
Keynes, famous activist-government advocate of the post-Depression era,
suggests, capitalism in the real world does not necessarily generate the set of
equilibrium prices that equate supply and demand. Put simply, capitalist
markets are sometimes unstable. Highly improbable events with enormous impact
do happen—such as 9/11, a category 5 hurricane hitting New Orleans, the
default of bonds backed by a pool of prime and subprime mortgages or the demise
of Lehman Brothers.
Some modern theorists, most notably Nassim Taleb, professor of mathematical
finance and economics and author of the bestselling book, The Black Swan:
The Impact of the Highly Improbable, point out that unpredictable
random events underlie almost everything about our global economy and financial
markets. These ‘black swans’ are more prevalent than we are
willing to acknowledge and they bear witness to the inadequacy of traditional
econometric and technical analysis, which uses history to predict the
future.
All of us in the financial world (myself included) that argued that, for
example, stocks are the appropriate investment vehicle for the long-term and
that even retirees should hold a considerable chunk of their portfolios in
stocks, were doing so based on historical analysis of the relatively recent
past. The widely accepted and most frequently quoted data on investments is
from Ibbotson Associates. They provide time-series data on stocks, bonds, bills
and inflation that go back as far as 1926. There are data available for earlier
years, but they are much less reliable and incomplete.
All students of the economy and the financial markets believe that you
ignore history at your peril. And it is for this reason, that we generally
ignore highly improbable events—those that are say 10 standard deviations
from normal and assume that things will go along pretty much as they have in
the past. So, as Professor Taleb says “large events continue to surprise
us and shape our world.” Those few economists that did (more-or-less)
predict the current financial crisis a few years ago, such as Niall Ferguson
and Nouriel Roubini, were seen as extremists and ‘showmen’ (wishing
to grab media attention).
The basis of traditional financial and economic analysis is the presumption
past is prologue. Such aphorisms abound:
“Those who do not study history are doomed to repeat it.”
George Santayana
“I know of no way of judging the future but by the past.”
Patrick Henry
“A page of history is worth a volume of logic.”
Oliver Wendell Holmes, Jr. in a 1921 decision (http://www.biography.com/search/article.do?id=9342405
Investors have been taught that historical patterns are predictive. In the
words of Nobel Laureate (1990 winner in Economics) and Stanford Professor
William Sharpe:
- “Although it is always perilous to assume that the future will be
like the past, it is at least instructive to find out what the past was
like.”
- “While results vary from asset class to asset class and from time
period to time period, experience suggests that for predicting future values,
historic data appear to be quite useful with respect to standard deviations,
reasonably useful for correlations, and virtually useless for expected returns.
For the latter, at least, other approaches are a must.”
- “…there is a well known tendency for future risks and
correlations to be more like those of the recent past than like those of the
distant past.” Source: Managing Investment Portfolios: A Dynamic
Process, Second Edition 1990, William F. Sharpe, Chapter 7.
In Sharpe’s latest book (2008), Investors and Markets: Portfolio
Choices, Asset Prices, and Investment Advice, he provides “a method
of analyzing asset prices that accounts for the real behavior of
investors” (book description). Sharpe makes this technique accessible
through a new, one-of-a-kind computer program (available for free on his
website at http://www.stanford.edu/~wfsharpe/apsim/index.html)
that enables users to create virtual markets, setting the starting conditions
and then allowing trading until equilibrium is reached and
trading stops. Program users can then analyze the final portfolios and asset
prices, see expected returns, and measure risk” (my bolding for
emphasis).
How cool is that? Your very own ‘black box’. But it was just
these black boxes, computer simulation models, that created the opaque complex
financial instruments (like collateralized debt obligations (CDOs)) that were
meant to share the risk and therefore maximize risk-adjusted rates of returns.
According to these models, many of these CDOs were so low risk that they won a
triple-A rating and paid yields well above those available on other triple-A
bonds such as Treasuries. It all worked perfectly…until it didn’t.
That is, until that nasty black swan showed up.
So much for using history predicting the future or as Warren Buffet
said:
“If history books were the key to riches, the Forbes 400 would consist
of librarians.”
Warren Buffet, Berkshire Hathaway Annual Report, 1990, 18.
Or, my favourite, from Keynes:
“In the long run we are all dead.”
Finally, Back to the GM Bailout
The reason that I brought up all this esoteric stuff (which admittedly might
have something to do with it being Saturday and I’m sitting in my kitchen
with a good cup of coffee and time to reflect on the financial mess I’ve
been immersed in) is that, as much as I thought I was a free-market capitalist,
I have to agree with Rick Wagoner (CEO of GM), Wilbur Ross (billionaire
investor dubbed Bankruptcy King whose holdings include auto-parts maker
International Automotive Components Group) and Obama, Pelosi, Reid and Frank
(Democrats) that it is too dangerous to allow GM or any other automaker to
file for Chapter 11 bankruptcy protection.
The economy is in a deep recession in the U.S. and in at least a mild
recession in Canada and elsewhere. Credit is not readily available, people are
not buying cars and unemployment is rising fast. The auto sector has already
put itself through enormous downsizing and restructuring and the Big Three are
in real peril. The credit crisis has left many auto companies without access to
the cash or credit needed to ride out what David Paterson (Vice President,
Corporate & Environmental Affairs at GM Canada) says “has become the
worst U.S. new-vehicle market decline in 25 years. Having made massive
investments in new technologies and in our own transformation, GM now faces a
U.S. market decline that in just one year is larger,” according to
Patterson, “than the entire Canadian auto sector. Put another way,”
he says, “you could now close down Canada’s entire auto
production and there would still be oversupply in today’s U.S.
market.”
The chain reaction that might be triggered by a Chapter 11 filing by GM
would make the Lehman bankruptcy and its ensuing fallout look like a good day
on Wall Street. CNBC-star Jim Cramer told his audience yesterday that the Dow
could fall another 2,000 points if GM were to file for bankruptcy protection. I
am not meaning to monger fear, but after what we have already been through
since the September 15th Lehman bankruptcy, might it not be prudent
for the government to loan GM the money it needs to stay afloat? Do we
really want to take the chance that GM might never come out of Chapter 11
because it couldn’t get the financing it needs from the banks or the
market? GM’s potential demise might just take the rest of the industry
down, including not just Ford and Chrysler, but also weakened auto-parts
manufacturers, other suppliers and dealers worldwide, causing the loss of
millions of jobs and a negative multiplier effect on local communities and
governments, the economy and, of course, the stock market. This would be a huge
drain on government spending for unemployment insurance, health care and
pension recoveries. A GM bankruptcy would threaten the health of the
government’s pension-benefit insurance arm, the Pension Benefit Guarantee
Corporation, which covers millions of workers not in the auto industry. The
failures could also hit Asian car makers like Toyota and Honda that share an
estimated 20%-to-25% of suppliers with Detroit’s Big Three.
Bottom Line: The U.S. Congress and the President should stop the
political haggling and extend emergency aid to the automakers. The potential
cost of forcing GM into Chapter 11 bankruptcy protection is far greater than
the cost of emergency aid. Markets don’t like uncertainty, and the longer
this drags on the worse it will be for the stock market and the economy. The
failure of GM could have a sufficiently large systemic impact that the U.S.
government should quickly provide emergency assistance.
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