In previous posts (see Chrysler Still Needs a Miracle or Chrysler/Fiat Update) I suggested that the Fiat/Chrysler deal looked increasingly like a longshot. Fiat was asking for deep concessions from both the auto union and Chrysler’s creditors, and it seemed unlikely that Fiat was going to receive those concessions.

But over the past few days, the Obama Administration, the auto union, and Chrysler’s creditors seemed to have come to some sort of understanding (see Treasury Close to Deal with Chrysler Creditors, Chrysler Reaches Agreement with UAW, and UAW Gets 55%).

Hallelujah??

Maybe, but not so fast. Several issues remain:

1. Creditors must agree to the debt cancellation.

According to the NY Times:

Chrysler has about $6.9 billion in secured debt owned by big banks like Citigroup and JPMorgan Chase and a group of hedge funds. Under the proposal, all of the debt would be canceled in exchange for $2 billion in cash…

The Treasury drew up the latest proposal in consultation with Chrysler’s biggest secured creditors, which hold about 70 percent of the company’s secured debt. It requires approval by almost all of the secured lenders. That could be difficult as some lenders, including several hedge funds, may hold their ground and reject it.

2. The issue of pay for union workers must still be resolved. Although Chrysler, the federal government, and the union have come to terms with respect to pension and benefits, my understanding is that they have not yet reached a meaningful agreement to reduce wages. Just how important are wage reductions to Fiat? That remains to be seen. According to the Michigan Messenger:

The new agreement does not cut wages, but it does apparently reduce Chrysler’s commitment to pay into the UAW-run retiree health care fund.

3. According to the latest accord, the auto union will get a 55% equity share in Chrysler. The US government will get a 10% share. Fiat would get a 20% share. Where does the other 15% go? Is this 15% set aside for Fiat depending upon whether it meets performance goals? Will this 15%, or a portion of it, get doled out to Chrysler’s creditors? This was not entirely clear to me.

4. Ultimately, Fiat needs to agree to be party to the alliance. Until that happens, there is no deal. Time will tell if these concessions are enough to convince Fiat that the deal is worthwhile.

Nevertheless, given the concessions that all parties have made to help Chrysler avert bankruptcy, a Fiat alliance seems far more likely today than it did as little as one week ago. Chrysler is no longer looking for a miracle. Perhaps now just a random act of kindness.

But assuming a Fiat/Chrysler deal goes through, the question then becomes: Is this the best outcome for Fiat, Chrysler, and the auto industry? It is not entirely clear. The global auto industry continues to be plagued by massive overcapacity. Keeping a weak competitor around will certainly not resolve systemic overcapacity.

For Fiat, it might be a bit premature to re-enter the U.S. market (the most competitive auto market in the world) and sign on for a complicated global expansion/integration (see Fiasco for Fiat?). Let’s also not forget that Fiat is a firm that, as little as two years ago, was on the verge of bankruptcy itself.

Finally, for Chrysler, it is not clear that its products (even with technology infusions from Fiat) can improve quickly enough for it to once again become a profitable enterprise. For this reason, and as I’ve mentioned before, Chrysler likely needs more than Fiat and an additional $6 Billion infusion from the federal government to survive.

So even if the deal goes through this week, it is entirely possible that Chrysler might end up right back in the same place – on the verge of bankruptcy.

And we wait…

Last week, in the post Chrysler/Fiat Update, I suggested that Chrylser’s debtholders would likely be better off with Chrysler in bankruptcy. I wrote:

Some creditors (e.g., secured bondholders debtholders) would likely be better off with Chrysler in bankruptcy than make the kinds of concessions that would allow the Fiat deal to go through.

For this reason, among a host of others, I concluded:

Chrysler now needs a miracle to survive.

Sure enough, as reported yesterday in the Wall Street Journal (see Banks Reject U.S. Terms for Cutting Chrysler Debt), Chrysler’s debtholders seem unwilling to make the necessary concessions.

A group of big banks and other lenders rebuffed a Treasury Department request that they slash 85% of Chrysler LLC’s secured debt, proposing instead to eliminate about 35% in exchange for a minority stake in the restructured car maker and a seat on its board.

The lenders’ counteroffer marks a significant act of brinksmanship as the banks and the Obama administration’s auto task force duel over concessions to avoid liquidating the country’s third-largest car company.

In their five-page counteroffer, which was sent to the Treasury late Monday, the lenders said they are prepared to cut Chrysler’s first-lien debt by $2.4 billion, or down to about $4.5 billion, in exchange for a 40% equity stake and a Chrysler board seat, according to a copy of the proposal provided by individuals outside the lenders’ group.

In making their case for a significantly smaller sacrifice than what the government wants, the lenders have argued that their fiduciary duty to their own shareholders and investors requires them to recoup as much as possible from the car maker. The lenders have told Treasury officials they believe they could recover at least 65% of their loans if Chrysler is liquidated in bankruptcy.

Tick, tick, tick. We are now one week from the government imposed deadline. And we aren’t any closer to a deal. Fiat wants the auto union and Chrylser’s creditors to grant more concessions. Chrylser’s creditors and the auto union do not seem particularly motivated to make such concessions. What’s more, they both want Fiat to put more skin in the game.

Looks like time for that miracle is running out fast. Now let’s see if the Obama administration has the fortitude to make good on its bankruptcy threat…

From the vault of “Oh Gee, What a Shock” comes the latest pronouncement from Fiat: Concessions or No Chrysler Deal. According to the Associated Press:

Automaker Fiat Group SpA will walk away from a deal to take a 20-percent stake in Chrysler LLC if the U.S. automaker’s unions don’t agree to major cost cuts, Fiat CEO Sergio Marchionne said in an interview published Wednesday.

…Chrysler…needs concessions from creditors and unions to ink the Fiat deal.

My comment: As I suggested in a prior post (see Finally a Sensible Approach), Chrysler needs much more to survive than Fiat and the $6 Billion that the US Government has promised. Moreover, since Chrysler has no other options and the federal government has given Chrysler an ultimatum with respect to the Fiat deal, Fiat can play a very strong hand in any negotiation. And they will.

“Absolutely we are prepared to walk. There is no doubt in my mind,” Marchionne told the Toronto Globe and Mail. “We cannot commit to this organization unless we see light at the end of the tunnel.”

Marchionne said there is a 50 percent chance the deal will fail because of lack of progress in labor negotiations in both the United States and Canada.

“The dialogue is out of sync,” Marchionne said. “I think they need to see what state the industry is in. Canada and the U.S. are coming in as the lender of last resort. … No one else would put a dollar in. This is the worst condemnation of the viability of this business.”

My comment: I think Marchionne’s estimate, that there is 50% chance that the deal goes through, is wildly optimistic. As with GM, it will be very difficult for Fiat/Chrysler to extract meaningful concessions from the auto unions and Chrysler’s various creditors. Some creditors (e.g., secured bondholders debtholders) would likely be better off with Chrysler in bankruptcy than make the kinds of concessions that would allow the Fiat deal to go through. Therefore, and as I alluded to in my previous post, Chrysler now needs a miracle to survive.

And we wait…

Advertising Age recently asked me to write a short Op-Ed summarizing my reaction to the Obama administration’s stance toward GM and Chrysler. You can find the full piece on the Advertising Age website, or by clicking on the accompanying link (The Obama Administration Got it Right).

For those of you who have followed this blog, my opinion should not come as a surprise. I have expressed sentiment consistent with the Auto Task Force’s decision for the last half-year or more (see GM and Chrysler: Finally a Sensible Approach, Pre-Packaged Bankruptcy, Preventing Moral Hazard, and Aid for Chrysler? Just say No! for background).

Given that the decisions made by the Obama administration were largely consistent what I had been advocating, I am sanguine.

In January I predicted (see Notable Bankruptcies of 2008) that “major” bankruptcies in 2009 would challenge the 383 mark set in 2001 (the high-water mark after the dotcom bubble). I even suggested that it was possible that we could exceed 400 “major” bankruptcies in 2009.

According to Bankruptcydata.com, there have been 90 “major” filings thus far in 2009. Assuming that bankruptcies are equally distributed throughout the year, this puts us on pace for 360 bankruptcies. I fully expect the filing pace to quicken as the year goes on, and as the economy continues to deteriorate.

Below you can find an updated list of what I see as the “noteworthy” bankruptcies of 2009, as reported by Bankrupctydata.com (please note that this is not an exhaustive list):

• Bearingpoint, Inc. (Consulting)
• BI-LO, LLC (Supermarkets)
• Charter Communications, Inc. (Telecom)
• Chemtura Corporation (Chemicals)
• Fleetwood Enterprises, Inc. (Recreational Vehicles)
• Fortunoff Holdings, LLC (Retail)
• Goody’s LLC (Retail)
• Herbst Gaming, Inc. (Gambling)
• Idearc (Publishing)
• Journal Register Companies (Newspapers)
• Lyondell Chemical Company (Chemicals)
• Magna Entertainment (Gambling)
• Masonite Corporation (Real Estate Manufacturing)
• Midway Games, Inc. (Entertainment Software)
• Monaco Coach Corporation (Recreational Vehicles)
• Nortel Networks, Inc. (Telecom)
• Pacific Energy (Oil & Gas)
• Philadelphia Newspapers, LLC (Newspapers)
• Ritz Camera Centers, Inc. (Retail)
• Shane Company (Jewelry)
• Silicon Graphics, Inc. (IT/Computing)
• Silver State Bancorp (Banking)
• Smurfit-Stone Container Corporation (Paper Manufacturing)
• Spectrum Brands (Consumer Products)
• Star Tribune Companies (Newspapers)
• Sun-Times Media Group, Inc. (Newspapers)
• Tarragon Corporation (Real Estate)
• Trump Entertainment (Gambling)
• WL Homes, LLC (Real Estate)
• Young Broadcasting, Inc. (Television)

In addition to “major” bankruptcies (e.g., those firms with assets greater than $50M) tracked by Bankruptcydata, the U.S. government tracks all bankruptcy filings by type (e.g., Chapter 7, Chapter 11, Chapter 13). You can find detailed bankruptcy statistics at the U.S. Courts website. Business bankruptcies for 2008 came in at 43,546, slightly shy of my 45,000 prediction; however, that still represents a 54% increase over 2007, and the greatest number of business bankruptcies since 1997.

The chart above presents annual (calendar year) business bankruptcy filings from 1990-2008 (click on the picture for a larger image). Interestingly, the number of filings had been trending steadily downward from 1990 through 2006. In 2007 the numbers started to reverse course. I expect that trend to continue in 2009, with total business bankruptcies reaching 55,000.

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.

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.

Thomas Oliver recently penned a piece for the Atlanta Journal Constitution in which he referred to my post Notable Bankruptcies of 2008. In The Year of Bankruptcy Mr. Oliver notes:

It has to happen. As painful as it is.

And there is no magic wand or legislative action or Federal Reserve printing press that can make it all right.

The laws of economics are stronger than any policy…

And so the deleveraging, or debt reduction, of the American economy continues…

Twenty years of excess leveraging can’t be worked out of the system in a normal recession…

I could not agree more with Mr. Oliver. As I explained in my post, I fully expect business bankruptcy filings to increase in 2009. Bankruptcies will likely increase to around 55,000. And as I expressed to Mr. Oliver, I would not be surprised to see bankruptcies surprise to the upside.

As with banks and financial institutions, for many firms in the broader economy, it’s not just a liquidity problem. It’s a solvency problem. Firms borrowed excessively, and at rates that were too cheap – not reflective of their inherent risk. All was fine as long as they were able to refinance the debt, and delay the day of reckoning.

But then the party ended.

We can analyze the situation and pretend that the problem affecting many of these firms is the lack of available credit; or, we can recognize the reality that, for many, their business strategies have serious flaws. I look at firms like Sirius XM (see So Long Sirius), Circuit City, Trump Entertainment, and Bearingpoint (among others) and can only conclude that these are not good firms suffering from unfortunate short-term liquidity problems. Rather, they are poorly managed firms in incredibly competitive markets. This makes their overall value propositions, market positions – or both – extremely unattractive.

Those are problems of the more permanent kind.