Why GM Should File For Bankruptcy

(TMA International Headquarters)

All this talk about a government rescue of General Motors and other automakers is misguided, likely a waste of taxpayers’ money, and a potential further diminution in the creditworthiness of the U.S. government. It is time to focus seriously on the gut-wrenching question of whether GM, this struggling and probably insolvent giant American icon, should file for bankruptcy as soon as possible or continue to attempt to survive outside the protective confines of the Bankruptcy Courts.

Given GM’s financial profile, based on my Z-Score bankruptcy prediction model, the company now is clearly deep into the distressed firm zone. With the prospect of a severe and likely prolonged global economic recession, the correct choice for GM  is to file for bankruptcy and seek an immediate significant liquidity boost from the post-bankruptcy debtor-in-possession (DIP) financing mechanism. This traditional option for failing firms will require a unique twist—assistance of the U.S. government as a meaningful player, but at little risk and with attractive potential returns to the U.S. taxpayer.

The latest chapter in this continuing debate is that the current administration in Washington will likely honor its commitment to provide $25 billion in low interest loans to the major U.S. auto manufacturers for the development of fuel efficient cars. There also is mounting sentiment in the Congress and within the President-elect’s transition team to provide still more assistance, although the exact bailout mechanism is unclear.

The fuel efficient car development request would require, however, that the Energy Department conclude that the borrower has assets that exceed its liabilities and that it is likely to be able to repay the loans. As of September 30, 2008, however, the former was not the case for GM, as the company had total assets of $110 billion but total liabilities of $170 billion. GM must somehow convince Energy Department officials that it is solvent and creditworthy, a dubious possibility now that it has announced it will run out of cash by mid-2009 and will violate loan covenants on about $6 billion in debt very shortly. Unless it secures new sources of capital or unless the government infusion is in the form of equity, GM’s liabilities still will exceed its assets.

Unfortunately, some form of traditional loan guarantee or outright investment in a combined GM/Chrysler entity is destined to fail and to be followed by repeated requests for more rescue funds. As noted, these firms are facing the likely prospect of an extended, severe economic recession in the United States and abroad, not to mention the staggering weight of their own inefficiencies, huge pension and health care benefit packages, and their now clear bankrupt profiles. The latter is based on GM’s Z-Score of -0.17 as of September 2008. GM’s profile is clearer, since Chrysler is a private company and its financials therefore are not available. If the government does increase the loan program for more fuel efficient cars, GM still will need substantial interim support until any tangible benefits from this subsidy are observable.

Now comes the tricky part—what is the alternative to a highly controversial government bailout? If it were not for the potential panicked reaction in global credit markets and in the world’s automotive markets, the answer would be clear. Both GM and Chrysler should file for protection—yes, protection—under the U.S. Bankruptcy Code as soon as is feasible.

The enormous benefits afforded under Chapter 11 to companies, whose assets are protected and whose fixed payments on most liabilities are suspended while they attempt to reorganize in bankruptcy, are clear and known by most advisors to these firms. Another, sometimes overlooked benefit for firms in bankruptcy is their ability to borrow substantial amounts of funds for continued operations under what is known as debtor-in-possession (DIP) financing. This unique aspect of the U.S. Bankruptcy Code gives the provider of funds a super-priority status over all existing unsecured claims and is almost always accompanied by specific collateral, such that the chance of a lender losing any of its investment is quite remote. Indeed, the number of DIP losses to lenders can be counted on one hand from among the thousands of such financings consummated in the past.

GM and probably Chrysler still have some unencumbered assets to qualify. Even if they did not, the super-priority status gives the new lender a greater degree of confidence of being repaid. Ford has fewer unencumbered assets, although its Z-Score is somewhat higher than GM’s.

Critics of this idea will quickly point out that the current market for DIP lending is essentially shut down, as financial institutions are in a massive deleveraging phase, and DIP risk capital, even at spreads of 700-800 basis points (7 to 8 percent) over LIBOR, is currently unavailable. (Circuit City’s $1.1 billion DIP facility, however, did show some life in the DIP market.) Because of this and rather than allowing its domestic vehicle production industry to be sold off to foreign interests, the U.S. government should be the DIP lender of last resort.

I advocate that the government work with one or more conduit organizations—perhaps by merely providing a loan guarantee—such as JPMorgan Chase, Citi, Wells Fargo, and GE, which are experienced in structuring and monitoring these loans. DIP loans can be increased over time, with appropriate fees, to sustain GM over this expected long and likely deep recession. Without this support, GM and Chrysler, I am afraid, are doomed to file for bankruptcy at a later point, with lower recoveries as asset values deteriorate and job losses mount. Indeed, Chrysler already has announced that 50 percent of its workforce would have been laid off if the two firms had merged.

In addition to the DIP support, bankruptcy status enhances the ability of management to renegotiate existing and legacy pension and health care claims, which is much more difficult to accomplish outside the protective confines of the court system. The savings alone on interest payments by GM and GMAC would be at least $16 billion a year, easily covering the interest of about $3.5 billion to $5 billion a year to the government or its conduit on, say, a $50 billion DIP facility.

Some fear that a GM bankruptcy announcement will cause immeasurable harm to the economy and to financial markets. The current situation of "waiting for the other shoe to drop" in the credit market meltdown includes a possible GM/Chrysler bankruptcy filing, and no doubt there will be some negative consumer and vendor fallout should they file.

But, pointing out the high likelihood of bankruptcy—something that I and the credit default swap market have been forecasting for some time—will help reduce the surprise impact. And, the indication of guaranteed government support via the post-bankruptcy DIP financing route could help blunt consumer fears of liquidation, lost warranties, spare parts availability, and other bankruptcy costs that the management and board of GM worry about. Face it, those costs, in the form of lost sales and profits, have already mostly been absorbed as potential customers assess the health of the major auto companies in their purchase decisions.

The management and boards of these two firms, which have been in a state of denial, should face up to the reality of their dismal outlook and request the DIP loan. The government should be given the choice of supporting this unique rescue, concluding that it would be far better for the country and the economy to "right-size" the U.S. auto business now and make it more competitive, rather than to have it deteriorate further and to be sold off at a later date with even more lost jobs and cuts in pension/health care benefits.

Nobody wants to see our American motor carrier icons go into bankruptcy—not even me and others who have been predicting this fate for some time. But, if most stakeholders will be better off and if we can minimize the surprise factor, then Chapter 11 reorganization, not liquidation, with government-sponsored DIP lending is the way to go.