Can the Big Three Cheat Death?

Last Tuesday (18 November 2008), the CEOs of the Big Three said at the Senate Banking Committee hearing that if the federal government does not provide assistance promptly, the American auto sector will cave in, leaving millions out of a job.

“If you don’t save me, there will be massive unemployment.” The threat may not be unfounded but it reflects the dependency of mega companies on the government.

What’s wrong with the once-mighty automotive industry, the pillar of the American manufacturing base? Why is the American government so reluctant to help when it came to the rescue of mortgage players like Fannie Mae and Freddie Mac and insurance giant like AIG so swiftly? Can the Big Three avoid bankruptcy all together?

Deep-seated problems in the American auto industry

How severe is the predicament? For 15 years since 1986, General Motors (GM), the largest carmaker in America, had claimed the top spot of the Fortune 500. In 2000, GM was worth $63.8 billion. Today, only eight years later, the combined value of GM and Ford, the second largest carmaker, is less than $5 billion. In comparison, GM’s market cap stood at $4 billion in March 1929, on the cusp of the Great Depression.

American third largest carmaker, Chrysler, is in a cliff-hanging position. Since its acquisition by German Daimler, Chrysler has not been well. Daimler sold its 80% of its stakes in Chrysler last year. Last month, Chrysler sold a mere 94,530 cars in the American market, 35% fewer than the same period last year.

Why have the Big Three landed in this sorry state?

First of all, it is the high production cost. Based on GM’s deal with the United Auto Workers (UAW), its American workers are drawing an hourly wage as high as $70. GM provides life-long pension and medical insurance to about 50,000 of its retired workers and their families. At the same time, Japanese auto companies pay their American workers a mere $15 an hour.

As the Japanese carmakers entered the U.S. only recently, they are not loaded with benefits provision for their retired workers, at least not yet. In addition, under the Job Bank Programs established during 1984 labor contracts talks between the UAW and the Big Three, there are more than 12,000 out-of-job union members drawing the full pay and benefits enjoyed by employed staff. In 1990, GM signed a labor contract that obliges it to pay each retrenched worker 3 years of their wages.

Moreover, the Big Three pay their workers the same hourly wage, regardless of seniority. Such a high wage model had proliferated after the World War II and provided the thrust for the rapid growth of the auto sector. However, as global competition intensifies, first came the European, then came the low-cost Japanese and Korean, making it increasingly difficult for the Big Three to hang on.

Secondly, the Big Three have, under the influence of unique auto culture in the U.S., largely ignored the development of fuel-efficient cars. Since the oil crisis in the 1970s, European and Japanese carmakers have come out with their own answers to fuel-efficiency. As pump prices in the U.S. are relatively low, American consumers have a preference for big cars. High profits from these cars have led the Big Three to focus on large car business and to make bigger cars like the ultimate “Hummer” with a fuel consumption of 25 liters per 100 km.

However, in recent years, high fuel prices and environmental movements have driven consumers to more fuel-efficient mid- and small-sized cars. Last year, GM sold more than 100,000 units of pickup, SUVs and the likes every month; this year, the sales volume has plummeted. At the same time, Japanese carmakers are building new plants and expanding existing ones in North America.

In the first 8 months of 2008, Japanese carmakers sold more cars than the Big Three in America for the first time in history. Toyota, Nissan and Honda are expected to produce more than 5.4 million cars in North America by 2010.

The Big Three used to invest substantially in research and development of fuel-efficient cars. In fact, GM was one of the first carmakers to work on hybrid cars but Toyota has the most sellable hybrid models in the market.

For a number of years in the 1990s, GM had experimented on hybrid cars that ran on both oil and electricity. It later shifted its attention to electric car EVI. However, EVI was abandoned soon after its introduction out of commercial considerations. On the other hand, Toyota persevered and introduced Prius, one of the first hybrid models in the market, and thereby established a leading edge in the American market.

As evident from the above, the Big Three have failed to come to grips with the major directions in which the auto sector is heading. They have rested on their laurels, have been slow to react to the market and have not adjusted in time to cater to what the consumers of today want.

Detroit’s glory days

The Big Three have a place in the American History. Over the past 100 years or more, they have, together with the Americans, created a unique auto culture. In 1913, Henry Ford brought assembly lines and left a permanent mark on the way Americans live. During the World War II, GM brought loads of American soldiers to liberate Europe.

Since the end of the World War II, the high car ownership rate has moved Americans to suburban areas where they can enjoy the tranquility of rustic life and pursue their dreams along the well-linked state highways.

Today, car is an integral part of the American spirit and the Big Three are closely tied to the American culture.

For the past century, the auto sector has been one of the three pillar industries in the U.S. America has been the world leader in the auto sector. Detroit, where the Big Three headquarters resides, is known to be the world’s car capital. At its peak, more than 90% of its 4 million-plus population based their livelihoods on the automotive industry.

In 1953, ex-CEO of GM, Charles Wilson, boasted to Congress, “What’s good for the country is good for General Motors, and vice versa.” Today, American automakers hire more than 240,000 workers plus 700,000 more making materials and parts for cars. Not to forget the 1 million salesmen under the payrolls of over 20,000 car dealers.

While GM and Ford shares have hit their historical low, they are still among the 30 companies that make up the Dow Jones Industrial Average. The automotive value chain is enormous, involving steel, design, parts, second-hand cars, gas, sales and repair, car financing and insurance and many others.

The value chain is so gigantic that it takes only one of the Big Three to go out of business to wipe out millions of jobs and to strike off more than $100 billion from the payrolls of auto manufacturers and their suppliers alone.

Michigan Governor Jennifer Granholm told the CBS Morning Program that the automotive industry accounts for one out of every ten jobs in America. If the Big Three crumble, there will be substantial chain reactions taking place around the country.

The U.S. government is not entirely indifferent to the sufferings of its auto sector. In 2007, Congress approved a $25 billion loan at a 4 – 5% interest rate for the carmakers to retool their factories for the production of fuel-efficient cars.

At last week’s hearing, the CEOs of the Big Three asked for an additional sum of $25 billion to tide them over the cash shortage. GM said that it will go bankrupt in the early part of 2009 if no help comes in.

However, Senate Republicans and the White House do not want to tap on the $700 billion package for the automakers. Secretary of the Treasury, Henry Paulson, reiterated the stand that the package does not cover the non-financial sector. Any solution has got to be leading to the long-term viability of the industry.

On the second day of the hearing, Senator Richard C. Shelby of Alabama, the senior Republican on the banking committee, blamed poor management for the failure of the auto sector. The only way out for the Big Three is to file for bankruptcy and have their senior management stepped down.

As the Senate and the White House are pointing fingers at each other, the Senate Majority Leader Democrat Harry Reid decided to delay votes on the $25 billion auto rescue plan till 2 December 2008. He made it clear that the rescue would not be considered until the Big Three produced a convincing plan for rebuilding their industry. This implies that the Big Three have to fight for their own survival before Obama takes office on 20 January 2009.

Government can help to restructure the auto industry

GM posted its last profit in 2004. Over the past 4 years, GM has lost in excess of $70 billion. To the White House, the auto rescue plan is using taxpayers’ money to fill up the abyss created by poorly run enterprises and it would not solve the real problem.

In addition, the Big Three’s quagmire is not the doing of the financial crisis but of bloated production costs and passé business models that fail to capture consumers’ preferences. Hence, their products need to be revamped and their organizations need to be restructured.

On 18 November 2008, White House Press Secretary Dana Perino expressed her surprise, saying, “What the Democrats put forward yesterday is a proposal that fails to require automakers to prove viability.” As a quick relief, the White House suggested the speedy release of a $25 billion loan program passed earlier to help the carmakers develop fuel-efficient cars.

Bankruptcy may be a better option for the Big Three. They have done too little in restructuring their products and labor costs to cater to the changing marketplace. Temporary cash hand-outs could only serve as a life support machine and could not solve the problem at its root. The Big Three have to make tough decisions in re-rationalizing their operations and re-positioning their products in order to rise from the ashes.

The auto sector in the U.S. will not vanish simply because the Big Three have gone under. However, the job market of the auto sector is going to take a hit whether the Big Three are filing for bankruptcy or not. Foreign carmakers are likely to increase their production in America and create more jobs to buffer the adverse impact the distressed Big Three have on the sector. One thing for sure, these companies are not going to be as good paymasters as the Big Three.

These foreign auto substitutes will inevitably dent the so-called “American Spirit”, but this is the price to pay for free market and globalization much advocated by the U.S.

The U.S. government should only step in after the Big Three have filed for bankruptcy. Poorly timed assistance will lead to concealment of entrenched problems and delays in reforms.

The U.S. government has a critical role to play in the transformation of the Big Three. Bankruptcy is a brutal process. The Big Three’s pension gaps will be exposed and their retirees would not be getting benefits at the current level. We feel that the U.S. government should offer help in the restructuring process. This is reasonable and acceptable to the people under the current economic situation. Effective rescue measures worth considering include providing special aids and social benefits, and facilitating the development of the next generation of technology for the auto sector.

Professor Jin-quan Duan is Cycle & Carriage Professor of Finance and Director of Risk Management Institute with the National University of Singapore (NUS)

Dr. Mu Deng is a research fellow of Risk Management Institute with the National University of Singapore (NUS)