NEW YORK (Fortune) -- The other shoe dropped at Chrysler Tuesday and the fallout isn't pretty. Six weeks after the company announced that it might lose $600 million in the third quarter this year, it admitted the number would be more like $1.5 billion, as it cut production to reduce its inventory of unsold cars and trucks.

Coming after similar announcements in the past year by General Motors (Charts) and Ford (Charts), Chrysler's news sounded like just a footnote in the decline and fall in Detroit. But it's actually more serious than that. It reveals deep problems with DaimlerChrysler (Charts) management that could sink the company if they aren't corrected. Less than nine months into his tenure as chairman, Dieter Zetsche has some serious repair work to do to prevent Chrysler from total collapse.

Here's why: Either the top executives at DaimlerChrysler are operating with their eyes shut, or somebody isn't telling them the truth. All year long, Chrysler has been operating with bloated inventories that sometimes stretched out to 100 days or more.

The company had built its reputation on the pickups, minivans and SUVs that constitute 71 percent of its sales, but they weren't selling because of high gasoline prices. And with more than one-third of car buyers looking for four-cylinder engines, Chrysler was doubly hurt because they account for just 15 percent of its sales.

Unsold Chryslers, Dodges, and Jeeps began stacking up around Detroit and jamming dealers' lots across the country. But rather than cut production, Chrysler kept the assembly lines moving, relying on a revival of last year's employee discount promotion and an ill-considered corporate ad campaign to boost sales. Neither worked.

Yesterday, Zetsche finally bit the bullet and announced that Chrysler would cut production in the third quarter by a total of 90,000 units, producing that jaw-dropping loss, and another 45,000 in the fourth quarter.

But that didn't answer the question why Chrysler persisted for so many months in producing more vehicles than the market could support. Excess inventory is the industry's profit killer. It forces clearance sale tactics, costs dealers floor plan charges, and destroys residual values. Overstock is especially damaging at the end of a model year because dealers whose lots are clogged with last year's cars are hardly in a position to order next year's cars.

Zetsche offered a peculiar explanation for the excess production during a conference call with analysts. "We were too optimistic," he said. "We said, 'Next month we will make it.'" One can only wonder at the source of his optimism at a time when his crosstown rivals were watching their SUV sales plummet as oil prices soared during the summer. Was his intelligence flawed? Was some trusted advisor whispering falsehoods in his ear?

To his credit, Zetsche took full responsibility for the fiasco. "There is no way to muddle yourself out of inventory situation," he admitted. "To hope was a mistake. We are not afraid of unpopular or tough decisions but we did not do it in time in this case." But it wasn't his call to make. He should have been relying on the advice of subordinates.

Zetsche is too much of a gentleman to do so, but he could have easily blamed Chrysler CEO Tom LaSorda or marketing boss Joe Eberhardt for the fiasco. You have to wonder: They are both experienced auto men. Were they under pressure to hit some financial targets? Or was their market intelligence and production scheduling so misguided that it couldn't tell them what was happening outside their own windows?

This year marks the third time since Chrysler merged with Daimler-Benz in 1998 that Chrysler has shocked investors with a billion-dollar loss in a single quarter. The first of those events brought Zetsche to Detroit to lead one of Chrysler's frequent turnarounds, the second occurred while he was in charge, and now the third comes as he oversees the operation from Stuttgart.

The breakdown in inventory controls makes you question Zetsche's conviction that "we are on the way on the way to recovery with the Chrysler Group." It also makes you wonder whether Zetsche's reputation for managerial genius extends beyond product creation and employee relations.

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Is the future now for the 'car of the future'? Not quite, but it may come sooner than you think - and from GM.