The big story today is the Obama administration’s decisions regarding GM and Chrysler aid (see US Lays Down Terms for Bailout). I won’t spend time re-hashing the specifics; instead, I will provide commentary on the plan as it has been advanced, assuming you already know the specifics.

Overall, I think this plan represents a sensible approach. It recognizes that there is substantial heterogeneity across GM and Chrysler. Their importance to the broader economy differs. GM is obviously the more systemically important firm of the two. Moreover, the two are not on equal footing with respect to future prospects. GM’s product portfolio moving forward is far superior. For these reasons, I have been an advocate of treating GM and Chrysler differently (see Pre-Packaged Bankruptcy, Preventing Moral Hazard, and Aid for Chrysler? Just say No! for details).

Kudos to the auto task force for recognizing this and responding accordingly. As a result, the Obama administration has committed to seeing GM through this crisis. Chrysler, by contrast, is on its own.

The Obama administration will provide additional aid for GM, and has committed to an out-of-court restructuring, provided GM receives substantial concessions from its creditors and its union. In the absence of a meaningful agreement with the UAW and bondholders, at the very least, the US government has pre-committed to act as GM’s DIP financier in bankruptcy, and guarantee its existence through the restructuring process (see Could GM Survive Bankruptcy?). The threat of bankruptcy for GM (hopefully a credible one) should be enough to elicit cooperation from the bondholders and the UAW.

With respect to Chrysler, this is the beginning of the end. The administration has told Chrysler that it has 30 days to strike a deal with Fiat or else it will not receive any additional public funds. This creates a dilemma for Chrysler. It needs Fiat to survive, but Fiat needs the US government to commit a significant amount of capital before it agrees to any deal. After all, Fiat does not intend to inject capital into Chrysler (see Fiasco for Fiat and Chrysler and Fiat Revisited). What is clear is that Chrysler would require significantly more to survive than the $6 Billion that the government has promised in the event that they strike a deal with Fiat (see GM, Chrysler Need More Aid than Requested). Fiat knows that. Moreover, the likelihood that the US government will continue to throw money at Chrysler (in excess of the $6 Billion promised), even if they strike a deal with Fiat, is remote. Fiat knows that too.

So the writing is on the wall. Chrysler is likely finished.

What is unclear to me from the plan as it has thus far been outlined, is whether the US government acts as the DIP financier when Chrysler goes bankrupt, or whether it allows Chrysler to be liquidated. Obama seems to be hinting (as I listen in real time) that the government will act as DIP financier to Chrysler, …but I am skeptical.

Irrespective of whether the US government acts as Chrysler’s DIP financier, Chrysler will serve as a lesson to GM, its creditors, and its bondholders union. Allowing Chrysler to go bankrupt should be enough to wake up GM’s creditors and bondholders union to the reality that US taxpayers will not support them indefinitely.

As a first shot over the bow, the Obama administration began by ousting Rick Wagoner.

UPDATE @ 11:30am

One last point, some have been asking why not just impose bankruptcy now (at the very least for Chrysler) if that will be the endgame anyway. I think the answer to this question lies in the shock that would have reverberated throughout the market. A sudden bankruptcy would have caused panic among stakeholders of all sorts. At this point, bankruptcy for Chrysler is all but assured. Bankruptcy for GM is a real possibility (perhaps 50/50). So the point of today’s action (stopping just short of imposing bankruptcy) is to forewarn market participants. Given this information, it would be prudent for those who have a stake in this outcome to get their affairs in order.

Several months ago, Fiat announced an alliance with Chrysler in which it would take a 35% ownership stake in Chrysler. In a post entitled Fiasco for Fiat, I discussed the alliance’s prospects for success, and what the deal meant for Chrysler and its creditors. With respect to Chrysler’s outstanding debt, I wrote:

As a Chrysler creditor (a U.S. taxpayer), anything that increases the likelihood, even infinitesimally, of receiving a return on my investment makes me happy. The U.S. taxpayer (and by corollary, the U.S. government) should therefore be positively predisposed toward this deal, taking comfort in the fact that, at the very least, in exchange for a 35% ownership stake in Chrysler, Fiat should be commensurately responsible for 35% of the liabilities. This should come as welcome news, assuming Fiat can keep Chrysler viable long enough to repay the U.S. government.

I then expressed incredulity at Fiat’s willingness to sign itself up for 35% of Chrysler’s liabilities:

Personally, I can’t believe that signing up for 35% of the liabilities of Chrysler would not be enough to scare off Fiat, …or any other potential investor for that matter.

But who am I to object. Caveat Emptor.

Well guess what?? Surprise, surprise. Fiat is not willing to assume 35% of the liabilities. According to recent reports (see Fiat Not to Take Debt), Fiat, while interested in owning 35% of Chrysler’s upside, is not interested in inheriting 35% of Chrysler’s problems. It’s like Geithner’s Public Private Investment Partnership – Fiat wants to be able to benefit from the upside while Chrysler’s current shareholders/creditors bear the downside risk (heads I win, tails you lose). According to the AP article:

A public tiff between Italian automaker Fiat SpA and Chrysler LLC apparently ended Friday when Chrysler rescinded a statement on its Web site that Fiat would be responsible for part of Chrysler’s debt if the two companies join forces.

Chrysler, in a Web video on Thursday explaining why an alliance for the two companies would be good for Chrysler and the country, said Fiat would be responsible for 35 percent of what Chrysler owed to the U.S. government.

But Fiat on Friday denied that it would be responsible for any of Chrysler’s debt.

…Chrysler, in a statement issued Friday, reversed the claim it made on the Web and said Fiat would become an equity holder.

“To clarify, this does not mean Fiat would assume responsibility for any of Chrysler LLC’s debt,” the statement said.

Fiat Group said in a statement Friday said it “intends to make absolutely clear that the proposed alliance will not entail the assumption of any current or future indebtedness to Chrysler.”

I have to admit, from a transactional perspective, I am not sure exactly how such an arrangement could be structured – i.e., how a firm can acquire 35% of the residual claims to a firm but not also be liable for 35% of the outstanding claims on the firm. Call me crazy, but that’s what I thought “ownership” meant. But that’s something for the lawyers to figure out.

What most interests me is what Fiat’s lack of commitment to Chrysler might mean for Chrysler’s prospects of receiving additional government aid. Answer: It cannot bode well for Chrysler.

Personally, I do not believe Chrysler deserves additional government loans with or without Fiat (see The GM and Chrysler Plans, Aid for Chrysler? Just say No! and Is the End Nigh for Chrysler? for details). That notwithstanding, the latest Fiat developments cannot help.

I’ve had a series of interesting conversations with thoughtful, articulate, and intelligent academics who span disciplinary boundaries (finance, economics, sociology, and psychology) about what the future of the field of financial economics should/will/might look like. In light of the financial crisis, this has been a popular topic of conversation.

There have been two recurring themes:

1. Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?
2. Is shareholder wealth maximization the appropriate objective function?

With respect to the former, I have been engaged in conversations with folks who echo some of Willem Buiter’s concerns. In a brilliant blog post (see State of the Art Uselessness) Buiter contends:

The most influential…theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity – both funding illiquidity and market illiquidity – are also impossible…

[The] complete markets…theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’…is a much better one than that of ‘complete markets’.

My Comment: One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down. But back to Buiter:

In…approaches to monetary theory…the strongest version of the efficient markets hypothesis (EMH) was maintained.  This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.

My Comment: I would go one step further and suggest that associated with the EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail. Buiter alludes to that as well, although he does not come right out and say it:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH…are not models of decentralised market economies, but models of a centrally planned economy.

My Comment: Interesting, so in treating human behavior as governed by the tenets of homo economicus, our agentic models actually obviate agency.

In one of the conversations that I had with a prominent game theorist and a well-regarded entrepreneurship scholar, some of these issues came up. For example, we discussed the importance of incorporating the varying belief-structures of the participants in a market into the value equation. The participants themselves may have such varying beliefs about the market that, in effect, they might actually be playing different games governed by different rules. In such a circumstance it might be better to analytically treat assets as not having an intrinsic (fundamental) value, but rather, to treat the “value” of the assets as contingent upon participants’ subjective beliefs – i.e., the value of the asset is only worth what the next guy is willing to pay for it.

With respect to the second issue (shareholder wealth maximization), I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

As an alternative, a group of scholars in strategy have offered a Stakeholder view of the firm. Stakeholder Theory, most closely associated with Edward Freeman (see wikipedia for a brief overview), suggests that firms ought to incorporate the interests of various stakeholders into their decision calculus, and not simply what’s best for shareholders. They argue that this would result in a firm that generates value not just for shareholders, but also for stakeholders (suppliers, customers, employees, communities, etc.). It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties).

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

There hasn’t been much inspiring me to write these days. The news across the board has been pretty much the same – the economy stinks, joblessness is increasing, housing continues its downward spiral, consumption is nowhere near recovery, bankruptcies are on the rise, banks are under stress, corporations are struggling, and Jon Stewart continues his hysterical rant at the folly that is CNBC. Did I miss anything??

Seems like these days we’re in a holding pattern waiting for the results of the bank stress tests and a decision on the GM/Chrysler aid.

So while we’re all waiting, I came across an interesting issue in the debate about the merits of various approaches to the banking crisis (e.g., nationalization versus ringfencing troubled assets versus good bank/bad bank).  Paul Krugman and Simon Johnson (and the rest of the folks at The Baseline Scenario) have recently talked about what to do about bank liabilities; specifically, debt (not liabilities to depositors).

As Krugman points out (see Anti-nationalization Arguments):

some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

What’s clear, however, is that the current system, of implicit maybe-kinda guarantees on bank liabilities — call it wink-wink-nudge-nudge-say-no-more banking policy — is failing badly.

From The Baseline Scenario (see Quick Note on Liabilities):

…the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.

What’s clear is that several of the largest US banks (those subject to the stress test) are insolvent – their liabilities exceed the value of their assets. For those banks that are insolvent, shareholders will get wiped out, probably through nationalization, however administered. After shareholders get wiped out, the fact remains that the value of the remaining assets (after depositors are made whole) will not make existing creditors whole.

So the question remains, should the US government (taxpayers) guarantee the liabilities?

One of the issues, as I see it, depends upon the identity of those creditors. And this is where it gets complicated. Maybe this is what Krugman means by “deeply technical” (although perhaps he had something else in mind).

To the extent that US bank creditors include large sovereign wealth funds and central banks, forcing bondholders to take a haircut may come with political consequences. In contrast to small, private creditors, sovereigns have political and economic recourse. And, after all, we will probably need to rely on some of these same actors to fund our current deficit.

For this reason, I am inclined to believe that we will be forced to guarantee the liabilities of banks we nationalize, a la Sweden.

And we wait.

I received an e-mail message yesterday from the folks at Weber Shandwick (GM’s PR firm) calling my attention to a recent blog post by Tom Wilkinson, GM’s news relations director (see Why Not Bankruptcy?).

In that post, Mr. Wilkinson objects to those who have called for bankruptcy reorganization as a viable option for GM. He writes:

Let me briefly review why we think a tough out-of-court reorganization is best for GM, the taxpayers, and other stakeholders.

Bankruptcy reorganization takes cash – lots of it. For a company like General Motors to operate in Chapter 11, it would need massive debtor-in-possession loans. With credit markets frozen, there is realistically only one source of such loans – the federal government. We estimate loans needed to reorganize GM in Chapter 11 could top $100 billion, far more than the out-of-court fix envisioned in our restructuring plan.

MY COMMENT: OK, what’s the problem with that? So the government becomes the de facto DIP financier. And perhaps it is to the tune of $100B (although I think that might be a bit overstated). But that money does not fall down a sinkhole. It is a loan that is collateralized by GM’s enterprise, whatever the value of that may be. The real question is not whether the federal government would have to pony up $100B now if it forced GM into bankruptcy. The government could easily reach (if not exceed) that amount under the current arrangement, only in $10-20B increments.

The real question is whether a GM turnaround would result more quickly, efficiently, and effectively via bankruptcy; whether GM emerges as a healthier organization after bankruptcy; and, whether the likelihood of the federal government getting paid back is higher as a result.

I am not necessarily opposed to additional out-of-court aid for GM, provided that it come with extremely strict terms. However, in many ways, bankruptcy allows GM greater flexibility to reorganize (see GM Plan, Pre-Packaged Bankruptcy, and Preventing Moral Hazard for details).

Mr. Wilkinson continues:

One reason this [$100B DIP financing] figure is so large is that GM’s revenues would plunge in bankruptcy. I ask: “Would [customers] buy a car or truck from a company in bankruptcy, when there are similar products available at another dealership right down the block?” I expect that if they were honest, they would answer “Probably not.” So why do they expect other shoppers to behave differently? The GM viability plan includes a detailed analysis of this revenue risk (Appendix L, Exhibit 3), an analysis bankruptcy advocates seem eager to dismiss or ignore.

MY COMMENT: I am not so sure the answer to Mr. Wilkinson’s question is “no”, or even “probably not”. And this is where I take some issue with the GM plan.

GM assumes that post-bankruptcy revenues for their products will fall by around 35%-40% (compared with the non-bankruptcy alternative). They use Daewoo’s experience as a benchmark. They also try to gauge potential consumer demand via survey instrument.

I am not sure that Daewoo is the right benchmark. Moreover, I am skeptical of the surveys. The fact is that a GM bankruptcy would be very different from a “traditional” bankruptcy. As Mr. Wilkinson points out, in the case of GM, the federal government will act as the DIP financier. With the federal government as the DIP financier, GM not only has the explicit backing of the US government, but the implicit guarantee that it shall continue as a going concern. Moreover, the federal government can stand behind GM warranties. Those stylized facts alone are enough to diminish consumer flight.

It’s no surprise that GM management is strongly advocating an out-of-court solution. After all, an out-of-court solution maximizes their chances of continued employment with GM.

With respect to GM’s position on the matter, the insight of Milgrom and Roberts (RAND, 1986) rings true: Beware (and be skeptical) of information provided by interested parties.

So, YES, GM could survive bankruptcy, and we needn’t be frightened by the prospects, …no matter how much GM tries to convince us that it would spell the apocalypse.

As I mentioned several weeks ago (see Visit to the FT), I recently spent some time with Adam Jones, author of the FT Management Blog, and Business Education Editor at the Financial Times. Adam conducted a brief interview in which we discussed Business Schools, and job prospects for Business School graduates. The interview appeared in the on-line version of the Financial Times 2009 Business School Rankings.

Below is a brief overview of my comments.

On applications:

• applications to full-time MBA programs near all-time highs
• applications to Ph.D. programs near all-time highs
• applications to corporate-sponsored, and executive, programs way down

On job prospects:

• the current job market (for 2009 graduates) is extremely challenging
• the job market for 2010 graduates will likely be worse
• the job market for 2011 graduates is uncertain but likely difficult, as the post-recession recovery will be slow

On majors, course selection, and job opportunities for finance students:

• finance students are becoming more flexible (looking in consulting, general management, accounting, and other fields)
• finance students are looking in non-traditional markets (Dubai, Abu Dhabi, continental Europe, and Asia)
• increasing interest among students in general management courses, and in general management as a major

As promised, a link to the web page with full video is below. Unfortunately, the Financial Times would not allow me to embed the video on my site.