By Martin Hutchinson
Money Morning/The Money Map Report
Financial journalists, most of whom spend more time writing about derivatives than carburetors, have been scathing about the possibility of an auto industry bailout, even though they’ve happily accepted multiple bailouts for the financial sector.
Of course, the reality is that bailouts are likely to do more harm than good in the long run, regardless of what sector they are in. But given the choice, I would rather bail out General Motors Corp. (GM) than Citigroup Inc. (C), because the automaker has a better long-term future.
The financial services industry got far too big during the 1995-2007 bubble. Its growth accelerated in the 1990s on the back of innovative new financing techniques such as derivatives and securitization, as well as a huge expansion in areas such as leveraged buyouts. As a result, its share of United States gross domestic product (GDP) has approximately doubled since the late 1970s.
It is now clear that many of the new financing techniques were misapplied or even spurious. The problem of separating loan origination from credit-risk assumption has become obvious, and so securitization will have a much more limited future.
Of the derivatives, credit default swaps are clearly destabilizing and will be tightly regulated. Many of the new market participants, such as hedge funds and private equity funds, should disappear, since they merely represented conduits through which higher fees could be charged rather than truly innovative investment choices. It is thus likely that the financial services business will revert to close to its previous share of GDP. That would involve a downsizing of its 2007 capacity by 50%.
The automobile industry, on the other hand, has no obvious need to become smaller. With global warming now high on the political agenda, its products need to change radically, employing new technologies that greatly reduce carbon emissions. However, the basic demand for personal transportation has not gone away.
Indeed, it is still expanding rapidly in the growth economies of emerging markets such as China and India. And U.S. urban geography, with its widely spread suburban developments, is wholly incompatible with a sharp drop in automobile usage and would be impossibly expensive to modify except over a very long term.
Why Citi Should Fail
Allowing a large bank such as Citigroup to disappear is probably beneficial. It reduces competition for other major banks, allows medium-sized banks to expand into the space opened up, and provides an appropriate penalty for decades of bad management. Citi was a leader in the Latin American loan crisis of the 1980s; its then-Chairman Walter B. Wriston famously opined that “countries don’t go bust,” a sentiment that has been repeatedly disproved.
Wriston got his succession wrong in 1984, choosing the overaggressive retail banker John Reed (who had pioneered the unsolicited credit card offer in 1978 and lost $100 million – real money back then – in 1980 by doing so) over the capable corporate banker Tom Theobald.
Citi almost went bust in 1991, but was bailed out by Saudi Prince Alwaleed bin Talal. It assembled a financial services conglomerate in 1998 that proved unmanageable, and from 2003-2005 was prevented from making any more acquisitions because of its shaky position.
In short, Citi has been a classically mismanaged behemoth that, in any other industry would, have already collapsed.
Yet, its bailout risks more than $300 billion of taxpayer money, and to no obvious economic benefit.
Meanwhile, General Motors has been damaged by two factors: Misguided government regulation of the automobile industry, and a drastic societal shift away from unionized labor.
GM had a 60% share of the U.S. market in the 1950s, and was recognized for large cars that performed distinctly better than their imported competitors and were well suited to U.S. driving conditions. Some expansion of foreign competition was inevitable, as Europe recovered and Japan became a major automobile producer, but GM was particularly hard hit by the Corporate Average Fuel Economy (CAFÉ) legislation. CAFÉ, which mandated fuel economy standards instead of simply raising the gasoline tax, put GM’s large models at a disadvantage to their smaller imported competitors.
However, U.S. automobile companies found a loophole, which is that its standards were limited to automobiles. Vehicles built on a truck chassis were exempt. That gave rise to the sports utility vehicle. Now, higher fuel costs, environmental concerns, and tighter CAFÉ standards have made the SUV an endangered species, but it was a Frankenstein’s monster that only existed because of government meddling.
If GM and the other U.S. automobile manufacturers go out of business, only their foreign competitors will benefit. Furthermore, they have an interdependent network of suppliers, with a total of 3 million employees, which could easily be forced into bankruptcy by the disappearance of their major customers. U.S. automobile manufacturers have important, and in some areas unique technological capabilities, whose loss would severely damage the U.S. economy as a whole.
The automobile business is unprofitable now, but will eventually return its previous size in the United States, as well as expand worldwide. So, while there is no capacity downsizing needed, capacity restructuring, away from SUVs and towards smaller cars, hybrids and innovative power technologies, is essential.
Ultimately, the right decision would have been to bail out General Motors and allow Citi to go to the wall.
The Case for Citi
Of course, there are important modifiers to this recommendation. In Citi’s case, its interconnection with the financial system as a whole is such that an immediate bankruptcy followed by years-long court proceedings could render many of its counterparties unviable and damage the global economy badly. Hence, an orderly liquidation is needed, with a receiver appointed to wind down Citi’s positions and sell the viable portion of its operations, making good on those obligations incurred by Citi that appear to have systemic importance. Even if the taxpayer made Citi’s counterparts completely whole, however, it would not have been as expensive as the bailout.
As for GM, it has labor costs and pension obligations making it uncompetitive with foreign-owned producers. Those “legacy” costs can most efficiently be removed through a Chapter 11 bankruptcy filing. The pension obligations will then fall on the taxpayer through the Pension Benefits Guaranty Corporation, while the labor contracts can be rewritten in a way that is competitive with the market in which GM operates. If a government subsidy is then needed to cover GM’s operating cash deficit during the recession, and the investment costs of transforming GM into a producer of environmentally friendly automobiles, it should be provided through a post bankruptcy “debtor-in-possession” financing.
There is nothing magic about banking that should allow the industry to be uniquely permitted access to taxpayer money when disaster hits. Only bank customers and the market should be protected. Conversely, the automobile industry plays an important role in the U.S. economy that is unlikely to be significantly downsized. So, there is considerable justification for assistance to GM and Ford Motor Co. (F), which have valuable capabilities and long-term competitiveness, though less for a bailout of the smaller and less industrially valuable .
News and Related Story Links:
Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One’s Talking About.
Alwaleed bin Talal.