Financial Crisis 101 - 11/12/08

PHILADELPHIA - November 12, 2008 - That's basically why the stock market tanked for the third day in a row, with the Dow losing 400 points. There are three dominant themes today. The Treasury Secretary is abandoning the original rationale for the bailout; consumer spending is falling off a cliff; the automakers' rescue plea is sending editorial writers and economic pundits to their word processors en masse.

Treasury Secretary Henry Paulson announced today that he's putting on hold plans to buy bad mortgage-related assets from banks. If you recall, that was the original purpose of the 700 billion dollars in taxpayers' money that now makes up the TARP program. Paulson today said that the idea of the government buying bad mortgage debt from the banks is no longer the most effective way of utilizing the TARP funds. Instead, Paulson said the government will continue to inject capital into the financial system, but now with the distinct possibility of a big new string attached. Treasury is considering requiring banks that want government bailout money to raise private capital in order to qualify. Some economists think that's a good idea because it puts the free market back into the equation. If a bank is strong enough so that it can benefit from new capital, it should be able to raise some cash on its own. If it can't, then perhaps it's too far gone to save. In a sense, the government will be getting a recommendation from the private sector which banks should get TARP money. Interesting. But House Financial Services Chairman, Barney Frank, is objecting to the decision to abandon the government purchase of mortgage related assets. He reminded today that Congress gave the Treasury specific authority to buy the bad mortgage debt when it created the 700 billion dollar TARP program in the first place, and said Frank, "We have a need to use that funding" for that purpose. As for the market's reaction to Paulson's change of heart, if it's judging Paulson as indecisive, that's not good. Wall Street hates nothing more than indecision. By the way, reports say Paulson is almost out of the money he was authorized to spend before having to go back to Capitol Hill to ask for more.

Monday, it was Circuit City filing for bankruptcy, and today, Best Buy, the largest electronics retailer in the country, said its sales and revenue will fall more than it expected. It also said the upcoming holiday shopping season could be the worst in 23 years. But it was the words, even more than the numbers in Best Buy's forecast, that really caught Wall Street's attention, "Since mid-September, rapid, seismic changes in consumer behavior have created the most difficult climate we've ever seen." "Best Buy simply can't adjust fast enough to maintain our earnings momentum for this year." Predictably, Best Buy's stock suffered some "seismic" changes after that announcement. Bloomberg News has surveyed 59 economists and the consensus is that the drought in consumer spending may be the worst the country has ever seen. Said one, "the consumer economy has simply fallen off a cliff." The economists think the drought will extend into next year, forcing employers to continue to cut payrolls. That brings us to the crisis in Detroit.

Talk about falling off a cliff, all-wheel drive or not. We've reported here, and of course on Action News that all three U.S. car manufacturers are in big trouble, apparently led by General Motors, which depending on whom you listen to, doesn't have enough cash to survive much beyond the new year. It's pretty clear that political pressure is building on the federal government to come up with some kind of emergency assistance plan beyond the 25 billion dollars in loans already committed. Both House Speaker, Nancy Pelosi, Senate Majority Leader, Harry Reid, and President-elect Barak Obama are urging the current Administration to act quickly. But needless to say, there are diverse points of view on the idea of an auto bailout, and I've already included some of them here. Well here are some more.

Earn the bailout, Detroit
The Big Three auto giants can have public money when they agree to make the fuel-efficient cars people really want.
By Douglas Olin
November 12, 2008

One of the first real challenges President-elect Barack Obama faces will be what to do about the ailing American auto giants.

The stakes are high. For more than 100 years, the Big Three automakers have been a cornerstone of the U.S. economy and an important symbol of American industrial might. The auto industry is the largest manufacturing industry in America. And it's not just the 239,341 employees of Chrysler, Ford and GM.

A Center for Automotive Research study conducted for the Motor & Equipment Manufacturer's Assn. estimates that for every direct job at an automaker in the United States, there are 3.3 supplier jobs. These motor vehicle parts suppliers directly employ 783,100 people in the United States and are, in turn, estimated to generate another 1.97 million indirect jobs in industries ranging from steel to plastics to technical services. The spending by these employees generates yet another 1.7 million "spin-off" jobs. A total collapse of this industry could affect as many as 3 million jobs in the first year alone -- almost 5% of total U.S. manufacturing jobs -- and send shock waves through national and foreign markets.

But a "bailout" of the status quo is unappealing. Big auto has struggled for years. Once dominant in the domestic market, the Big Three now command less than 50% of the market, and even this share is in decline. Injecting cash into these ailing institutions has an air of reinforcing failure -- pouring good money in after bad.

Furthermore, the U.S. automotive industry has been on the wrong side of almost every environmental, social and safety issue since the 1960s. The industry objected to the Clean Air Act, publicly opposed fuel economy standards, fought against seat belt and air bag legislation, dragged its feet on alternative-fuel vehicles and lobbied against almost every socially responsible initiative. Exactly why would the public want to bail out an industry that has failed in the market and been so unresponsive to the public good?

Maybe it's time for America to buy some broad-based social benefits in return for public investment in these companies. If the U.S. government -- on behalf of the people -- is going to spend considerable sums of public money and incur public debt to keep these institutions alive, let's insist on returns that benefit society as a whole, not merely Big Three shareholders, management and employees.

What might these public benefits be? Well, for one, isn't it time for Detroit to turn out a car that gets at least 100 miles per gallon -- and to do it in three years? Couldn't we demand, in return for public money, that management deliver dramatic new fuel economy standards, with appropriate rewards for success and sanctions for failure?

Since transportation (mostly autos) generates one-third of U.S. greenhouse gas emissions, can't we demand auto fleets that systematically reduce carbon dioxide emissions, perhaps the 30% by 2016 proposed by California?

And America needs a laboratory for redefining the relationship between management and organized labor. Why not require those in the boardroom and the production line to work with the new administration to redefine the role of unions and labor relations?

This isn't socialism; it would be our tax dollars at work. For years, this country has maintained a system of tax incentives to urge individuals and corporations to spend money on things deemed to be in the collective national interest. The real estate and construction industries are supported by tax breaks on mortgages. Agriculture receives numerous tax incentives and direct subsidies in the interest of maintaining family farms. A socially constructive paradigm can and should be applied to the institutions and industries that would benefit from the wave of government spending designed to keep them alive in a time of dramatic financial distress.

If 300 million Americans are going to borrow money to bail out an industry, then it seems only reasonable to insist that that industry take more socially responsible positions toward energy conservation, safety and the environment.

With millions of jobs at stake and the potential repercussions of seeing an entire section of the industrial base collapse so soon after the fallout on Wall Street, it is a political, economic and social imperative for the government to do something. But why not do it in a way that challenges this key industry to also help address society's need to reduce consumption of foreign oil, curb greenhouse gas emissions and increase safety on our highways?

I believe that our auto industry can meet this challenge -- given the right investments, challenges and incentives. After all, isn't it about time for Detroit to build smart, well-designed cars that also happen to get over 100 mpg?

Douglas Olin was a deputy assistant secretary of Commerce in the Clinton administration.

UAW Contracts Put Detroit On Road to Ruin, and A $50B Bailout Would Only Be The Down Payment

A bailout might avoid any near-term bankruptcy filing, but it won't address Detroit's fundamental problems of making cars that Americans won't buy and labor contracts that are too rich and inflexible to make them competitive (see chart above of the $25 pay gap between the Big 3 and Toyota/Honda, data here). Detroit's costs are far too high for their market share. While GM has spent billions of dollars on labor buyouts in recent years, it is still forced by federal mileage standards to churn out small cars that make little or no profit at plants organized by the United Auto Workers.

Rest assured that the politicians don't want to do a thing about those labor contracts or mileage standards. In their letter, Ms. Pelosi and Mr. Reid recommend such "taxpayer protections" as "limits on executive compensation and equity stakes" that would dilute shareholders. But they never mention the UAW contracts that have done so much to put Detroit on the road to ruin (see chart above). In fact, the main point of any taxpayer rescue seems to be to postpone a day of reckoning on those contracts. That includes even the notorious UAW Jobs Bank that continues to pay workers not to work.

A Detroit bailout would also be unfair to other companies that make cars in the U.S. Yes, those are "foreign" companies in the narrow sense that they are headquartered overseas. But then so was Chrysler before Daimler sold most of the car maker to Cerberus, the private equity fund. Honda, Toyota and the rest employ about 113,000 American auto workers who make nearly four million cars a year in states like Alabama and Tennessee. Unlike Michigan, these states didn't vote for Mr. Obama.

But the very success of this U.S. auto industry indicates that highly skilled American workers can profitably churn out cars without being organized by the UAW. A bailout for Chrysler would in essence be assisting rich Cerberus investors at the expense of middle-class nonunion auto workers (see chart above). Is this the new "progressive" era we keep reading so much about?

If Uncle Sam buys into Detroit, $50 billion would only be the start of the outlays as taxpayers were obliged to protect their earlier investment in uncompetitive companies.

Dr. Mark J. Perry is a professor of economics and finance at the Flint campus of the University of Michigan.

Marketplace on American Public Media

Robert Reich: When a big company that gets into trouble is more valuable living than dead, there's a well-established legal process for reorganizing it -- called Chapter 11 of the bankruptcy code. Under it, creditors take some losses, shareholders even bigger ones, some managers' heads roll. Companies clean up their books and get a fresh start. And taxpayers don't pay a penny.

So why, exactly, is the Treasury substituting government bailouts for Chapter 11? Even assuming Wall Street's major banks and insurance giant AIG are so important to the economy they can't be allowed to fail, they don't have to be bailed out. They could be reorganized under bankruptcy protection. Their creditors, shareholders, and executives would take bigger hits than they're now taking, now that taxpayers are bailing them out, but they took the risk. We didn't.

It would be different if Main Street was getting something out of all this. But credit still isn't flowing to small businesses or distressed homeowners, and unemployment is skyrocketing.

There's more at stake for Main Street when it comes to American automakers now on the edge of bankruptcy, because 2.5 million households depend directly or indirectly on them for their paychecks. But the best way to protect all these people is not necessarily to pay off the automakers' creditors, shareholders, and executives, with no strings attached. When the government bailed out Chrysler in the early 1980's, a third of its employees were laid off. In order to keep autoworkers employed and also move Detroit to more fuel-efficient cars, all stakeholders will have to sacrifice.

What a tragedy it would be if the government spends so much on these bailouts there isn't enough money left for the next administration to help average people get affordable health insurance, send their kids to good schools, and find good jobs -- including jobs rebuilding the nation's crumbling infrastructure and finding alternative sources of energy.

You see, it's not the big guys who need rescuing. It's the small. And right now, the government has its priorities upside down.

Robert Reich is a former Secretary of Labor in the Clinton Administration and is currently a member of President-elect Obama's Economic Transition Team

None of these three points of view necessarily match up with what's being talked about in the executive suites in Detroit, and that's why they make worthwhile reading. And again, it's not my purpose to promote any specific political or economic point of view. There's just a lot of opinion out there, and if it looks interesting and thought-provoking, it makes sense to include it here.

Jim Gardner

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