How to fix the Big Three
The debate over the fate of the U.S. auto industry starts with one question: What caused the crisis? And it ends with another: Bailout or bankruptcy?
NEW YORK (CNNMoney.com) -- Why is the U.S. auto industry in such a precarious position?
That question - and answers to it - will animate the debate this week over whether Washington should extend a lifeline to the Big Three. (For more, read Auto bailout: Showdown in Washington.)
There are extreme answers at both ends. Some observers cite labor contracts that prevent layoffs and guarantee high-cost health care coverage that can continue for decades after workers leave the company. Others say the companies are the victims of executives who over produced gas-guzzling SUVs and pickups and ignored the fuel-saving technologies of their Japanese rivals.
Either way, it's easy to see why so many people are troubled at the prospect of rewarding the automakers' management and workers with billions of taxpayer dollars.
But the problems that have put General Motors (GM, Fortune 500) on the precipice of a bankruptcy filing, and left Ford Motor (F, Fortune 500) and Chrysler not far behind, are complicated. And the decision about how best to correct those mistakes is similarly complicated.
Years of market share losses by the Big Three are a major part of the problem. As recently as 10 years ago, they had about 70% of U.S. auto sales. Now they have 47%.
Another blow came earlier this year in the form of record high gas prices, which cut deeply into demand for pickups and SUVs.
For years, pickups and SUVs brought strong sales and high profit margins. Americans purchased more light trucks than cars between August 2001 and March 2008.
Detroit had trouble adjusting to the sudden fall in demand. The United Auto Workers contract doesn't allow the companies to lay off workers. Idled UAW members receive nearly full pay until new jobs open up or the contract comes to an end.
The only way to cut staff is to buy workers out. In recent years, each company has trimmed its union work force by the tens of thousands. GM went from 107,000 UAW members in 2004, the year before its string of losses began, to about 64,000 today.
Another huge cost was health care, for which the Big Three paid billions more than their overseas rivals.
Japanese automakers are helped by the fact that their workers back home are covered by a government-paid health care system. What's more, their U.S. employees are generally much younger than their UAW counterparts at the Big Three's plants, and thus have lower health care costs.
But the biggest difference is the hundreds of thousands of retirees at GM, Ford and Chrysler - along with their surviving spouses and other dependents - who had been promised health care coverage. That coverage cost GM $3.3 billion in 2007 alone.
The U.S. automakers won important concessions from the UAW in the 2007 labor deal, including an agreement to shift retiree health care costs to union-controlled trust funds beginning in 2010. They also have a two-tier wage structure that will allow them to pay new hires significantly less money than the older workers who will be retiring in coming years.
But then the crisis in financial markets hit this fall. Credit tightened and nervous consumers stopped buying. U.S. auto sales in October fell to a seasonally-adjusted annual rate of 10.5 million vehicles - the worst sales pace in 25 years.
With huge fixed costs for plants and equipment, no automaker can make money when demand for sales collapse. Even Toyota Motor (TM) has seen profits plunge. But Toyota went into the current downturn after years of strong results, while the U.S. automakers had been losing money for three or four years.
Advocates of bankruptcy - not a federal bailout - as the best way out say court protection would allow GM and possibly other automakers to reorganize and emerge stronger.
They believe that the automakers' current lenders, to protect their own money, would make sure the companies receive financing. They argue that consumers would be willing to buy a car from a bankrupt automaker as long as the warranties are backed by a third-party.
And they say that bankruptcy laws are the best way to shed uncompetitive contracts with unions without having to spend billions of dollars. Bankruptcy judges have the power to void labor and other contracts to protect creditors.
"You can't have the kind of work rules and retirement benefits they have. The steel industry is a lot better off for going through bankruptcy," said University of Maryland economics professor Peter Morici. "The sooner they do it, the more jobs will be saved."
Another argument against a bailout is that a federal loan won't address the automakers' underlying high costs.
"To the extent that they do receive some assistance, it's more buying time rather than a fundamental solution," said Bob Schulz, senior auto credit analyst for Standard & Poor's.
On the other side of the debate, the advocates of a bailout argue that consumers wouldn't buy from a bankrupt automaker, even with guarantees on warranties, because of doubts about vehicle resale value. And further sales declines would make it impossible a bankrupt automaker to get financing.
Without that financing, liquidation, sale of assets and closure would be the only option left. Such a move would cause a shock to the economy that could cost millions of jobs.
But they say that a federal bailout would be a bridge loan to get the automakers back to profitability. Savings the companies won in 2007 labor agreements, as well as changes they're now making to respond to the current crisis, will leave them leaner and more competitive.
"We're going to see this industry profitable like it hasn't been in 20 to 30 years, because of capacity reductions, pent up demand coming back in the market and cost savings," said David Cole, chairman of the Center for Automotive Research, an Ann Arbor, Mich., think tank that is a strong advocate of a bailout.
And Cole argues that the cost of the bailout is far less than the cost to the economy if the companies are forced into bankruptcy.
"The cost of cleaning up is a lot greater than preventing it from occurring," he said. 
