Bankruptcy and the Detroit Three:

Jim's excellent post notes one-half of the argument against a Detroit bailout--that it is an unusually bad case for a bailout because of the need for long-term structural reform that a bailout is not going to provide.

But the other half of an argument against a bailout is that GM (or the others, but I'll use GM to illustrate the point) presents an unusually good case for Chapter 11 reorganization. GM is, in fact, the textbook example of what Chapter 11 was invented to do. GM almost certainly will not liquidate, and if it does, then this will almost certainly be beneficial from a social perspective because it will illustrate that the resources are better deployed elsewhere in the economy.

The fundamental question for any bankrupt business is whether the business is economically failed or financially failed.

Economically Failed: If the business is economically failed, then this means that the current deployment of assets to that company is economically inefficient--i.e., the opportunity cost of using the assets in this manner is less than their current deployment. For instance, if a typewriter manufacturer were to file bankruptcy today, it is likely that the firm would be economically failed. There is a limited market for typewriters and it is shrinking. The financial, physical, and human capital dedicated to typewriter manufacturing would probably be better redeployed to other places in the economy, such as to making computers.

Financially Failed: A financially failed firm is one where the value of the current asset deployment still exceeds the opportunity cost of the assets, but the firm is temporarily unable to generate sufficient revenue to cover its costs. This might be either because revenues are too low or costs are too high. For instance, when Texaco got tagged with a gigantic liability judgment by Pennzoil, Texaco was basically a healthy enterprise with one gigantic liability to deal with. When Boston Market filed bankruptcy, it used bankruptcy to close unprofitable stores (it basically expanded too fast)--there the liabilities were the contingent liabilities of landlord claims associated with closing the stores. When the Pittsburgh Penguins filed bankruptcy, there the idea was both to deal with certain liabilities (Mario Lemieux's unproductive contract) and also to try to generate more revenues by renegotiating bad contracts for sale of concessions, etc.

The basic idea of a financially failed enterprise is that there are economic rents or "going-concern surplus" from the current deployment of assets. The idea of a Chapter 11 reorganization is to preserve this going-concern surplus or economic rents.

GM is a classic example of a firm that looks like a financially failed rather than economically failed. We have both physical capital and human capital with high firm and industry-specific value, namely factories and uniniozed work forces, which value would be lost if those assets were redeployed. It also has at least some going-concern value in its goodwill and namebrands.

What GM needs to do is shed labor contracts, retirement contracts, and modernize its distribution systems by closing many dealerships. It appears to need new management as well. Bankruptcy gives them the opportunity to do all that.

So GM will almost certainly reorganize, as will the other car companies. GM does not look like an economically-failed typewriter manufacturer at this point, but rather a financially-failed company that needs to reorganize and go forward.

Federal Assistance for a Reorganization: Which brings us to the final benefit of a reorganization over a bailout--reorganization forces a market test on the enterprise to determine what is economically valuable and what is not. A bailout will inherently be a political process. Political processes are not in any way designed to determine which assets are allocated in an economically-efficient manner.

Some have expressed concern that the credit crunch has made DIP financing temporarily unavailable. I have seen no strong evidence that this is the case, although it is certainly possible. But if this is the case, then this seems like this might be a proper place for governmental intervention--basically have the government provide the DIP financing or guarantee the DIP financing (thanks to my colleague Steve Eagle for suggesting this idea).

To the extent that there was a rationale for the TARP, it was that there was a liquidity crisis in financial markets, not a solvency crisis. The idea was to save healthy banks from a bank run, not unhealthy banks from their own bad decisions. Well, GM is unequivocally a solvency problem, not a liquidity problem. As George Will has observed, it is not a quesiton of whether GM will be allowed to fail, it already has failed.

But even though GM is insolvent, an absence of DIP financing to reorganize GM in Chapter 11 would presumably be a liquidity crisis. So whereas a straight GM bailout does not follow from the logic of the TARP, it is at least arguable that the provision of DIP financing as part of a reorganization filing is consistent with the underlying premises of the bailout. But it is crucial that this money be made available, if at all, only as part of a chapter 11 filing that forces new discipline and ideally only after a demonstration that there really is no private DIP financing available.