Deal or no deal?

11/25/2008 - When the Big Three automakers return to Washington, D.C., in December to appear before Congress and request $25 billion to rescue their struggling industry, how should the lawmakers respond — yes or no?

If only the answer was that simple, say four Kellogg School faculty members who study the sector.

Meghan Busse, associate professor of management and strategy

Photo © Evanston Photographic

Paola Sapienza, associate professor of finance

Photo © Evanston Photographic

Sunil Chopra, senior associate dean for curriculum and teaching and the IBM Professor of Operations Management and Information Systems

Photo © Evanston Photographic

“One position says we ought to let these companies just go bankrupt and let the market take care of the fact that they have management and products that aren’t competitive,” says Florian Zettelmeyer, the J. L. and Helen Kellogg Professor of Marketing. “The other view is to say, ‘We should really bail these guys out because this is such a big industry.’”

But the reality is far more complicated, according to Zettelmeyer.

While U.S. automakers generally have resisted pressure to produce more fuel-efficient vehicles, at least Ford and GM over the last five years have recognized that they are in a very difficult situation, Zettelmeyer says. As a result, they have aggressively tried to make their cars more competitive. “It is not unreasonable to assume that even in the absence of this financial crisis that they would have recovered and eventually done well,” says the Kellogg marketing expert, whose recent research includes examining how the Internet impacts the auto industry.

However, the Big Three now face a key reputational disadvantage in the minds of many consumers, Zettelmeyer notes. Those people are more likely to see any “emergency loan” (as the bailout also has been framed) as a waste of money. Even so, denying the automakers any assistance would be a mistake, he says. “It’s not easy to resuscitate a car industry. These are hard industries to rebuild.”

A bailout “with some conditions” is crucial so that innovation can continue, says Sunil Chopra, senior associate dean for curriculum and teaching and the IBM Professor of Operations Management and Information Systems. Although the U.S. has lagged in production of hybrids and small cars, he said, GM’s attempt to move forward with the Chevy Volt, a plug-in vehicle, deserves support.

“That could be a game-changer in the industry, and the only people who will be able to participate in the game are those who can put some money into research. If you put a company into bankruptcy, the first thing that gives is research,” Chopra says. Unless U.S. auto companies can innovate, they will never catch up with foreign competitors, says the operations and supply chain expert. If federal funding can oblige the automakers to improve fuel-efficiency standards or make direct investments in new technologies, “that would be money worth spending.”

Meghan Busse, associate professor of management and strategy, questions whether a cash infusion would solve or merely perpetuate longstanding industry problems. “A bailout would forestall an immediate crisis, but you would want it to change incentives and change what firms did so they don’t end up as badly situated 10 years from now as they are today,” she says. “It’s not clear to me that subsidizing them with more money is going to guarantee that you get the kinds of institutional and organizational changes that need to happen to bring that about.”

What if Congress denies funding to U.S. automakers — or does not give them enough support — and one or more of them files for bankruptcy protection? Would the U.S. auto industry collapse?

“If American car companies go bankrupt, those assets aren’t going to disappear. There are still going to be plants; there are still going to be production lines; and there are still going to be skilled auto industry production workers who could simply be under different ownership,” says Busse, whose research focuses on market structure and competition, particularly with respect to pricing.

Cars would continue to be manufactured and sold in the U.S. by American workers and, with time, the industry might be healthier, she notes. “It’s not clear to me that having a reorganized or reduced or jointly owned American car industry is in the long run worse than what we would get if we help these companies continue on their current path with a bailout,” Busse states.

Her colleague, Paola Sapienza, believes that whether the price tag is $25 billion or $50 billion, a federal bailout with conditions is not viable. “The government has no business expertise to decide which kind of plant production or which specific strategy GM should follow,” says Sapienza, associate professor of finance and a Zell Center Faculty Fellow.

She cites the Italian government’s failed attempt to help guide the airline Alitalia toward solvency as a negative example for U.S. lawmakers to recall. “All this government financing meant was a soft budget constraint,” says Sapienza, whose research interests include corporate finance, banking and the role of social capital in finance. “When a company operates under a soft budget constraint, it doesn’t make efficient decisions. It doesn’t make market decisions.”

Total inaction is not politically expedient, so Sapienza suggests that the ailing companies “file for Chapter 11, but a slightly modified Chapter 11 with government financing, since the debtor-in-possession (DIP) financing is very tight right now.” The threat of liquidation would force automakers to come up with a restructuring plan and involve management, labor, suppliers and even retirees in renegotiating contracts. “Everyone would come together and say, ‘Let’s save the best of this company and let’s do it in a way that the market will accept.’”

All four Kellogg experts agree that the current global financial crisis will complicate any consensus solution.

What does the future hold — whether or not a bailout occurs? Demand for small, fuel-efficient cars remains high in emerging economies, and venture capital is being invested in new technologies around the world. Because of those trends, Chopra says, “Globally, the auto industry will be just fine. But I think in the U.S. the auto industry to some extent has peaked.”

“In the long run, there isn’t room for all these car companies in the U.S. unless they start exporting to other markets,” adds Sapienza. Each of the Big Three companies has unique strengths, “and all they need to do is find a good reorganization plan that makes those the central part of the new entity that will be restructured. This could take many forms — it could be one merged company from the three of them, or some parts, some models and some brands sold to a foreign company.”

Busse says that if the Big Three end up facing bankruptcy, the ordeal could lead to reorganization and changes in asset ownership. Hopefully, though, the firms could continue production and ultimately emerge stronger.

“There does need to be some kind of change that improves efficiency and effectiveness in how we produce cars in this country,” Busse says. Reorganization might do that, she admits, but most important is an outcome that reinstills a sense of global competitiveness among the Big Three.