This Is the End


Markets, Risk and Human Interaction

December 3, 2008

Should we keep the Big Three on life support?

Sometimes it is best to let the patient die. At least if the patient is a company. A company can be resurrected, and enjoy a new life no longer stricken by the debilitating weaknesses that left it lingering at death’s door. Weaknesses like encumbering labor agreements, pension liabilities and health care obligations.

The pleas of the Big Three are those of the management and of the equity holders they represent. They do not have much interest in the hereafter. They would have the company cling to life by the last thread, keep it on life support for as long as it is offered, even make a devil’s bargain to trade the possibilities in its second estate for more time, however impaired, in the current one. Management and the equity holders will not share in the corporation’s afterlife. If it dies, they are gone, no matter how bright the prospects are for the company in its resurrected state.

Thus the equity holders can end up on the wrong side of one of economics’ most prickly conundrums, the agency problem. Usually this problem pits the managers of the firm against the owners; i.e. do the managers of a firm have interests that are aligned with the owners of that firm? In the current crisis the agency problem is: do the equity holders act in the best interest of the firm as a robust, competitive going concern? Do they have an interest in the long-term prospects of the firm, which is our point of interest if we are the government making the bail out decision?

If the answer means pulling the plug, then of course they do not. They will bleed the cash flow to have the firm stay afloat, exert their will to live to the detriment of the future prospects of the firm in a reorganized form. And they will be urged on by those with an interest in the encumbrances that weigh the companies down now, but that will be excised postmortem.

What is surprising in this death drama is that here, in the non-ethereal plain of corporations, we get to observe the passage into the after-life. We get to know the better world where these firms are heading. For example, we can look at what happens to airlines. It seems one airline or another goes into Chapter 11 every few years, and yet they hardly miss a flight. We don’t worry that the planes will start to fall out of the sky; if you didn’t read the papers you might not even know what happened. It is almost a part of the business plan. An airline starts off with the advantages of a new fleet and a low cost work force. Over time the fleet ages, the labor force works its way up the pay scale, the union rules clog the arteries, and costs finally squeeze the life out of the margins. So the airline goes into Chapter 11 and starts the process over.

As Congress deliberates on the Big Three, it should recognize the agency problem it faces with management. And it should look to case studies of reorganizations to weigh the shackles that bind the companies in the current sphere with their prospects in the hereafter.

There is life after death.


  1. The only decent arguments I have heard for preventing bankruptcy is that debtor in possession financing might not be available in this credit crunch.

    Why not find out?

  2. Excellent metaphor!

    However in this case it is not only the equity and capital holders who would like to cut a little bit more out of what is now essentially a moribund corpus. It is also the unions who are desperately clinging to the excess rents they have been suckling from these mortally wounded corporations.

    I don't think anyone seriously believes that these companies can continue as unsubsidized going concerns so long as they are weighed down by their union contracts. But it is those contracts that attract political interest in maintaining taxpayer life support instead of just letting the companies resurrect through bankruptcy into vital and competitive businesses.

    There is an amusing irony in this case: Before the crisis unions lined their pockets with the capital of investors in the form of excessive contracts that crippled the companies. Now unions are the motive for a taxpayer bailout from which investors might extract excess rents ... at the expense of taxpayers!

    Of course, there is little social sympathy for investors who risked capital to build these businesses. Now if only we could undermine the knee-jerk sympathy for the unions that strangled the companies with excessive labor contracts....

    Corporate resurrection is a wonderful miracle. As you point out, bankruptcy can permit a useful business to continue to serve the market. Investors know that if they bankrupt a company they lose their investment. Unions must live with the same terms. Taxpayers and consumers should be the beneficiaries of the mechanism of capitalist death and rebirth.

  3. I'd like to see some numbers, specifically what is the labor component of a car from the Big Three versus non-union labor in the US and union labor in Germany, Japan and South Korea. I wonder how much of the opposition to a bailout is class prejudice towards blue collar workers and how much us really concern with good policy.

    I have no problem in bailing them out if it's an efficacious use of the money. But they sell products to consumers, and companies who do this generally try to find out what consumers think. I believe it's called marketing research. For 30 years all they had to do was read the car magazines, Consumer Reports, much less conduct surveys to find negative opinions on the quality and gas mileage of their cars. Doing something about this is a management function, not the province of labor.

  4. See M. Perry's blog for the numbers.

  5. hi rick, just a quick note. I am a rates derivatives trader in a european bank. just want to say that there are several portfolio insurance type disasters out there happening as we speak that take the level of absurdity to new highs. I have one of them in my book, extremely complex derivative product, sensitive to 2 or more yield curves, long term rates vols and fx vols, basis swaps, all correlations between them, you name it, all in one product. I am sure it will make a beautiful case study in a couple of years to show how absurd things can get, all under the watchful eye of an army of risk managers, mathematicians, and product controllers. These products got so big that they are driving markets they are exposed to against them, and completely controlling the less liquid ones. Nobody has the faintest clue what correlations should be (if everybody is the same way, this is not a statistics question any more), but people take comfort in marking to each other, “implying” correlations from consensus valuations offered by a private company, at which valuations nothing can be traded. In the meantime, everybody is buying high selling low every day big time, to “hedge” these bogus valuations, portfolio insurance style.
    So, just in case you are looking to expand the number of examples of financial disasters in your book, there is plenty of "new material" out there... under the cover of stochastic differential calculus and other heavy math these products are little more than scams, easy ways to declare profits and pocket bonuses. apologies if you know all these things already. liked your book very much. people won't listen to anonymous employees like myself (and probably shouldn't), but will definitely listen to you, so keep going please.

  6. good and well founded post- further to your point, how about the even bigger agency problem that exists in washington (dc)? the decision they are mulling is, basically, "do we spend opm (taxpayers) to improve the economy enough to be reelected, or do we do the most responsible thing for the long term benefit of the country, creating in medium term a pain that will affect the next wave of congressional elections?" gee, i wonder what they choose, these world class abusers of opm...

  7. Spekulatn,

    Thanks for the link to Perry's blog. I looked at some of the rest of it and thought a lot was partisan drivel. Even if his numbers are accurate, it doesn't say how much the UAW contributes to the price of an average car.

    If we do the thought experiment of imagining that there was no UAW, would the competitive position of the Big Three be any different today? I'm inclined to think it wouldn't have made much difference. Attention to quality and customer preferences seems way more important. OTOH, GM seems to make money outside the US, which tends to argue in his favor.

    The policy issue and subject for future B school courses is whether it's a good use of public money to bail them out even if labor costs are scaled back to the level of non-union factories in the US. (I have the impression that Germany and Japan are unionized, but possibly in a way that better promotes competition.) If people who hate unions get to eradicate the UAW, will it make a difference? I suspect not.

    Of course, in the real world, we'll probably subsidize management without providing any incentives to better performance, and reward the union, which I've noticed contains many voters. And fingers will still be pointed.

  8. Don Boudreaux echoes this argument in the WSJ yesterday: Bankruptcy Doesn't Equal Death


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