Written Testimony of Mark Zandi
Chief Economist and Co-Founder Moody’s Economy.com
Before the U.S. Senate Banking Committee
“The State of the Domestic Auto Industry: Part II”
December 4, 2008
Mr. Chairman and members of the Committee, my name is Mark Zandi; I am the Chief Economist and Cofounder
of Moody’s Economy.com.
Moody’s Economy.com is part of Moody's Analytics, an independent subsidiary of the Moody’s Corporation.
My remarks represent my personal views and do not represent those held or endorsed by Moody’s. Moody’s
Economy.com provides economic and financial data and research to over 500 clients in 50 countries, including the
largest commercial and investment banks, insurance companies, financial services firms, mutual funds,
manufacturers, utilities, industrial and technology clients, and government at all levels.
My testimony today focuses on four main points:
- The federal government should provide financial help to the domestic automakers. Without any
help, the automakers will quickly end up in bankruptcy, resulting in liquidations and hundreds of
thousands of layoffs at a time when the broader economy is suffering its worst recession since the
Great Depression.
- Under the most likely outlook for the economy and auto industry, the restructuring plans in which
the Big Three have requested $34 billion in loans will not be sufficient for them to avoid
bankruptcy at some point in the next two years. They would ultimately need $75 billion to $125
billion to avoid this fate.
- The restructuring plans, if fully executed, could result in a viable long-term domestic auto
industry. However, given the very difficult changes this will require of the Big Three and their
various stakeholders, there is a considerable risk that they will not be executed effectively. This
opinion applies most strongly to GM and Chrysler; Ford appears much better positioned to make
the changes necessary.
- I recommend that Congress provide the $34 billion in aid that the Big Three have requested in two
tranches in exchange for warrants and restrictions on executive compensation and dividend
payments. The first payout should be sufficient to forestall the automakers' imminent disorderly
bankruptcy at an extraordinarily fragile time for the economy. The second payout should be made
only if the restructuring plans are proceeding successfully. Congress should also at the same time
make it clear that if the restructuring plans are unsuccessful, then no more government loans will
be forthcoming. Instead, Congress will work to ensure that there is an orderly bankruptcy process
by providing financing in bankruptcy and guaranteeing warranties on new vehicles sold.
Point 1: The domestic auto industry needs financial help, and the federal government should provide
it.
Without any government help, the Big Three will quickly end up in bankruptcy and be effectively
liquidated, resulting in hundreds of thousands of layoffs at just the wrong time for the sliding economy.
They would file for Chapter 11, a restructuring, but it would likely turn into a Chapter 7, a liquidation.
Their factories and other operations would be shut down and their assets sold to pay creditors. Given the
collapse in the financial system and resulting credit crunch, debtor in possession, or DIP, financing would
be all but impossible to get. Bankrupt firms need DIP financing to operate their businesses – to pay
suppliers, finance inventories and meet payroll – while they restructure. It is a risky business for the DIP
creditors even in good times, but they are a senior creditor when the bankruptcy court distributes the
bankrupt firms' assets, and they also charge high rates and fees for the risk. However, in the current credit
crunch nothing will persuade creditors to take the risk.
GM appears to be in worse financial shape than Chrysler, which is in much worse shape than Ford.
GM is burning through cash quickly, and at the current rate could run out of the cash necessary to operate
in the next several weeks. Chrysler can avoid bankruptcy longer, but given the poor prospects for vehicle
sales and their almost certain loss of market share to the transplants and foreign imports, not much longer.
Ford has more financial latitude, but it too would be at significant risk of bankruptcy if GM or Chrysler
failed given the disruption to their supply base, dealers and creditors.
That would be very damaging to the sliding economy. The Big Three employ fewer than 250,000
people in the U.S., but given their broad links into the rest of the economy, closer to 2.5 million jobs would
be immediately at risk. The auto industry has among the largest economic multipliers of any industry. For
every one lost job in auto assembly, another nine jobs are lost in other supplying industries (see Table).
Industries that would face considerable negative repercussions include auto suppliers, auto dealers, steel
and metal suppliers, plastic and rubber companies, healthcare providers, and trucking and freight operators.
Hundreds of thousands of people would be laid off at a time when the economy is already set to lose
several million jobs. The hit to already record low consumer and business confidence would be devastating.
The economic fallout on the already very hard-hit industrial Midwest would be disastrous. The
Michigan and Ohio economies have been in recession more or less since the beginning of this decade, and
the collapse of the Big Three would completely undermine their economies well into the next decade. Other
state economies that would be significantly hurt include Indiana, Illinois and Wisconsin. Exacerbating the
economic fallout in the industrial Midwest is that unemployed workers would find it difficult to move to
perhaps Kentucky, Tennessee or Alabama to work for the stronger transplants. Their home values have
fallen so sharply that many are now underwater – they owe more on their homes than they are worth. To
move would require that they put more into their home or to default on their existing mortgages.
Point 2: It would cost the federal government $75 billion to $125 billion to keep the Big Three out of a
near-term bankruptcy, much more than the $34 billion requested by the Big Three in their restructuring
plans.
My $75 billion to $125 billion cost estimate is based in part on the expectation that light vehicle sales
will average close to 11 million units in 2009, 13.5 million units in 2010, and less than 15 million units in
2011. For historical context, vehicle sales averaged almost 17 million units annually from 1999 to 2006.
The extraordinarily weak vehicle sales outlook is due to three negative forces: the current sharp decline in
employment and surging unemployment, the very severe credit crunch that is undermining the availability
of vehicle loans and leases, and the significant amount of spent-up vehicle demand created earlier in the
decade as the automakers used increasingly aggressive financial incentives to support vehicle demand.
The nation's job market is rapidly weakening. Some 1.2 million net jobs have been lost so far this year,
and the unemployment rate has risen by over 2 percentage points to 6.5%. The recent level of
unemployment insurance benefit claims suggests that job losses are running at over 300,000 per month.
The downturn is broad-based across industries and regions. Sizable job losses are occurring through
construction, manufacturing, retailing, transportation and distribution, financial services, and professional
and business services. Thirty-three states are now considered to be in recession (see Chart). i The current
national recession is already extraordinarily long and broad-based and will very likely be the most
debilitating economic downturn since the Great Depression.
A principal contributing factor to the severity of the current recession is the near collapse of the global
financial system and the resulting credit crunch. Credit markets remain badly shaken. Bond issuance has
come to a standstill, with no residential and commercial-backed securities issuance in recent months and
very little issuance of below-investment-grade corporate bonds and emerging market debt. Asset-backed
issuance of credit cards, student loans and vehicle loans has been severely disrupted. The Treasury
Department and the Federal Reserve recently announced plans to establish a lending facility to revive the
asset-backed market, but this will take time to effectively implement, and there is no guarantee it will
succeed quickly after that. Vehicle lenders are also extraordinarily nervous about the surge in vehicle loan
credit problems; delinquency rates are already at record highs (see Chart). All of this suggests that potential
car buyers will have trouble getting loans or leases well into next year.
Also weighing on vehicle sales is the large amount of spent-up vehicle demand. Given broad
demographic, wealth and income trends, underlying new vehicle sales are at best 16 million units annually
(see Chart).ii The automakers were able to maintain sales of closer to 17 million units during the first half
of this decade only by providing increasingly large discounts and easier financing terms. At the peak of the
discounting in 2007, the average incentive was worth over $6,000, equal to 25% of the average vehicle
price at the time. This is about double the $3,000 in incentives that automakers were giving buyers in
1999.iii Total spent-up vehicle demand is estimated to be over 10 million units; at the current sales pace, the
entire auto industry would have to shut down production for nearly a year to work it all off.
Vehicle sales will eventually return to their underlying annual pace of 16 million units, but only when
the job market stabilizes, credit flows more freely, and the spent-up demand is worked off. It could well be
two decades or more before sales return to the 17 million unit sales pace that prevailed during the first half
of this decade.
The cost of keeping the Big Three out of bankruptcy also significantly depends on their ability to slow
the decline in their share of total vehicle sales. Their share has been steadily falling since the mid-1990s
from nearly three-quarters of the market to less than half in recent months (see Chart). This reflects many
factors, but most critically the higher gasoline prices of recent years. Gasoline prices, which had been as
low as $1 for a gallon of regular unleaded at the start of this decade soared to over $4 a gallon at its peak
this past summer. Prices have since receded to below $2 a gallon, but the damage to the Big Three's market
share has been done. Even despite lower gasoline prices, vehicle buyers likely still expect higher prices in
the future and will not quickly return to buying the Big Three's less fuel-efficient vehicles.
The Big Three's market share will come under even more intense pressure given their current financial
problems. Potential buyers will fear that their new car would not be serviced properly and any warranties
could become void. Foreign automakers will also step up their efforts to gain market share through more
aggressive marketing and discounting. Although some of these pressures may be mitigated by government
help, they are unlikely to be completely dispelled.
Given the long-running decline in the Big Three's market share, the prospects for higher gasoline
prices in the future, and even more intense competition from foreign automakers, it will be very difficult for
the Big Three to hold onto to their share of the market. If they are can maintain close to 50% market share,
the cost of avoiding near-term bankruptcy will be only $75 billion. If their share falls to 40% over the next
two years, however, then the cost will be closer to $125 billion.
Point 3: The restructuring plans put forth by the Big Three are sound in theory, but effectively
executing them so that that the automakers become viable companies will be a significant challenge.
Each automaker has outlined dramatic changes to return to long-term profitability. The measures they
envisage include deep cost-cutting by closing facilities and reducing more hourly and salaried workers.
They also plan to focus on producing more fuel-efficient cars and crossovers, rationalizing their brands and
retail outlets, and refocusing their marketing efforts. All these actions are critical to turning the automakers
around.
It is important to recognize that the automakers have made significant strides in restructuring their
operations and reducing their costs in recent years. The industry's unit labor costs – labor compensation per
unit of output – have actually declined during this decade through 2006.iv In 2006, unit labor costs fell by
nearly 8%. The only other manufacturing industry to experience a larger decline in labor costs was the
wireless telecommunications industry (see Table). Given the considerable United Auto Workers wage and
benefit concessions in 2007, further substantial cost savings would occur over the next several years. The
automakers and the UAW have thus shown both the willingness and the ability to make the significant and
difficult changes necessary to become more productive and competitive.
Despite this clear progress, it will be very difficult for the Big Three to make the even more substantial
changes now needed to quickly become viable companies. This is evident in that most of what the Big
Three outlined in their restructuring plans had already been announced. There is nothing particularly new in
the plans they put forth in part because their current plans are so ambitious and in part because it is difficult
to envisage other changes that could be implemented anytime soon.
The most significant new information in the restructuring proposals is GM's plan to cut its debt load
roughly in half. This would require significant concessions by GM's debt holders, and it is not at all clear
they would be willing to make the necessary compromises, at least on the terms GM is hoping for.
Conspicuously missing from the plans is exactly what more the UAW will be required to do. For the Big
Three to become viable will require substantially smaller headcounts and other compensation concessions.
The UAW can reasonably argue that it has already done a lot to help the Big Three, but it is not enough.
The broader point is that all of the stakeholders in the Big Three, including management, shareholders,
debt holders, the UAW, suppliers and dealers, will be required to make very substantial financial
compromises very quickly to make this all work out as outlined in the Big Three's restructuring plans.
Though possible, this seems unlikely.
Point 4: The federal government should provide the $34 billion in financial aid requested by the Big
Three in two tranches. The first payout should be sufficient to forestall an imminent disorderly bankruptcy.
The second payout should be provided only if the restructuring plans are proceeding successfully.
Congress should also make it clear that no further aid will be forthcoming and prepare to facilitate the
orderly bankruptcy of one or more of the automakers.
Given the prospect of an imminent disorderly bankruptcy of GM and possibly Chrysler without quick
government aid, and the very negative fallout this would have on the fragile economy, the government
should provide the $34 billion in financing requested by the Big Three. In exchange the Big Three would
provide warrants to the government and agree to limitations on executive compensation and dividend
payments. Policymakers should provide the money in at least two tranches to ensure the automakers are
effectively executing their restructuring plans.
As previously argued, this aid may very well not be sufficient to return the Big Three to financial
viability. Policymakers should thus also make it clear to the automakers that no more financial help will be
forthcoming. Their next step would be to enter into a prearranged bankruptcy. To facilitate a more orderly
bankruptcy process, the government could promise to provide or guarantee debtor in possession financing
for any automaker in bankruptcy. The government guarantee would ensure an orderly restructuring and not
liquidation. All stakeholders, including management, creditors, suppliers and the unionized workforce,
would be forced by the bankruptcy process to make the tough choices they have so far been unable to
make. It's not that they haven't made strides in lowering labor and material costs and improving
productivity, but what is required for the automakers to become viable longer run is too draconian for them
to do outside the bankruptcy process.
Even in an orderly bankruptcy, there still would be substantial layoffs. The companies would come out
of bankruptcy much smaller, reflecting the much smaller new-car market and their loss of market share.
But if this rationalization is done in an orderly way, the job losses should be thousands of jobs per month
and not hundreds of thousands. While painful, this is manageable.
There is a reasonable concern that if the Big Three file for bankruptcy – even a government-supported
bankruptcy – people would stop buying their cars. Who wants to buy a car from a company that won't be
around to fulfill any warranties or even service it? This is a reasonable concern, but there is no better way
to ensure that the Big Three will be around than if they are significantly restructured in bankruptcy. Getting
a loan from the government, even as large as $34 billion, won't convince anyone that they will be around
for very long without big changes in their operations. To allay some of these concerns, the government
could also guarantee warranties on any new cars sold by the Big Three while they are making their way
through bankruptcy.
The damage to the financial system of a prearranged bankruptcy should not be significant. The
automakers have approximately $100 billion in debt outstanding, and the automakers' captive finance
companies have close to $300 billion. Most of the debt is secured, and very little is held within the banking
system.v Their credit market debt has been rated below investment grade for some time and thus is not held
by pension funds and insurance companies but by investors that specialize in owning distressed debt. The
credit default swap market has also already priced in the high likelihood of defaults.
Bankruptcy for the Big Three would also send an important signal to any other industry or businesses
contemplating asking taxpayers for financial help to get through these very difficult times. Most industries
don't hold the same importance to the economy as the domestic auto industry, but that won't stop others
from asking for help. They may not ask if they know that along with government help comes bankruptcy.
Conclusions
A concerted, comprehensive and consistent government response to the current financial and economic
crises is vitally needed. The economy needs a very large and prolonged dose of fiscal stimulus and a large
foreclosure mitigation plan, but the government's resources for quelling the crisis are not unlimited and
must be used wisely. The federal budget deficit, which topped $450 billion in the just-ended 2008 fiscal
year, will easily exceed $1 trillion in the current fiscal year and again in fiscal 2010. Borrowing by the
Treasury will be even greater, topping $2 trillion this year. The automakers' pleas for government
assistance must be answered, but the answer should ensure that they undertake some fundamentally and
ultimately very painful changes. The $34 billion requested by the automakers will very likely not be
sufficient to make those changes. Policymakers must be prepared for this very real possibility.
____________________________________________________
i State recessions are determined using a methodology similar to that used by the business cycle dating committee of
the National Bureau of Economic Research for national recessions.
ii In other words, underlying vehicle sales measure sales that are expected abstracting from the ups and downs in the
job market, gasoline prices, and the availability and cost of credit.
iii This is based on data from CNW/Marketing Research.
iv 2006 is the most recent historical data available from the Bureau of Labor Statistics for a wide range of industries.
See http://www.bls.gov/news.release/prin.toc.htm
v There is no more than $20 billion in outstanding bank loans to the auto makers and the captive finance companies.
(c) Moodys' Economy.com
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