Rescuing Detroit Without Bankruptcy

On Tuesday, executives from Chrysler, Ford, and General Motors will submit reports on how they can restructure their operations. And quite a lot is riding on what those reports say. If Congress isn’t satisfied that the planned changes will make the companies more competitive, it’s unlikely to approve the $25 billion in emergency loans that the automakers may need to survive the current crisis. If just one of the companies should fail, let alone all three, the economic repercussions could be enormous--and not just in Detroit.

But exactly what kind of changes should the executives promise? And how can government make sure those changes actually occur? If you’ve been following this discussion, you’ve probably heard a lot about tearing up old labor contracts. You may also have heard people call for a “pre-structured” bankruptcy, under which automakers would file for Chapter 11, like the airlines have, while the government provides loans necessary for the companies to continue operating.

As scholars who have spent our professional lives studying the auto industry, we think these recommendations are misguided. Yes, the auto executives owe Washington a plan. But it needs to be the right plan. What follows is a suggestion for what that plan should look like.

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Let’s start by looking at exactly what the Detroit Three do well--and what they don’t. Despite what you may have heard, labor costs are no longer a big problem. The Big Three negotiated a new contract with the United Auto Workers in 2007. Under its provisions, many experts believe that average hourly compensation (wages and benefits) for the Detroit Three’s domestic workforce will--within a few years--be lower than that of employees of foreign-owned domestic plants. Health insurance options also became less generous; they now include co-payments, deductibles, and limited physician networks--just like in the rest of America. More and more, workers collaborate with management on improving the production process, something rival Japanese companies have done in the U.S. for over a generation.

Another innovation the Detroit Three have picked up from Japan is better collaboration between the people designing cars and the people building them. Today, America’s carmakers practice “design-for-manufacturability”--that is, they use feedback from their plants to re-engineer features that make a vehicle difficult to build. In many plants, the results of these efforts have been better vehicles. Some of the Big Three’s vehicles are as good as those from foreign-owned carmakers, according to quality ratings from the J.D. Power Index; their factories churn out the cars almost as productively, according to the Harbour Report. (Both J.D. Power and Harbour are considered industry standards).

But the Detroit Three have not applied these lessons consistently throughout their operations. Many plants still cannot produce multiple models on one line; many have also been slow to institutionalize management-worker cooperation. Some labor restrictions remain, such as rules that made it difficult for management to move around laborers and thus make the production process more efficient.

The restructuring of obligations to UAW retirees also remains incomplete. In order to shed the large burden of retiree health costs, the 2007 UAW agreement created a special trust for retiree benefits, thereby taking the infamous legacy costs off the companies’ books. But as part of the agreement, the companies agreed to put money into the trust until 2011. The problem is that, now, they just don’t have the money to do so.

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Of course, all the attention to labor costs misses the fact that they account for a relatively small portion of car price--about 10 percent. Supplied parts account for a much larger portion--over 50 percent. And for all of the progress the Detroit Three have made in their relationship with labor, they could do much more to improve relations with suppliers.

U.S. automakers have enormous bargaining leverage with their suppliers, because of their size. They use that leverage to drive prices as low as they can. But that’s not as great as it sounds. As suppliers strive to meet demands for lower prices, their margins shrink and they may deliver parts that simply aren’t as good. That can actually cost the automakers more in the long run.

After all, the true cost associated with a part isn’t simply the price that an automaker paid for it upfront. It’s also the cost of installing that part, of reengineering either the part or the car to fix production problems as they arise, and of repairing finished cars should the parts fail while still under warranty. Keep in mind that most automotive components aren’t modular; they don’t simply snap together like lego pieces. They are part of a tightly integrated machine and must fit together just about perfectly. Otherwise, the resulting noise, vibration, and harshness will turn off consumers.

The Detroit Three’s approach to suppliers stands in stark contrast to the approach Honda and Toyota have taken. These automakers make very strenuous performance demands on suppliers. But they do so in ways that reduce defects, improve design features to make products more attractive to consumers, and yield profits that sustain suppliers throughout the business cycle. The process starts with a rigorous joint examination of each step in the design and production process: Is this step necessary? Could it be done more cheaply? The information that surfaces during this process yields far greater savings than does multiple rounds of competitive bidding by suppliers.

Still, none of this should obscure the other major problem with the Detroit Three--the one most people do seem to get intuitively. The companies really are too big, although the problem starts with the number of brands, rather than the number of factories. Each brand has its own set of dealers, each of whom demands vehicles and attention to their product lines. It’s impossible for the companies to fill out each brand’s lineup with innovative, quality products--let alone to market each of them appropriately. In other words, it’s hard for GM to push Pontiac when it’s also pushing Buick, Chevrolet, and Saturn.

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Many people seem to think the best solution to these lingering problems is Chapter 11 bankruptcy. But it’s not clear how much bankruptcy would help, particularly since the companies have already rewritten their labor contracts--something Chapter 11 would normally enable. The incentives of Chapter 11 might discourage the automakers from further integrating the innovative production techniques described above, by encouraging them to focus on short-term profits even more relentlessly. Bankruptcy could also do permanent damage to an auto brand: Surveys have shown people are unlikely to buy cars when they worry the manufacturer will be out of business in a few years, making it harder to find servicing and parts.

A better solution would be a process that preserves the most helpful elements of Chapter 11 bankruptcy while avoiding elements that might push the auto industry in the wrong direction. Under this scenario, the government would make available $25 billion in financing--similar to the “debtor-in-possession” financing that the private lending market would make available in a healthy economic environment. And, as in a normal bankruptcy, existing creditors would get heavily reduced payments (say, 30 or 40 cents on every dollar owed) along with equity. The creditors would take a hit, but they’d also have a chance to make back that money--and perhaps earn some more--if the companies rebound and stock prices rise.

But instead of letting a bankruptcy judge supervise this process, the government would appoint a special advisory committee to oversee the process. This committee would consist of knowledgeable, independent monitors--a mixture of former industry executives with experience working for Toyota or Honda; academics who study the industry; experts in alternative engine technology or labor-management collaboration. It would, naturally, have a director and full-time staff, plus the ability to work with outside consultants. Under the scenario we envision, the committee would set goals and require the companies to report on progress quarterly, as a condition for obtaining additional funds. If a company missed its goals for, say, two quarters in a row, the committee would then provide only enough funds to prepare for liquidation or nationalization. (Leftover money could go to retraining workers and softening the blow of downsizing on communities.)

By putting such a committee in charge, the government could not only spare GM--and its counterparts--much of the messy, wasteful litigation that goes with Chapter 11 filings. It could also encourage the right kind of restructuring. Instead of simply paying people less for doing the same inappropriate tasks they used to do, the Detroit Three would further change the way they design, build, and sell cars--and evolve into a smaller, more sustainable set of automakers headquartered in the United States.

The goals for automakers to meet would start with the obvious “outcome” measures: To keep receiving funds, the companies would have to keep scoring well on familiar consumer tests, like the J.D. Power Initial Quality Scores that appear every June and the federal government’s crash safety experiments. But “input” measures would be just as important. The companies would need to demonstrate that they were finally collaborating with suppliers the way Japanese companies do--by documenting meetings, then hitting targets for the cost and quality of the parts they use. The automakers would have to sit down with the United Auto Workers, as well, in order to make sure all plants featured regular, institutionalized labor-management cooperation.

The companies would also owe the government a downsizing roadmap. How many workers will lose their jobs? What kind of help will they need? And what about the dealerships? The latter are a particular challenge. They enjoy the protection of franchise laws, written at a time when lawmakers feared that the mighty automakers would have too much leverage over owner-operated dealerships. Worse still, the states set the laws, which means there are literally 50 different versions. In bankruptcy, every dealer in the country--there are still 20,000--could bring its own legal action to get its share of the available assets.

Once the downsizing plans were in place and approved, the government could act to make the transformation possible--while cushioning the blow on individuals. It could, for example, set up a federal standard for dealing with dealer claims, while devising a formula for compensating dealers fairly. To help displaced workers, it could establish and fund retraining initiatives, perhaps modeled on existing programs that help workers who lose their jobs because of trade. It could also consider taking on some of retiree health benefits.

The government could set one final set of goals, not so much to address a lingering failure but to advance an important social goal: fighting climate change. Each company seeking funds could commit itself to exceed, by at least twenty percent, the recently passed Corporate Average Fuel Economy requirement of 35 miles per gallon by 2020. This requirement could be made contingent on the passage of a broader climate change bill that effectively kept gas prices high, to make sure consumers actually want such vehicles.

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Many of these ideas are consistent with the two leading bills in Congress--one proposed by Senator Carl Levin and one proposed by Congressman Barney Frank. Each would provide $25 billion in loans. Each would prohibit the payout of bonuses for top executives, golden parachutes, and dividends--for as long as the government loans are outstanding. If the companies recover, government--i.e., the taxpayers--would be the first in line (among creditors) to receive payment.

To get the money, the automakers would have to submit both a short-term operating plan and a long-term restructuring plan. The Frank bill includes an oversight board to be made up of the secretaries of Labor, Energy, and Transportation and the EPA Administrator. Both bills take the money from the $700 billion banking bill already passed, and maintain the oversight provisions (such as they are) of that bill. The main elements we would add would be the quarterly review process--that is, requiring the companies to report on progress every three months and make the continued distribution of funds contingent upon meeting thresholds.

We can’t be certain that the rescue will work. Even with the money, one or more of the automakers could end up in bankruptcy at some point in the future. But the timing makes the case for this kind of effort compelling. If GM stopped producing, a million people could easily lose their jobs, including employees at dealers and suppliers. (Note that ‘only’ 1.2 million have lost their jobs so far in this already-severe recession.) Paying them $25,000 in unemployment compensation for a year would be an outright expenditure of $25 billion--to say nothing of the three-quarters of a million UAW retirees whose pensions the federal government would inherit, via the Pension Benefit Guaranty Corporation, or the tax revenue lost when workers become unemployed. A $25 billion loan, at least some of which is bound to be repaid, seems like a pretty cheap alternative.

And it’s likely the government would get all of its money back; as with the financial bailout, the government would be holding equity in the companies until they are back on their feet. In the meantime, the auto industry would emerge smaller, but stronger, serving multiple national goals. Getting Americans where they want to go doesn’t require American automakers; international competitors provide plenty of good vehicles. But maintaining strong manufacturing and technological ability requires sustaining at least some healthy domestic automakers. There is tremendous opportunity in this crisis, but only if the government and everyone involved in the auto industry rise to the challenge.

Susan Helper is AT&T Professor of Economics at the Weatherhead School of Management, Case Western Reserve University. John Paul MacDuffie is Associate Professor of Management at the Wharton School, University of Pennsylvania and Co-Director of the International Motor Vehicle Program (IMVP).

By Susan Helper and John Paul MacDuffie