After Big Auto is Bailed Out, Who Will Buy Their Cars?

by Ian M Fried :: Filed Under The Economy :: December 7th, 2008 @ 1:08 pm EST

Reports right now are that the Democratic congressional leadership is negotiating with the White House over a $15 billion bailout plan that is designed to help the auto companies through March. I watched large portions of both the Senate and House hearings on a potential bailout for the Detroit Automobile Manufacturers this past week and came away with a few observations:

Testifying before the Senate Banking Committee on Thursday, December 4th, Moody’s chief economist, Mark Zandi, discussed how important it was to offer the full bailout due to the layoffs and economic distress that would be caused by allowing companies to enter bankruptcy. However he had two other points that made bankruptcy seem like a potentially viable option. First, the main argument that the auto executives and others of their supporters have been using to gain congressional support to stave off bankruptcy is that consumers, out of concern for the future of their vehicles, would not purchase cars from a company in bankruptcy. Well Zandi suggests that to counter this problem, the government could “guarantee warranties on any new cars sold by the Big Three while they are making their way through bankruptcy.” In other words, the government has a much less expensive option than a full bailout — if the warranties are guaranteed then that removes the worry by consumers that their warranties will not be honored. This does not address the whole problem but does lessen the concern about what would happen to these companies while they were being restructured under Chapter 11.
On the side of supporting a bailout are both key committee chairmen, Barney Frank of the House Financial Services Committee and Chris Dodd of the Senate Banking Committee. In his opening statement to Friday’s hearing in the House, Frank made the compelling argument that allowing the Detroit Auto Companies to enter bankruptcy would have a broad, harmful impact on the economy as a whole — “[B]ankruptcy is the ability to walk away from debt. The fact is that while we have this serious job loss, we continue to have a serious credit crisis in this country… And a permission to these three large entities to stop paying their debts — that’s called bankruptcy — would greatly exacerbate the credit crisis.” Frank is right in that bankruptcy is a debt forgiveness program, although Chapter 11 bankruptcy is as much about reorganization and debts are not washed away, but those who are owed money from these firms would be getting much less than the total of their billing. The consequences of this would not just be critical for teh credit market, but also for all the businesses that rely on the auto industry for their survival.

Frank’s argument is compelling, but the question to me still is who is going to buy Detroit’s cars over the next year? First there is the general downturn in the economy, meaning fewer people will be purchasing new automobiles. Second, even if the Three American auto companies do change their ways and develop better products, we are years away from those vehicles making it to the market. It is, as is well known, not a recent phenomenon that Detroit’s cars have been losing market share for years. From Zandi’s charts used in his Senate testimony,market share for GM, Ford and Chrysler has dropped from about 75% in 1995 to less than 50% today. Default rates on auto loans are at record levels, at 4% and rising, which leads to the question as to whether lenders will be so willing to grant auto loans to people in the current credit crunch. As Zandi wrote in his opening statement:

Vehicle sales will eventually return to their underlying annual pace of 16 million units, but only when the job market stabilizes, credit flows more freely, and the pent-up demand is worked off. It could well be two decades or more before sales return to the 17 million unit sales pace that prevailed during the first half of this decade.

Two decades! Can we afford to wait that long? The funds that are part of the bailout are loans, expected to be paid back over 10 years. Under current economic conditions — and the expected environment over the next few years, where is the inflow of capital that will allow these companies to pay back these loans? Who is going to buy their cars?