The bailout of GM and Chrysler are the results of many decades of willful neglect of good business practices by the leadership of the auto industry. That both are now making long-deferred strategic changes under government ownership tells us a lot about what happens when internal agendas triumph over creating and delivering value to the marketplace. Transforming the industry means new products that customers want to buy, different manufacturing strategies and operational capabilities and a different approach to the market.
I believe that Obama Administration should have not bailed out General Motors because most of the company’s problems are due to self-infliction by failing to adapt to changing tastes and behaviors, also the shrinking of quality gaps, increased labor costs, lack of innovation, and the management of funds by their subsidiaries. In addition, General Motors has failed to consider the entrance by new auto players and refused to mass produce an electric vehicle due to political reasons. These self-inflicted problems played a significant role in the near collapse of the auto giant.
Government’s Reason for Bailing Out the Auto Industry
The collapse of any of the “Detroit big three” would mean loss of millions of jobs. Other ripple effects known as reversed multiplier effect in economics will follow suit, resulting in further increase in job loss. The collapse would also send shock waves and uncertainty through the stock market and drive down stock prices. When the government decided that the financial, social, and political cost of the collapse was too great, it finally stepped in and reluctantly bailed out GM, urging the company to declare bankruptcy and reorganize.
One of the most obvious moral hazard problems related to the plight of General Motors is the issue of quality products affecting business decisions. General Motors has struggled financially due to their lack of innovation and inability to compete with foreign automobiles such as Toyota. A potential moral hazard associated with this government bailout is that it could have more incentives to take risks if it is allowed to take government bail-out for granted whenever it is in crisis. A good way to prevent this kind of moral hazard problems is to make sure the executives of the GM understand that GM is always there to save it whenever it needs money. If GM knows government is not always there to help it, it will not take risks or engage in irresponsible behaviors. However, prior to the bailout GM executives continued to acquire huge annual salaries and bonuses while companywide layoffs were implemented. This principal-agent problem was a common theme throughout the financial crisis.
GM’s structural and financial problems were magnified in 2008 when gas prices skyrocketed and thousands of American consumers were not able to get loans owing to the credit-crunch brought on by the global financial crisis (Note: the official recession started in December, 2007). Share prices started to decline in late 2007 and have been on the free fall since the beginning of 2008. The price of one share in early 2008 was approximately $27 and in 2009 priced at $0.66 per share. ($0.66 was the closing price as of Nov 18, 2009.)
The stakeholders who suffer from GM’s problems are creditors (bondholders), stock-owners, retirees, GM employees, GM’s retailers, related manufacturers, and the federal government (decreased revenues). The equity of the stock holders were wiped out as share prices plummeted. There is negative equity for owners as total liabilities exceed total assets. GM has fired 75,658 employees as of June 9, 2009 (Layoff Tracker) and has reported $1.1 billon losses in the third quarter of 2009. The “Detroit big three” has supported nearly 3 million jobs in the U.S. (Center for Automotive Research). The foreign car-makers operating in the U.S could increase production and sales, assisting with the United States economy and helping to lower the unemployment rate.
As the national and global economy fell into an extraordinary financial crisis, numerous large-scale corporations either failed completely or were taken over by the federal government. These include: Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG, and General Motors. The bailout package that the government initiated was an unprecedented measure to save the largest business entities in America for numerous economic and financial reasons. This political intervention into private business caused concern because of its resemblance of socialist policy. However, if not for the bailout General Motor’s and Chrysler’s failure would have catapulted the nation’s unemployment rate to a level unimaginable. Detroit, a primarily manufacturing city struggling financially, would have been permanently damaged. According to Sean McAlinden, labor analyst and economist, “political economics are now part of the economy in the United States” (GM Bailout May Mean Government Becomes Biggest Holder).
With the $15 billion General Motors government bailout package, the United States government has become the largest shareholder of the nation’s largest automobile company. Because the government loans are secured by assets, the government has more control over the company’s creditors leaving the $27.5 billion in bond debt unsecured (GM Bailout May Mean Government Becomes Biggest Holder). However, GM’s bonds are scheduled to mature in 2033 and will be converted into equity with their values increasing significantly from $3.75 to $21.25 (GM Reports $1.2 Billion Third-Quarter Loss). The primary reasoning that the government was considered the lender of last resort and responsible for providing General Motors $15 billion in asset relief is because of the magnitude of the debt and the implications that the company’s failure would have on the United States and the international economy. Because financial institutions were also failing simultaneously, the government was the only logical source for such an enormous loan.
As the lender of the financial bailout, the government’s role has been debated extensively. Immediately after the company filed for chapter 11 bankruptcy, the federal government asked its chief executive officer to resign and installed Fritz Henderson as its new leader. Henderson said “the government wants GM to develop a viable plan to ensure taxpayers get repaid in the case of government loans or get a good return in the case of equity” (GM Bailout May Mean Government Becomes Biggest Holder). While the government has primary control financially, it has remained determined to refrain from operational decisions. According to White House spokesman Robert Gibbs, “The role of the U.S. in GM is to develop a plan whereby the automaker can be self-reliant and not need federal aid to survive. This administration and this government have no desire to run an auto company on a day-to-day basis” (GM Bailout May Mean Government Becomes Biggest Holder). According to a recent report, GM has declared their intentions on beginning to pay off their debt back to the federal government and will come from a “$16.4 billion contingency fund set up by the U.S. government in case sales worsened or other problems cropped up” (GM Reports $1.2 Billion Third-Quarter Loss). The idea of paying back government debt with money already budgeted by the treasury has been criticized by many. However, this proves that the company’s financial health is improving which is important for consumer confidence, especially when they are scheduled to become public once again with an initial public offering (NYSEARCA:IPO) in 2010.
Changing Tastes and Behaviors
The main culprit behind the tragedy of General Motors (NYSE:GM) is the failure of the largest American auto-mobile manufacturer to adapt to the changing tastes and behaviors of the consumers in the market. GM’s business model of focusing on producing big gas-guzzling Sport-Utility-Vehicles (SUVs) is no longer profitable for the company, thanks to rising gas prices and fierce competition from foreign-car makers that produce smaller more fuel-efficient cars and SUVs. GM’s failure to shift its focus on manufacturing large pick-ups, trucks, and SUVs was greatly penalized by decreasing sales and market share. GM’s market share has decreased from 46.2% in the 1950s to about 20.3 % in 2009.
Spending on Quality Gaps and Labor
Quality gaps between GM, other American car-makers, and foreign makers have widened, consumer satisfaction for American cars has fallen. Japanese car-makers such as Toyota, Honda, and Nissan spend much more capital on research and development to update their cars with the latest technology available. Moreover, research and development (R&D) capital invested by the Japanese car-makers goes to fewer vehicles compared to GM. For instance, in 2005 GM spent $7 billion while Toyota spent $15.3 billion for R&D. While Toyota models stay in the market for an average of 3 years, GM models sit in the market for an average of 4 years. (Note: according to the American consumer satisfaction index, consumer satisfaction for American cars has improved this year.) Labor cost is also cited as a reason for GM’s accelerating decline. GM has been providing life-time benefits to its half of a million retirees while its sales and revenue have plummeted. It is estimated that GM’s generous retiree health care benefits add $1,300 to the cost of every vehicle produced in the U.S. due to union agreements. Regardless of the loss, the company cannot lay off its employees or shut down manufacturing plants without paying stiff penalties. In contrast, Japanese car makers such as Toyota operating in the U.S. do not have unionized workers and retiree benefits as a major corporate financial burden.
Elimination of Funds
Effort to revamp General Motors should include thorough reorganization of the company by eliminating the pension, loans, and mutual funds that are managed by their subsidiaries, Promark and GMAC. Removing all of these funds would allow the group to outsource their administration to firms which fully specialize in those forms of management.
Removal of GM’s fund management burden will free up the company to focus on its core mission of manufacturing cars and trucks. In the past 15 years alone, General Motors has spent over $103 billion on retiree healthcare and pension expense, crowding out investment that otherwise would have been made in quality, safety, fuel efficiency and innovation (Restructuring Plan for Long-Term Viability). This is because a significant portion of General Motor’s current operations can be attributed to the running of their in-house pension funds. Promark Global Advisors, formerly known as General Motors Asset Management manages about $84.5 billion of pension fund assets (Understandably, They Dropped the GM Name). The removal of pension funds would negatively affect current employees and those retirees that are receiving benefits from the basic benefit and supplement plans. General Motors pension plans for hourly and salaried workers, cover 673,000 employees and retirees (GM to Keep Responsibility for its Pension Plans). Elimination of General Motors funds would allow the company to create independent funds that can be contracted out to third party fund services that fully specialize in those niche areas. Also, the liability of a contractual obligation of a third party fund service provider is higher than that of an in-house employee. The interested parties who gain from the removal of these funds would be the company’s retailers, manufacturers, creditors, stock-owners, and contracted out fund firms. General Motors would then be able to fully focus on their revenue drivers and cost factors from their manufacturing business.
General Motors had a substantial financial sector that had to be bailed out by the federal government. Another problem was that too much of their business involved the running of their pension funds. Freeing up the company from their in-house pension and mutual funds obligations would be right step forward to overcoming current financial issues. The company’s main focus should be on their core business of manufacturing cars and trucks. The first choice is superior to the nationalizing option because the current political environment would not favor increasing role of the government which would not make the second alternative a strong option in the United States.
Entrance of New Auto Players
General Motors could find itself in a far worse situation if it does not brace up for the potentially very aggressive new entrants into the United States auto market.
U.S. market entrance by multiple new auto players like China’s BYD and India’s Tata could put GM in a far worse position if it does not brace up quickly. This will cause auto industry competition to get far more intense than it already is. While the global competitive nature of the automotive industry requires mass economies of scale, the relatively young Chinese and Indian manufacturers are ramping up quickly.
Affordability will be a key driver in the industry in the coming years and China and India will offer automakers an important testing ground for pushing the boundaries. India’s Tata Motors unveiled its much anticipated $2,500 car, an ultra cheap price that suddenly brings car ownership into the reach of tens of millions of people (Carmaker in India Unveils $2,500 car). The reason that the ultra cheap car called the Tata Nano hasn’t been released yet in the United States is because the company hasn’t met necessary safety and emission standards. This is why Tata decided to purchase brands Jaguar and Land Rover. Ford sold both Jaguar and Land Rover to Tata Motors for an approximate price of $2.3 billion (Tata to (Finally) Announce Jaguar, Land Rover Purchase). Both brands bought by Tata have multiple cars that exceed American safety and emission standards. An India and China entry would pose a significant competitive threat in the coming years.
China’s Build Your Dreams (NYSE:BYD) auto group has just showed off their latest model called the e6. BYD is also preparing an entry into the United States automotive market. Warren Buffett famously has an investment in the company (Warren Buffet’s Chinese Cars Will Start Killing the U.S. Auto Industry as Soon as This Year). The billionaire has been making a killing betting on companies that he believes will succeed and he seems to think that China will be a big player in the near future. Chairman Wang Chuanfu has hinted that BYD’s first target could be both U.S. companies’ and the U.S. government’s vehicle fleets (Warren Buffet’s Chinese Cars Will Start Killing the U.S. Auto Industry as Soon as This Year). In China, where the e6 will first be sold, it will be used for city use by government, utility companies or fleets of taxis.
Both companies’ biggest advantage over American manufacturers is their low cost of labor. As previously stated, GM’s generous retiree health care benefits add $1,300 to the cost of every vehicle produced in the U.S. due to union agreements. It will be very hard for General Motors to compete with Tata’s $2,500 car.
Future is Electric Vehicles
In addition to affordable cars, many think that the future of the car industry is headed towards electric vehicles. President Obama has a goal to have one million plug-ins on the road by 2015 (Nissan’s All-Electric Leaf Challenges GM Volt and Toyota Prius). The administration sees plug-ins as a way for the US to replace foreign oil used for transportation with domestically generated electricity. Also, with carbon-dioxide emissions from power plants expected to come under federal control, electricity will be the cleanest, cheapest fuel (Nissan’s All-Electric Leaf Challenges GM Volt and Toyota Prius).
Many companies are getting ready to sale new electric cars to the public. GM Is getting ready to release its new plug-in electric hybrid, the Chevy Volt, in the next year. The main competition right now to GM is from Nissan with their release of the Leaf which is a 100% electric vehicle with zero emissions.
Right now, it appears that the Nissan Leaf is winning the battle in terms of sales with GM because they have over 85,000 people pre-registered to buy the Leaf when they are released later this year (Nissan’s All-Electric Leaf Challenges GM Volt and Toyota Prius). In terms of pricing, the Leaf is miles ahead of the Volt. Nissan just issued a statement regarding the price of the Leaf which has it placed at around $32,000, but with a government rebate for buying an electric car, it is closer to $25,000 while in some states like California and Georgia you get an extra $5,000 rebate so it is even cheaper (Nissan’s All-Electric Leaf Challenges GM Volt and Toyota Prius). Right now, Wall Street analysts are speculating that the Chevy Volt will be priced at over $40,000 though nothing has been officially announced.
If the future of the car industry is headed towards electric cars, then GM will have to do something if it wants to remain competitive. GM’s president of North America Mark Reuss has even been quoted as saying that in the long-term pure electric cars like the Leaf will be more popular than Chevys hybrid volt. So with a far more reasonable pricing and better technology, Nissan is very likely to win the battle with GM in the long run.
GM’s Missed Opportunity of Mass Producing 100% Electric Vehicle
Also General Motors has already designed and refused to mass produce an electric car by the name of the EV1. It was among the fastest, most efficient, production cars ever built. It ran on electricity and produced no emissions. The documentary “Who Killed the Electric Car” points out that the EV1 was made available for lease mainly in Southern California after the California Air Resource Board passed the ZEV mandate in 1990 (Who Killed the Electric Car?). After it was passed, it was reversed after suits from automobile manufacturers, the oil industry, and the George W. Bush administration. The EV1 was eliminated from the GM Line in 1999. General Motors arguments were that 1) that there was no demand for their product and 2) lack of consumer interest due to the maximum range of 80-100 miles per charge. But GM’s arguments were completely false. There was huge demand by California citizens for an all electric vehicle with no emissions because the state was suffering from a smog problem that was threatening public health in big cities like Los Angeles. But the main reason behind GM’s decision to withhold production of the EV1 was that the oil companies were afraid of losing trillions of dollars in potential profit from their transportation fuel monopoly. The documentary points out that Bush’s chief supporters/aides, Dick Cheney, Condoleezza Rice, and Andrew Card, were all former executives and board members of oil and auto companies.
In studying the General Motors case it is realized that the major reason the company declined was due to the company’s self-inflicted problems. Their business model focused on the production of SUV’s, which is no longer profitable because of the rise in gas prices and the fact that their competition is making smaller and more fuel efficient cars. Since GM spends less capital on research and technology to update their cars, the quality of GM’s products has become increasingly inferior to other American car makers as well as foreign car makers. We have also learned that labor costs were also a high contributor to GM’s decline. GM’s retirement plan seemed feasible when it was first created but over time has become a huge burden on the company. With an estimated $1,300 added cost to every vehicle produced as a result of their retirement plan, GM’s price of a vehicle has to be inflated. Therefore, while GM has been providing life-time benefits to its half of a million retirees its sales and revenue have plunged. The steady decline in GM’s revenues would have eventually led to a collapse. In order to improve GM’s problems, the company would have to reorganize. In this reorganization plan GM should eliminate the pension, loans, and mutual funds that are managed by their subsidiaries. GM also needs to consider the entrance of new auto players and reconsider the idea of mass producing an 100% electric vehicle similar to the EV1. One of the lessons to be to be taken from the GM case is that no automotive company should be handling fidelity instruments. This puts too much liability in the company, and funds are spent on paying for them instead of for improving their products. Another lesson to be taken from the GM case is that there should be no reason that the government should depend so heavily on one sector for the health of the economy. If one huge sector fails it would have a greater negative impact on the economy than if one or two smaller companies failed.
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Disclosure: BGM, GMGMQ.PK, GMS, GMW, HGM, XGM, TM, TATA, GMA, GM, NSANY, NISSAN, General Motors, Nissan Leaf