Jonathan Lipson’s Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System

posted by Dave Hoffman

[Jonathan Lipson has been a terrific, episodic, contributor to CoOp on the bankruptcy aspects of the financial crisis and the bailout. He approached me about posting the following very useful set of thoughts about the auto-mess, which I'm happy to now share with you.]

Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”

Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.

According to the Times, the President now believes that:

bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for the American automakers at this time,” Mr. Bush said, noting that consumers would be unlikely to purchase cars from a bankrupt manufacturer.

While I am ordinarily a cautious supporter of the Chapter 11 reorganization system — and suspect much of today’s trouble could have been averted (or at least minimized) if Bear Stearns had been permitted to go through Chapter 11 — I think this is probably the right move, albeit for the wrong (stated) reasons.

Two Weak Arguments Against Bankruptcy

Two principal arguments are made against auto-maker bankruptcy: (1) as the President suggests, bankruptcy might scare off customers, and (2) it might cost jobs.

There is some truth in both—but probably not much.

First, I am skeptical of claims that people will stop buying cars because a manufacturer is in Chapter 11. After all, virtually every U.S. airlines has been through Chapter 11 at least once. People continued to strap themselves into pressurized metal tubes and fly at 30,000 feet despite bankruptcy’s dislocations (no pun). In any event, the only thing of concern to consumers that bankruptcy could likely affect would be warranty commitments. While there’s no guarantee of success, there are ways to deal with this, including acquiring third-party assurance of performance, etc. In any case, if the company reorganized, it would almost certainly “assume” these obligations—and probably work hard to let consumers know that it intended to honor them.

I am sure bankruptcy would scare off some customers. But I suspect that the real problem for consumers (and thus the industry) is, as it has been, the financial services sector, which continues to suck enormous value from the public fisc without, apparently, converting it to productive uses (by, for example, lending to credit-worthy would-be car purchasers).

I know, I know: Detroit makes inferior products. That may be true. I don’t own a car at all, and the one that I once had was a pre-Ford Volvo (it was blown up through no fault of the Swedes). But my sense is that U.S. cars have been getting better and, if the companies survive, this is likely to continue. In event, it doesn’t really matter. If, as was reported today, Toyota can’t sell cars in the U.S., no one can.

The second argument—about lost jobs—is doubtless true, but likely exaggerated. The Center for Automotive Research has estimated that millions of jobs would be lost if the car companies went under. But Chapter 11 probably wouldn’t eliminate all of these jobs. Rather, at least in an “orderly” reorganization (more about this below), the companies would restructure and likely emerge in some newer, smaller (perhaps better) form.

Don’t get me wrong: Even a successful Chapter 11 would cut plenty of jobs and benefits. The Bankruptcy Code specifically gives debtors the power to reject or modify (breach) collective bargaining and benefits agreements. This is a gross simplification, but if this power were used (and there are plenty of impediments), it could convert workers’ rights into unsecured claims against the company (very small dollars) or shift these obligations to the Pension Benefit Guarantee Corporation, which may not be quite so generous as GM. In any case, bankruptcy could be used to dilute the companies’ obligations under their ostensibly outsized union obligations.

But it wouldn’t be pretty. Indeed, the prospect of a nasty fight over these contracts may be one reason the administration relented: They may understand that no auto industry bankruptcy could be “orderly” for this reason alone (and there are others discussed below).

Moreover, many of these jobs and benefits already have been lost or reduced. Indeed, if you look at what has happened (and is continuing to happen), a slow-motion, herky-jerky form of “workout” is already taking place. The UAW and (to some extent) management have already made significant concessions. The union has taken over some legacy health care costs and cut some of the fat from its workplace rules.

According to the Times, today’s proposal would accelerate this:

The loan deal also requires the companies to quickly reduce their debt obligations by two-thirds, mostly through debt-for-equity swaps, and to reach an agreement with the United Auto Workers union to cut wages and benefits so they are competitive with those of employees of foreign-based automakers working in the United States.

As I’ve noted in prior posts here, these are the sorts of moves that should accompany any restructuring, within or without bankruptcy. The parties, not the taxpaying public, should share these losses if at all possible. While I would prefer no bailout, these are the sorts of conditions I would have hoped attached to all TARP money.

If the stated reasons for avoiding bankruptcy are not persuasive, why do I nevertheless think it’s the right move here?

Chiefly because bankruptcy reorganization today is not what it once was, and those changes may matter in this context. The Administration’s (currently abandoned) hopes for an “orderly” reorganization are likely to be unrealistic—and not just because of fights over wages and benefits.

The Shadow Bankruptcy System

The real problem may be what we can think of as the rise of the “shadow bankruptcy system”®. We have all (sadly) become familiar with the notion of a “shadow banking system”—the unregulated mass of hedge funds, private equity funds and investment banks that got us into this mess in the first place.

Bankruptcy has not been immune from this phenomenon, although we don’t talk about it much. But the same sorts of players that got us here—hedge funds and private equity funds, in particular—also play the market for claims against distressed firms. And this can make the shadow banking system look like sunshine itself.

As I argue in this draft paper (written last summer), Chapter 11 increasingly looks like an unregulated securities market. This is due to the explosive growth in trading claims against distressed firms.

Historically, when a company went into Chapter 11, creditors (and perhaps irrationally exuberant shareholders) would wait—often years—to get paid some fractional amount of their claims or interests. Beginning in the 1990s, however, smart people with money recognized that they could purchase these claims and shares—often at bargain prices.

The original creditors would want to sell because they would get cash up front, even if significantly discounted. The purchasers would want to buy because, if successful, they might be able to acquire enough claims to reach what is now known as the “fulcrum point”—sufficient investment across the capital structure to influence the case and (more important) to make money no matter the outcome. Think of it as a sort of applied version of the Capital Asset Pricing Model.

Like secondary markets for securities generally, there is much to be said for the development of claims trading. At least in theory, it probably does—or at least could—link capital and assets in a more efficient way than a bankruptcy court.

But, like all unregulated markets, the potential for abuse is enormous. Claims traders may have very different interests than original company creditors. Odd as it may sound, they may, for example, want to see the reorganization fail, not succeed.

Why? Two reasons.

First, these same folks may also want to buy the debtor’s assets. This is especially likely if they have purchased claims secured by those assets (in which case they may be able to “credit bid” their claims). Assets are likely to be cheaper in a liquidation than if sold (or retained) as a going concern. Lynn LoPucki and Joseph Doherty have recently made the case that these sorts of “fire sales” are occurring with disturbing frequency even in Chapter 11 reorganizations. As I argue in the linked draft, if they are right, it may be in part because the reorganization process has been distorted by the shadow bankruptcy system.

Second, and more ominously, there is (as also discussed in the linked draft) some evidence that these sorts of folks may also hold credit default swaps that pay off only if the reorganization is worse than expected. That is, they may have purchased credit protection that is triggered when a company sells certain assets, or pays less than a defined amount on its debt, and so on. Either way, the moral hazard is obvious.

Thus, the real problem here, as with any unregulated securities market, is opacity that permits (and perhaps encourages) these sorts of perverse incentives. Given the velocity and secrecy of claims trading, we do not know who holds what claims against what debtors, in what amounts, and what their real goals are. We thus lack the capacity to know who can really control cases.

For lots of bankruptcies, this may not matter much. But the auto industry is different. I admit that it is unlikely that any one investor could acquire enough GM debt or shares to control a bankruptcy. The problem is that we just don’t know who is out there, or what they are doing in this context. To paraphrase the great epistemologist, Donald Rumsfeld: In reorganization we increasingly don’t know what we don’t know. That lacuna is likely to matter here.

Moreover, while it may be true that Detroit’s products are not great, U.S. manufacturers cannot be credibly blamed for their predicament. The auto industry (as such, and not owners such as Cerberus) had no obvious and direct role in the events leading to the Great Credit Seizure of 2008.®

The industry—and its thousands of direct and indirect employees and suppliers—are nevertheless vulnerable victims of it. They are to credit system failure what an immune-suppressed person might be to, say, avian flu. While they may not have caused the infection, their condition may frustrate their ability to survive it.

Thus, the “auto immune system” (sorry) is literally compromised. But the traditional hospital for sick companies—Chapter 11—may be infected with the same sorts of diseases that hurt these companies (and the rest of the economy) in the first place. Much as it pains me to admit it, I think the administration may have it right, here—for reasons that it doesn’t even know.

 December 19, 2008 at 3:03 pm   Posted in: Bankruptcy, Corporate Finance, Corporate Law, Securities    Print This Post

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