Monday, November 17, 2008

Biz Prof Says No to Car Maker Bailouts

Just Say No to Detroit
Given the abysmal performance by Detroit's Big Three, it would be better to send each employee a check than to waste it on a bailout, says David Yermack.

Before Michael Moore became famous for documentaries like "Fahrenheit 9/11" and "Sicko," his first big success came in 1989 with "Roger and Me." In that film, Mr. Moore followed General Motors chairman and chief executive Roger Smith with a camera crew, asking him why the company was closing plants and producing low-quality vehicles. Mr. Smith looked flustered and inartfully avoided Mr. Moore's camera crew while it lingered outside his country club or GM's executive offices.

"Roger and Me" was entertaining, but it missed the real story about Roger Smith, who turned out to be a forward-thinking genius. Mr. Smith made big investments in information technology and satellite communications, acquiring Electronic Data Systems in 1984 for $2.5 billion and Hughes Aircraft in 1985 for $5.2 billion. Mr. Smith's successors divested those businesses at huge profits -- EDS was taken public in 1996 for more than $27 billion, and Hughes, renamed DirecTV, went public in 2003 for more than $23 billion. (The man who sold EDS to Roger Smith at a bargain price was H. Ross Perot, who then convinced many people that the experience qualified him to be president.)

Mr. Smith understood all too well that GM shouldn't continue investing in its failing automobile business. That was 25 years ago. Today, our government is being asked to put tens of billions of dollars in GM, Ford and Chrysler, but we would be much better off if Washington allowed these companies to go bankrupt and disappear.

In 1993, the legendary economist Michael Jensen gave his presidential address to the American Finance Association. Mr. Jensen's presentation included a ranking of which U.S. companies had made the most money-losing investments during the decade of the 1980s. The top two companies on his list were General Motors and Ford, which between them had destroyed $110 billion in capital between 1980 and 1990, according to Mr. Jensen's calculations.

I was a student in Mr. Jensen's business-school class around that time, and one day he put those rankings on the board and shouted "J'accuse!" He wanted his students to understand that when a company makes money-losing investments, the cost falls upon all of society. Investment capital represents our limited stock of national savings, and when companies spend it badly, our future well-being is compromised. Mr. Jensen made his presentation more than 15 years ago, and even then it seemed obvious that the right strategy for GM would be to exit the car business, because many other companies made better vehicles at lower cost.

Roger Smith, who retired as chairman in 1990, seemed to understand that all too well, and so did Chrysler's management, which happily sold their company to Daimler Benz for $30.5 billion in 1998. That deal, one of the savviest corporate divestitures ever, ended very badly for Daimler, which essentially paid Cerberus a few billion dollars (by agreeing to retain pension liabilities) to take Chrysler off its hands in 2007.

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s. GM has invested $310 billion in its business between 1998 and 2007. The total depreciation of GM's physical plant during this period was $128 billion, meaning that a net $182 billion of society's capital has been pumped into GM over the past decade -- a waste of about $1.5 billion per month of national savings. The story at Ford has not been as adverse but is still disheartening, as Ford has invested $155 billion and consumed $8 billion net of depreciation since 1998.

As a society, we have very little to show for this $465 billion. At the end of 1998, GM's market capitalization was $46 billion and Ford's was $71 billion. Today both firms have negligible value, with share prices in the low single digits. Both are facing imminent bankruptcy and delisting from the major stock exchanges. Along with management, the companies' unions and even their regulators in Washington may have their own culpability, a topic that merits its own separate discussion. Yet one can only imagine how the $465 billion could have been used better -- for instance, GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan and Volkswagen.

The implications of this story for Washington policy makers are obvious. Investing in the major auto companies today would be throwing good money after bad. Many are suggesting that $25 billion of public money be immediately injected into the auto business in order to buy time for an even larger bailout to be organized. We would do better to set this money on fire rather than using it to keep these dying firms on life support, setting them up for even more money-losing investments in the future.

Two main arguments are being raised to justify a government rescue of the auto industry. First, large numbers of jobs may be at stake, perhaps as many as three million if one counts all the other firms that supply the Big Three. This greatly overstates the situation. Americans are not going to stop driving cars, and if GM, Ford and Chrysler disappear, other companies will expand to soak up their market share, adding jobs in the process. Many suppliers will also stay in business to satisfy the residual demand for spare parts even if the Detroit manufacturers go under. If the government wants to spend $25 billion to protect auto workers, it would do better to transfer the money to them directly (perhaps by cutting each worker a check for $10,000) rather than by keeping their unproductive employer in business.

Second, it is suggested that the failures of the U.S. financial industry, which have cost us something like $700 billion, justify bailouts of other sectors of the economy. This makes no sense. If the government diverts our national savings into businesses that have long track records of destroying investment capital, eventually we'll end up with an economy like France's -- orZimbabwe's.

Other arguments are on the table as well. Some see the troubles at GM and Ford as opportunities to retool the auto industry to produce environmentally friendly cars. Given their long track records of lobbying against fuel economy standards and producing oversized gas guzzlers, this suggestion seems ridiculous, sort of like asking cigarette companies to help with cancer research.

Not many of my students today remember "Roger and Me" (many confuse the film with another picture from the same era about the cartoon character Roger Rabbit). However, Roger Smith's example casts a long shadow over the auto industry today. It's time to cut our losses and let society's scarce investment capital flow to an industry with more long-term potential to create jobs and economic value.

David Yermack is a professor of finance at New York University's Stern School of Business

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