Auto bankruptcy: What it means
A bankruptcy at GM or Chrysler will have widespread impact, from consumers to auto workers to taxpayers.
NEW YORK (CNNMoney.com) -- In Detroit, the unthinkable -- an automaker bankruptcy -- has become very thinkable.
President Obama is giving General Motors 60 days to come up with a more aggressive plan to cut costs and debt. Chrysler is only getting half that time to work out a combination with Italian automaker Fiat. If they fail, the government will force them into bankruptcy court.
Americans have grown used to the bankruptcy of airlines, retailers and other businesses. But a bankruptcy of one or more of Detroit's Big Three could have a much more wide-ranging impact on the U.S. economy. Here's what a bankruptcy could mean for car owners, dealers, auto workers, suppliers, lenders and U.S. taxpayers.
The government has announced it will stand behind the warranties for new GM and Chrysler cars. But that would do little good to somebody trying to sell a model that winds up being discontinued. The loss in resale value could be tremendous.
After GM and Chrysler killed off Oldsmobile and Plymouth, two-year old vehicles of those discontinued brands were worth as much as a similar five-year old model at the companies' other brands, according to used car price tracker Kelly Blue Book.
And if either company was forced to go out of business due to bankruptcy, it would cost people a lot more to buy a new car. Even with demand for new cars at a 26-year low, a shutdown of all GM or Chrysler plants could soon create a shortage of new cars.
That would allow other automakers to pullback from the record average of $3,169 in cash-back and other incentives now being offered to buyers. Jesse Toprak, industry analyst with sales tracker Edmunds.com, estimates that average incentives could fall by about $1,000 per vehicle within a year or two if GM and Chrysler were forced to halt operations.
The popular assumption is that bankruptcy would give GM the power to get out of their labor contracts with the United Auto Workers union and other unions that put them at a competitive disadvantage to nonunion automakers such as Toyota Motor (TM). The truth is far more complicated.
Heidi Sorvino, head of the bankruptcy practice in the New York office of law firm Smith, Gambrell & Russell, said it is much tougher for a bankrupt company to shed its labor contracts than other obligations.
The threat of bankruptcy gives management far greater leverage at the negotiating table. But the legal process is cumbersome enough that management at bankrupt companies typically find it quicker to reach a new labor deal than have the court impose one. Bankrupt automaker Delphi took nearly 21 months to reach a new deal with the UAW after its bankruptcy filing.
So while GM might get better contracts in bankruptcy than they would outside of bankruptcy, the 54,000 UAW members would not be at the mercy of whatever the company wanted to impose on them.
John Weykamp, an auto restructuring expert at accounting firm Crowe Horwath said retirees at GM would probably continue to have health care coverage, although the company would likely not have to put as much money into the trust funds that are being set up to pay for that coverage. And he doubts the union would be pushed by management to accept significant pay cuts.
Both companies have announced plans to cut their bloated network of dealerships, which were established when they had a much larger share of the nation's new car market. But cutting ties with dealers is an expensive process, given the strength of state-by-state dealer franchise laws. GM spent about $1 billion to drop its Oldsmobile brand, most of it to buy out dealers.
Bankruptcy could make it easier for the companies to get out of those dealership agreements, although Sorvino said that dealers would still have the ability to challenge such a move in court.
"It's not a slam dunk," she said about using bankruptcy as a tool to get around franchise laws.
But the bigger problem could be finding money for the dealers that stick around. Dealers need financing to buy vehicles they hold in inventory, and it's not clear whether lenders such as GMAC, now an independent bank holding company, would continue to provide dealers with that crucial financing if GM was bankrupt.
So the government might need to step in to provide that funding for dealers, which in turn could increase the cost to taxpayers of the industry rescue. GMAC has already received $6 billion in government assistance while Chrysler's financing arm has received $1.5 billion.
GM owed its suppliers $22 billion at the end of 2008. Chrysler reported it owed suppliers about $7 billion .The companies would be able to pay some of the money it owes suppliers, but only those whom the court determines to be "critical vendors."
The $5 billion federal bailout of the auto parts sector announced in March only helps the suppliers that GM and Chrysler have identified as vital to their continued operations. So many other suppliers would not get the money owed to them.
That means there would be widespread bankruptcies and factory closings across the parts industry, which employs more people than the automakers themselves.
"When a major company like this files, there will definitely be a domino effect," said Sorvino.
GM has about $27 billion in unsecured debt. Almost all of it was issued years ago when the company was still making money. Those bonds are now trading at pennies on the dollar. Chrysler has nearly $7 billion in secured debt.
The companies want to get creditors, which include mutual funds, pension funds and individual investors, to accept equity in return for significantly reducing those debt levels. So far, they've made little progress in reaching agreements on those swaps.
Bankruptcy would essentially wipe out those current debts. The secured debt holders would be in a better position than the unsecured bondholders. But both would likely have to wait to see what value either company has after emerging from bankruptcy -- and what fraction of that value they can recover.
The investors holding the debt would most likely receive stock in the new companies following a bankruptcy reorganization. But if one or both companies do not emerge from bankruptcy, all bondholders would get is the proceeds of the sale of assets that occurs during liquidation.
And then there's the investors in GM's stock, which include anybody that owns an S&P 500 index fund. The company's shares have plunged 90% in the past year and would be essentially worthless if the company went bankrupt. Chrysler, a privately held company, is owned by hedge fund Cerberus Capital Management.
Bankruptcy would not be the end of the drain on federal dollars. In fact, it could mean an even greater cost to taxpayers.
There is widespread agreement that the companies would need more financing to fund their operations during a bankruptcy than the $21.6 billion they are asking for from the government to stay out of bankruptcy court. GM has estimated that it would need $45 billion in additional federal help for even a quick trip in and out of bankruptcy.
Chrysler didn't provide such an estimate for a speedy bankruptcy. But if Chrysler can't reach a deal with Fiat in the next month, many think it would be forced to liquidate since the Treasury Department found it is not viable as a stand-alone company.
Chrysler has estimated it will need $24 billion in federal help over 24 to 30 months to accomplish an orderly shut-down of its operations, in order to limit the shock to the rest of the industry.
But those loans would be only part of the cost to taxpayers of a Chrysler bankruptcy. There would also be an estimated $110 billion in lost tax revenue over the next three years. And it seems safe to say that a bankruptcy could drag out the current recession.
The auto industry's woes helped shave 1.1% from the nation's gross domestic product in the fourth quarter. Imagine how much worse of an impact there would be if one or more of the Big Three actually goes out of business.