Wednesday, November 12, 2008

Saving the Taxpayer from GM bailout

It seems likely that the government is going to devote taxpayer funds to a bailout of GM. It seems to me, however, that acting as a corporate raider the government can do a lot better for the taxpayer, and for other stakeholders as well. This seems bizarre, but I think it is correct. Here goes.

A Bailout for the Taxpayers: Government as a Corporate Raider

We hear that GM is likely to go bankrupt if the government does not offer a bailout. It is losing $2 billion a month, and by the end of the year its cash reserves will fall below feasible operation. We also hear that GM's problems are the result of legacy costs. These costs are a fixed cost that GM cannot unilaterally cut, and these prevent GM from investing in R&D and new models. Hence, it puts GM at a competitive disadvantage relative to other auto companies.

Let us suppose that this is true. It seems that the government, by acting as a corporate raider, could make everyone better off – surely compared with a bailout. The simple way to think of this is that GM is a company with two divisions. One produces autos and earns revenue. The other produces health and pension benefits but sells nothing. The combined value of this company is now valued at about $3 per share, which gives a current market valuation of GM at $1.8 billion. Let us suppose that legacy costs are $20 billion, and for simplicity assume that this is GM's only debt. Then the present value of cash flows must equal debt plus equity, so the present value of cash flows is $21.8 billion.

Now suppose the government purchased all the shares of GM at the current price (ignore for now the problems of making a tender). The government owns all of GM. Now it creates two companies, by splitting the two divisions. It then sells the auto division to the private sector. What would this company be worth? If the cash flows of the company were unchanged it would be worth $21.8 billion. With these proceeds the government could fund the entire legacy costs, since this is just the difference between what GM sold the auto company for and what it paid for the whole company.

But GM claims that its legacy costs are hurting its competitiveness. If this theory is correct then the expected value of GM auto cash flows would be higher if the company was relieved of the legacy costs. Hence, the government ought to get even more than $21.8 billion. If the theory is correct, splitting up the company this way ought to produce value. And remember, the legacy costs are now fully covered (perhaps they should not be, but that is a different question).

Notice that the current value of GM may be higher than it is really worth. The market may have factored in the expectation of a bailout. Perhaps, the present value of the bailout is worth $1.8 billion. Even if this is true, the government would make money on this raid as long as the expectation of future cash flows rises by more than $1.8 billion when the auto division is relieved of these costs.

How does this compare with bankruptcy? If the government does not bail out GM the company will still be restructured. But in that case the government will be stuck with the legacy costs, which will be turned over to the PBGC. The retirees will be worse off because the PBGC will pay perhaps 40 cents on the dollar of obligations (I am not sure that 40% is the right number, but you get the idea). More important, however, the government is worse off. Why? Because when GM emerges from bankruptcy the government will owe 40% of the legacy costs but have no revenue to fund this (there is future tax revenue, but they get that under the corporate raider plan too). The current shareholders are worse off because under the corporate raider plan they at least get $1.8 billion.

If this deal is so good why doesn't a private investor do it? Notice that if a private investor made a tender for GM its price would rise, lowering the gain of the deal. Presumably the government can purchase all the shares outright without having to accede to SEC regulations on tenders. Moreover, the private investor would have to be large enough to be able to fund the legacy costs until the new company is re-sold. Without this the unions would not accept the deal. In fact, it would probably be illegal for the private raider to split the company into these two divisions without putting up a guarantee for the legacy costs. But the US government could do this easily.

It seems like everybody wins. Surely, it is better than a bailout that allows GM to continue to operate with the legacy costs for more months, hoping the auto market will turn around. The only reason why this would not work would be if GM's argument that its operations are hampered by legacy costs is not really true.

It could be that GM's losses are sufficient to drive the company bankrupt even without the legacy costs. In that case the government would be out the full $20 billion for the legacy costs and receive nothing for the auto company, or perhaps some smaller amount, say $5 billion (which means the market is currently valuing the potential bailout at $16.8 billion = $21.8 billion - $5 billion, which is hard to believe given that the probability it takes place is less than certain). Then the government will be out $17 billion. Presumably in that case it can restructure the legacy costs, recognizing that if the company had gone bankrupt, which it certainly would in this case, the government would inherit the legacy costs anyway.

Let us suppose that if the government inherits the legacy costs it has to pay 40%. So if the company goes bankrupt the government is out $8 billion. Then even if the auto-GM is only worth $5 billion (as in the previous paragraph) as long as the government settles the legacy costs for less than $11 billion, the government is better off, and certainly the retirees are better off.

So far I did not consider corporate debt, aside from the legacy costs, but it is not hard to include this in the analysis. Suppose that there is $10 billion of corporate debt. Then GM's cash flows would be worth $31.8 billion ($1.8B + $20B legacy +$10B in corporate debt). If GM's theory is correct, then nothing is changed in the analysis. Absent the debt the company can be sold for $31.8 billion, which is enough to fund the legacy costs and the debt.

The interesting case is when GM's theory is incorrect, when the company is worth less than its current debt plus equity. To continue with the previous example, suppose the government can sell it for only $5 billion, so it is left with $3 billion after the purchase price. This now has to cover $27 billion in debt (corporate plus legacy). Using the 40% rule the government must reserve $8 billion for the retirees. The question then is how much of the $3 billion goes to the corporate debt holders and how much to the legacy costs. If the government pays 20 cents on the dollar to the debt holders, it can still pay $8.5 billion to the retirees, who are better off than under bankruptcy. Is 20 cents on the dollar fair? The government sold assets for $5 billion that had $27 billion in debt. Surely under bankruptcy proceedings the debt holders would have done even worse.

And what about the taxpayers? Even in this case they are better off. The government saves half a billion in this most pessimistic scenario compared with bankruptcy. And if GM is really worth something the government and the other stakeholders share in the gain. Alternatively, under a bailout the government is out the subsidy plus the same legacy costs if it is unsuccessful. And if GM still labors under the legacy costs there is no improvement in its operations. So the corporate raider solution is the best way to protect the taxpayer.

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