The Chrysler Bankruptcy

Monday, the stock market rose more than 200 points, pushing one of the key indexes into positive territory for this year-to-date, as signs of life in the economy become more visible. We are anxious to tell you about these things. However, other events continue apace as well, including the U.S. auto companies' financial restructuring; Chrysler is in bankruptcy and General Motors could follow. As we've complained about before here, there's too much to talk to you about all at the same time!

There are so many reasons U.S. car companies are in trouble, we can't begin to count them. And they have several groups of stakeholders, complicating their efforts to adapt. What we want try to do here is explain why Chrysler has resorted to the bankruptcy court to sort out its issues. We are hardly experts in the complexity known as the auto industry, but we can highlight some of the main players and what's at stake.

Weak Car Sales, More Restrictive Financing
First and most fundamental, vehicle sales have fallen precipitously. In April, 9.3 million* cars and light trucks (mostly SUVs, some pick-ups) were sold in the U.S., almost 36% fewer than a year ago and about 45% off the average pace of the last 7 to 8 years. In fact, the first quarter of this year saw the lowest sales since the fourth quarter of 1981, more than 27 years ago.

We see little press these days about the impact of high fuel prices on vehicle demand; everyone seems to think that the credit crunch is mainly to blame. It surely plays a big part, but last summer's $4.00 gasoline hurt a lot too, as well as the continuing burden of cheap-but-still-expensive $2.00/gallon fuel. This is especially painful for auto companies whose product mix favors large SUVs, souped-up high-end sedans, vans and trucks. Read GM and Chrysler.

Financing is a second problem. The impact of the credit crunch can be seen in interest rates on auto loans. In April, loans from banks reached what is at least a 4-year high of 7.32% on a 48-month loan [we only have 4 years worth of these figures], and while rates at auto finance companies dropped in February [latest available official information], the previous couple of months they ran well above 8%. Other terms, including loan-to-value ratios and average amounts financed, have become less generous as well. So it's been more expensive for vehicle buyers to borrow. Dislocations in other parts of the financial markets have meant that the auto companies themselves have faced high rates meeting their day-to-day cash-and debt-management needs.

More Retirees than Workers
The third issue has nothing to do with making cars, but it's certainly part of the U.S. auto industry: worker pay and retiree benefits. The following graph shows the magnitude of the second aspect of this problem, the large and growing population of retirees and the large multiple they constitute of the current pool of active workers.**

The companies and the UAW have all been racing against time to find some sustainable way to manage retiree costs, especially for health care. The 2007 contract included reforms to contain these burgeoning costs. One has been some cost-sharing by the retirees, who now pay a small monthly premium plus some co-pays and deductibles. A further action has been the formation of a VEBA for each company, a "Voluntary Employee Beneficiary Association". Rather than handling the insurance themselves, the companies began in 2007 to make payments to their respective VEBAs, which are administered by the union. However, with falling revenues, the companies are all still strained in making these payments. In February and March, Ford negotiated with the union to make part of the payment in company stock in order to conserve its cash supply. Chrysler, too, wants to switch to this kind of arrangement, indeed putting a 55% ownership interest for its VEBA in its proposed new financial structure.

Which brings us to the fourth issue, a hybrid that amounts to a combination of the financing and health insurance problems. Chrysler was bought in mid-2007 by Cerberus Capital Management, a private equity firm. Associated with that transaction, it borrowed heavily by mortgaging some factories and other facilities and taking sizable loans, altogether totaling some $22 billion. It soon became evident that running the company, much less paying off the debt, would be increasingly difficult, leading up to the first set of government loans back in December. Times only became tougher, eliciting ever more strident calls for restructuring of financing and of the labor cost arrangement. Finally, ten days ago, April 26, the UAW and the Company announced they had reached an agreement on still more health-care changes by retirees – taking away dental and vision coverage, in particular – and other concessions. Staying out of bankruptcy court then depended on the creditors, the investors in the debt that is secured by those mortgages on the factory properties.

Auto Company Lenders Object to "Cramdown"
Some of these creditors, especially the banks that have received TARP monies from the government, acceded right away to the terms of an agreement. But some 20 other lenders balked. They were being offered only $2.25 billion for the $6.9 billion in debt they own. They contend that since they hold mortgages, their debt should get satisfied first and only then should any remaining funds be disbursed to the other lenders or to the workers. This would be the usual course of bankruptcy settlement. This is what their standing as "secured creditors" normally means. In this instance, since there are specific assets backing their bonds, those assets would be sold and the proceeds used first to pay their bonds. Then the workers and their health insurance fund could have access to what is left; they shouldn't have their share decided first, this argument goes.

Apparently, members of the Obama Administration are arguing that since taxpayer funds are involved, the government can try to persuade the parties (possibly with considerable pressure) to accept a non-traditional settlement. While trying to keep up the retirees' health insurance is a noble concept, accomplishing this by altering the terms of loans that are already in place could add an arbitrary element to the financial outcome. This would be a hazardous precedent to impose on the whole financial and legal system. Others in government have already dealt with similar concerns in another context. Last week, the Senate actually defeated a proposal that would call on bankruptcy judges to ease the terms of residential mortgages, a practice described as a mortgage "cramdown". If cramdowns were mandated or even encouraged, lenders would likely make the initial loan more costly as they would face the added uncertainty that the interest rate or other loan factor might be arbitrarily reduced. Oh, my. These things are never as easy as they look at first.

All this said, the third of the "Big 3", Ford Motor Company, seems to be limping through on its own. That surely deserves discussion here, and we will do so soon.

*These monthly sales figures are quoted at an "annual rate", which means that the amount is expressed as if it were sustained over an entire year. Much economic data is shown this way; then periods of varying lengths can be easily compared.

**The graph, showing 2007 numbers, comes from the blog of Mark Perry, a professor of management at the University of Michigan at Flint – right in the heart of auto country.