Book Review of “All the Devils are Here
The Hidden History of the Financial Crisis”

“Hell is empty and all the devils are here” - William Shakespeare - The Tempest

This brilliantly written book should be required reading for any registered voter in the USA. With all the misinformation “out there” about who and/or what caused the financial crisis, it is important to know where to go for answers. This book is “The Source.” The authors are Bethany McLean and Joseph Nocera. McLean was co author of the highly regarded book on the Enron crisis, “The Smartest Guys in the Room.” Nocera is an acclaimed financial writer for the New York Times. The authors’ mission is to tell the story accurately and honestly with no particular political agenda, to explain the complex in a way that can be understood by those not steeped in Wall Street “speak,” and to provide insight into the personalities and characteristics of the major players. The level of research evident in the book indicates to me that the authors were already well connected before they began their research for the book.

Why is the issue of the financial system meltdown important to those who follow the auto industry, and other sectors of the economy? In the late 1970's, consumption represented about 60% of the total economy. 30 years later, consumption was up to about 70%, despite the fact that the income of the middle class had remained stagnant during that time span. How did this occur? The additional consumption funding came from credit fueled primarily by “securitization.” Wall Street’s version of “securitization” had been invented and had grown to 40% of the total credit market by 2008. This expansion of credit fueled economic growth. When the mortgage backed securities market collapsed, it took down the entire securitization market including, credit cards, student loans, commercial loans, auto loans, dealer floor plan, and many other forms of credit. Losing a major portion of available auto credit and funding for dealer floor plan and working capital, pushed already shaky auto manufacturers over the brink, as auto sales slid and dealers dropped like flies. The resulting vicious cycle took the economy downward into recession. The Troubled Asset Relief Program (TARP) was all that stood between the economy and a major depression.

“Securitization” was the process that “allowed mortgages to be converted into a “bond” by combining numerous mortgages into one huge financial instrument. First, Wall Street invented “tranching” to divide up the securities into segments, typically three, based on the inherent risk each tranche entailed. This protected the highest risk level tranch from loss by paying off defaults from the lower rated tranches first. The next step was to devise “derivative” contracts to “insure” the risk. Based on derivative “insurance” like credit default swaps, Wall Street was now able to convince regulators that it was not necessary to “reserve capital” as a hedge against default claims. Now, if only they could get these securities rated AAA by rating agencies like Fitch and Moody, Wall Street nirvana could be achieved. Now junk could be sold around the world as high yield AAA rated securities. AAA is the rating equal to the rating of Treasury bills. To say the least, billions of dollars were made, huge bonuses paid, and many innocent people bilked.

Guarantors of risk were not required to have the money to make good if their bets didn’t pay off. Yet, traditional depository banks were still required to reserve capital, as had been the norm ongoing. This rendered traditional banks to be uncompetitive UNLES they sold their own mortgage originations to Wall Street. If a depository bank originated a mortgage, it could sell that mortgage to Wall Street, buy it back as a part of a AAA rated security, and avoid the “capital reserve requirement. Rating agencies like Fitch and Moody were paid by the Wall Street banks whose products they rated.

Junk mortgages could be assembled into a MBS (Mortgaged Backed Security), tranched into 3 segments based on “risk,” “insured” with a Credit Default Swap contract where no capital reservation was required (it was assumed that Wall Street would not take risks not in their own interests), obtain a AAA rating to represent the securities’ safety as the highest grade, which allowed them to be purchased by entities limited to AAA investments by law, like pension funds, and sold around the world . Profits were privatized on Wall Street as huge profits were made and mind boggling bonuses paid to executives. The risk, however, was socialized to U.S. taxpayers.

The U.S. government, in the form of the George W. Bush administration and it’s Treasury Secretary Hank Paulson, was put into the position of allowing the world financial system to collapse or step in with TARP. Fortunately, Congress approved TARP, which despite its imperfections, saved the world from an incomprehensible disaster. After all, it was the U.S. government’s lack of oversight that stood by and let it happen in the first place. Other countries were looking to the Americans as their own economies were severely impacted by the actions of American investment bankers.

Governments are generally expected to protect it’s citizens from avoidable disasters. The Republican Party found this out after the Great Depression. Democrats paid a price after Jimmie Carter. Even President Barack Obama has been blamed by some despite the fact he had nothing to do with the disaster, other than casting some votes while a Senator. Unfortunately, many voters lack the ability to grasp complex issues, and fall prey to simplistic explanations.

In 1979, the Wall Street version of securitization was invented and launched by Merrill Lynch. Government Sponsored Enterprises (GSE) in the form of Fannie Mae, Freddie Mac, etc., had securitized the first mortgages in previous years. The GSEs were given objectives of how many low down payment low income loans they should make at a minimum by Congress. The compensation packages of the executives of the GSEs were predicated on these objectives. Interestingly, the GSEs were already making these types of loans at a much higher rate than the objectives they were given, making huge bonuses a given. Further, the GSEs received credit just for purchasing AAA MBSs containing them from Wall Street. The GSEs thought that was safer than holding the paper themselves. In fact, Wall Street had rendered the GSEs superfluous.

Wall Street was allowed to create a “betting market” on almost anything. The problem was not so much deregulation, but a refusal to regulate at all. During the period of time Wall Street was “rocking and rolling” American home ownership increased only 1.7%. Yes, we have paid a terrible price for such a small increase in the percentage of those who get to experience the American dream. Yes, mortgage originators “approved” huge numbers of loans with little chance of them being paid back. And they did this because they were never going to hold the paper anyway, just as an auto dealer sells auto loans to his/her banks. It was all being sold to Wall Street because they could take the lousy paper, turn in into AAA rated securities, and sell it to anyone. But the real problem was with home refinances and home equity lines of credit.

So who caused the meltdown and who were the players? In 2008, I wrote that the meltdown was caused by an “unholy alignment between liberal and conservative political causes.” This was after watching hours of testimony on CSPAN and studying the subject intensely. After two years of additional study, including watching Hank Paulson, the Bush Treasury Secretary and author of TARP, testify before Congress under oath, I have adjusted my thinking. But my own personal opinion is not important. All of us have to satisfy ourselves. For those who want to believe the meltdown of the financial system was caused by the overly altruistic “holding a gun” on lenders, forcing them to make loans they knew would never be paid back, you will be disappointed. It’s a non issue.

Some major “players,” their roles, and some resources are listed as follows:

“All the Devils are Here,” Nocera and Mclean

“On the Brink: Inside the Race to Stop the Collapse of the Global Financial System,” By Henry Paulson”

The last chapter of Bush speech writer David Frum’s recent book: “Comeback: Conservatism That Can Win Again”

“Overhauled” by Steve Rattner

George W. Bush speech on American home ownership from 2002

http://autosandeconomics.blogspot.com/

George W. Bush - consciously worked to prevent anything from slowling the housing juggernaut that was fueling the economy. He also had the guts to stand up to his own party’s ideologues to move to save the economy from destruction by proposing and passing TARP along with his Treasury Secretary. Moved against Congress to bail out GM and Chrysler by using TARP funds after Congress had turned down a bailout package.

Alan Greenspan - a disciple of Ayn Rand, Chairman of the Federal Reserve, fought regulation of derivatives at every turn

Larry Summers - under the Clinton administration was an opponent of regulating derivatives. Teamed with Robert Rubin to squelch Brooksey Born’s bid to regulate derivatives. At the time, Born was Chairperson of the Commodities Futures Trading Commission. As a member of Barack Obama’s administration, Summers was a key player in the bailout of GM and Chrysler, and the direction of many TARP funds.

Robert Rubin - Treasury Secretary under Bill Clinton - worked to quell efforts to regulate derivatives

Brooksey Born - Chairman of the Commodities Futures Trading Commission - moved to regulate derivatives, and was squelched by Rubin and Summers.

J P Morgan - invented the credit default swap by paying the European Bank for Reconstruction and Development to assume it’s risk in their exposure to Exxon, which tapped 4.9 billion of it’s 5 billion dollar credit line after it’s notorious oil spill disaster. It never occurred to anyone to ensure the EBRD had the funds to make good in the case of a default. It turns out it didn’t make any difference. Years later, the were many claims to be paid and only the U.S. taxpayer to pay them.

Moodys, Standard and Poor, and Fitch Rating - Were paid by the same companies who’s products they were supposed to rate. Enabled Wall Street to sell junk as AAA level investments.

The Three Amigos - Lewis Ranieri - Salomon Brothers bond trader - “I wasn’t out to invent the biggest floating craps game of all time, but that’s what happened.” David Maxwell - CEO of Fannie Mae, formed an uneasy alliance with Ranieri and Wall Street. Larry Fink - After creating some of the first mortgage backed securities he later served as a key government advisor.

Blythe Masters - helped invent the credit default swap for J P Morgan

Joe Cassanno - Ran the Financial Products division for American Insurance Group (AIG) - Began selling credit default swaps (CDS) on collateralized debt obligations (CDOs) “Collateral triggers” built into AIG CDSs helped bring the company down.

Phil and Wendy Gramm - As Senator and later as Chairman of the Senate Banking Committee, Phil blocked attempts at regulation at every turn. Wendy Gramm, a PHD economist, was installed as Chairperson of the Commodity Futures Trading Commission (CFTC) by Geroge H W Bush when it’s current Chairman, Mark Brickell, was moving to regulate derivatives. The move stopped the move to regulate in its tracks.

Roland Arnall - Appointed to the post of Ambassador to the Netherlands by George W Bush while his company, Ameriquest, a major sub prime mortgage “lender,” was a leader in blatantly deceptive lending practices. At one point, a group of ex auto business F&I managers operated a consulting company, specializing in showing fledgling mortgage brokers how to falsify and manipulate documents. They went so far as to have a web site devoted to creating phoney pay stubs, tax returns, job letters, etc. In fact, Wall Street wasn’t really concerned about documentation, as they were able to turn lousy mortgages into AAA rated investments under most circumstances.

President Barack Obama - Was duped and gave Arnall a pass during Senate questioning regarding Arnall’s ambassadorship because a mutual friend, Deval Patrick, the current Governor of Massachusetts, sat on the Ameriquest Board of Directors. His administration inherited the economy in a dreadful condition, although without the strong and decisive action of George W Bush, Hank Paulson at Treasury, and Ben Bernanke at the Federal Reserve Bank, things would have been much worse.

These are only a few of the personalities and characters involved. Before a reader allows themselves to be intimidated by the prospect of not understanding everything in the book, please understand that the people perpetrating these evils on the world didn’t fully understand what they were doing themselves. People don’t usually buy books about business for entertainment purposes, but I couldn’t put this one down. It read like a riveting“who dunnit.” Don’t pass up the opportunity!

Ruggles

Ruggles in Wards, reprinted with permission

Ta-Ta Clunkers; Now What?
Let's hope a dead spot won't follow successful program
By David Ruggles, Ward's Dealer Business, Sep 1, 2009 12:00 PM

Cash for Clunkers has been a surprise success to many, including government.

Hopefully, we won't have a serious dead spot now that Clunkers is kaput. We all know how rebates can be like getting on drugs.

Training consumers not to buy until the next program contributes to a “whip saw” market that makes good consumer satisfaction impossible. It also makes marketing dependent on loading up dealers' inventories and then introducing a program to sell them.

Still, Clunkers was worth it. In my 38 years in the business, this has been only the second time I have seen a federal initiative spark so much sales activity in the new-vehicle business. The first time was when the Nixon administration repealed the excise tax on cars in 1971.

There have been other government initiatives that stimulated sales, but mostly through tax policy. Most recently, the Bush administration provided a substantial tax credit for those purchasing a vehicle over a particular GVW rating.

This was meant to spur the purchase of trucks by ranchers, farmers, plumbers, and other small business people. It also spurred the purchase or lease of Navigators, Escalades, Suburbans, etc. to doctors, consultants, and anyone who could take of advantage of the business write off.

But the tax policy measures didn't have the broad appeal of Cash for Clunkers.

As a consequence, about 707,000 old vehicles have been designated for the crusher. Engines have been destroyed to ensure the clunkers do not find their way back into the system. Initially, this is having an impact on the Buy Here, Pay Here dealers. What the Feds call “clunkers,” they call inventory. Any revival of the program will exacerbate their plight.

Clunkers is not the only factor impacting the pre-owned market. The low seasonably adjusted annual sales rate has generated fewer sales. This means fewer pre-owned vehicles will be available down the road.

A lot fewer rental vehicles have been placed in service. There's a dearth of new leases put on the books. As pre-owned values strengthen, fueled by the inevitable shortage, there will be more people in an equity position than before.

I expect this trend will be tempered by people keeping their vehicles longer. We all know that above-average miles have a major impact on true resale value at auction. But the trend is certainly toward higher pre-owned prices down the road.

Despite the recent rise in pre-owned prices we hear complaints from dealers that some guidebooks' loan values are not reflective of what is really going on in the pre-owned marketplace, so owners who should show equity are shorted by lenders who use those guides in their finance advance calculation.

Another interesting by-product of the strengthening pre-owned market might be the impact of current lease returns to the OEM captives and independent bank lessors.

I am told many lenders took write offs for current and anticipated residual losses. Some of those previously stated losses may turn out to be profits in the current marketplace, which is driven by the pre-owned shortage and low fuel prices.

Pre-owned values can only go so high, but perhaps we have not yet hit the ceiling. Just imagine a world where new vehicles can be sold without rebates or dealer “trunk money.”

A true pull market scenario would strengthen pre-owned values even more and provide even more trade equity for would-be buyers. Might we be able to return to the pre-Joe Garagiola days when the baseball player turned Chrysler TV pitchman said, “Buy a car, get a check” in 1975? My guess is probably not.

The domestic auto makers have trained an entire generation not to purchase unless there is a rebate. In addition, there are just too many competitors all vying for sales. Where will it end up? Nobody knows. Here's hoping those guidebook loan values will catch up with the market. Dealers and consumers need all the legitimate help they can get!

Former auto dealer David Ruggles is president of Advanced Concepts & Techniques. He is at Ruggles@msn.com and 312-925-1863.

Lies, Damn Lies, and Statistics!

David Ruggles
See also Cliff Banks article in Wards

As I watched the Senate hearings today on CSPAN my blood boiled. When asked about the money they would save by cutting their dealer count these guys, Henderson (GM) and Press (Chrysler), engaged in some serious obfuscation. They asserted that by swapping an "under performing" dealer for a "performing dealer" they would pick up the gross profit of the additional sales of the new "performing" dealer. These calculations of the difference between what they got and what they felt they were entitled to makes up the bulk of what they claim the rejected dealers "cost" their companies.
I have a little experience in this area. I have operated dealerships in a number of markets. As a consultant I have visited hundreds of dealerships and worked closely with them. The best dealers are those who have structured their business in such a way as to be less vulnerable to the inevitable downturn in either the new vehicle market or the times when the offerings of their manufacturer weren't well accepted in the market. These successful dealers learned to develop their pre-owned business and other profit centers, and they probably brought in other manufacturer makes to help cover their fixed costs in the event of a market downturn.
These dealers are typically still profitable, despite our difficult sales environment. These are precisely the type of dealers targeted by Chrysler and GM.
Markets are not created equal. To understand the concept, think in terms of MSR, which stands for Minimum Sales Responsibility in the Chrysler business. GM has its own terminology, but the same meaning. MSR is where a manufacturer's national market share percentage is applied to the total new vehicle volume in a specific dealer's market. Any deficiency – shortfall from the target – is what a manufacturer views as lost sales. They can calculate the gross profit they would have made had the dealer hit its MSR. But now they appear to count it as a cost in justifying the arbitrary termination of dealers and their employees. There are additional assumptions. The gross profit they calculate is the margin they make when they sell the a new vehicle to the dealer. The dealer has to sell it at retail to make money themselves, which isn't always possible. MSR also varies by locality; it is certainly possible that a dealer who exceeds MSR in one market would underperform in another.
The fact is, Chrysler and GM resent dealers who have managed their business in such a way as to not be overly dependent on selling their products. Many rejected dealers have been targeted as a result of their business acumen. In addition, Chrysler and GM are moving to force more expense onto their retained dealers. GM has sent out "participation agreements" that any dealer wanting to go forward must sign. It effectively replaces the franchise agreement, forcing dealers to agree to do anything and everything, or else. Don't sign, and the dealer is terminated. GM and Chrysler want more elaborate and expensive facilities. The also want exclusivity in those expanded facilities, meaning the manufacturers won't allow competitive makes in these facilities, even though they are purchased or leased by the dealer, NOT the manufacturer.
Normally, dealers would be protected from these types of unreasonable demands by state and federal franchise laws. But GM and Chrysler are taking advantage of their bankruptcies to avoid these restraints. They are showing why these laws existed in the first place - there is a long history of franchisors abusing franchisees, once the franchisee has money in the business that they can't extract. The auto industry isn't unique, but each store represents a far larger investment than in fast food or most other franchising. Congress and the states had made such blackmail illegal; now Chapter 11 is being manipulated to allow it.
I have a friend who had a Chrysler-Jeep operation yanked from one store, and a Dodge operation from another. Now Chrysler can give them to a competitor. These yanked franchises didn't fall out of the sky, good money was paid for them. Chrysler wants to exact a 3 million dollar building from the other dealer in return for being granting it the franchises. The dealer who was NOT terminated was not selling near their MSR, so there must be other motivations. It will be poetic justice if the yanked Chrysler, Jeep and Dodge franchises languish for lack of a party willing to invest that much for a new facility. Time will tell.
According to Chrysler's Press the distribution costs per vehicle amount to about $1000. Of course, each vehicle bears its proportion of these costs regardless of which dealer they were shipped to. In Press' argument this cost would be less if they could replace under performing dealers with (fewer) performing dealers. But these costs aren't related to the number of dealers – they represent the money spent to develop and maintain the software in the first place.
Furthermore, neither executive mentioned the costs their companies have transferred to the dealer. While claiming there were substantial costs associated with the software and hardware related to their dealer communication IT package, Press neglected to mention that each dealer is charged about $2600 a month for this. He failed to mention that there really are very few, if any, field people these days, as dealer contacts are made by email and telephone instead of actual in-store visits. There was a concerted effort to overstate costs and avoid altogether any mention of how much of these costs are actually reimbursed by dealers. In fact, studies show that each dealer represents POSITIVE cash flow BEFORE they buy a vehicle or a part!
I've been frustrated by previously not being able to determine who made the decision to cut dealers, rather than to allow natural attrition to thin out dealer ranks. (That attrition rate is high at present!) It is hard to believe that Henderson and Press have that little understanding of the auto business. I have to conclude that the initiative to lower the dealer count is driven by the Task Force, who think Toyota's business model is what everyone should emulate. The Task Force may be made up of restructuring geniuses, but they have little understanding of the auto business. Their profession means they are mostly North Easterners who may not even own a vehicle, and are not oriented to the issues of smaller businesses. But when a dealer closes, it likely results in a bankruptcy in which a family's life savings are wiped out. It's not just a job loss. The Task Force doesn't seem to understand this. Closing dealerships will cost sales for Chrysler and GM, something they can ill afford. And the ill-will it generates will cost them a lot more than any potential savings.
Imagine Gillette volunteering to give up shelf space space at the super market to Schick! It's the same principle. Foreign competitors looking to expand their dealer base will scan the ranks of rejected GM and Chrysler dealers. If not for the recession, that would save many of the terminated dealers.
In the meantime the "task force" is driving the bus while all parties deny any micro managing by the government.
But remember: as bad is it is, it's better than liquidation! Those who think Chapter 11 for GM and Chrysler should have been declared last summer have forgotten the financial crisis. To operate in Chapter 11 still requires financing, and for almost a year now that has only been available from the US Treasury. The Task Force is necessary, but the specialized nature of their skill set is apparent. The faster these two firms exit Chapter 11 and the Task Force stops calling the shots, the better.

Dealerships are a Cost? - I Don't Think So!

Mike Smitka

The statements of the CEOs of GM and Chrysler at today's Senate hearing on dealership closures make very little sense overall. (For details, see the National Automobile Dealers Association website. Full details should be on the website of the Senate Committee on Commerce, Science and Transportation.) It is true that some dealers run shoddy operations that hurt the brand in the communities where they operate; that is a problem in any franchise system. Current state franchising laws make it very difficult for "the factory" to yank the franchise of such dealers. Well and good if those are the dealerships being targeted – but there is no evidence that is the case. Are there that many bad apples in the GM dealership barrel? I don't think so.
The only GM statement that had any numbers in it refered to incentives paid to dealers and sales people, along with training, advertising and other support, at an average of $1,000 per vehicle.* For GM to save money, they have to cut that number a lot. Is there a lot of fat to be cut?
I don't think so. Here's why.
So let's say GM trims the number of dealers. IT and the like are fixed costs, independent of the number of dealers – though generally dealers get charged for software, brochures, everything. There are thus big savings only if the incentives are trimmed. So the bottom line is that for consolidation to save GM money, the productivity of sales staff and the dealership as a whole has to increase. With 20% of dealerships being cut, each sales person has to sell 25% more (= 1/.8), because for this to make sense the dealership can't add personnel or other costs. All while the dealership is earning significantly less for each car they sell. Is that realistic? I don't think so.
With fewer sales points, GM will somehow have to attract more customers, a lot more customers, to each physical location. They've failed at that in the past two decades. Are GM products so hot now and henceforth that they can get by with fewer locations? I don't think so.
OK, so GM wants newer dealerships, sometimes in new locations, so that volume per dealership can increase. But if I'm making less per vehicle because GM has just cut the wholesale discount, why would I want to do that? Not unless I'm making so much money that I can be coerced by GM into handing more over to them. If I were the banker for such a dealership, how would I react? They want me to lend them a lot of money to build a new dealership in a down market under a marketing plan that intends to cut the margins that dealers earn? Would I as a banker lend them the money to do it? I don't think so.
And hasn't GM ever heard of the internet, customers shopping online, test driving here and there, but coming to a dealership only to sign the paperwork? Does a fancy store add value in the new retailing world? Carpet reeking of mildew is one thing, I've been in dealerships like that, and walked out. But will fancy brick and mortar make me more likely to say "yes" to a harried salesperson? I don't think so.
Finally, what of Certified Preowned Vehicles? GM needs to sell those – especially once leasing starts to increase and rental car companies renew their now-aging fleets. "Underperforming" dealers are still in business because they were doing something right. Looking only at new vehicles is narrow-sighted. Are the fewer number of urban megastores going to let GM move that metal? I don't think so.
One possibility is that this is coming from the Administration's automotive team. They've proven to be brilliant workout specialists, getting the potentially viable portion of Chrysler through Chapter 11 in a manner the bankruptcy lawyers I've talked to thought impossible. Is that skill set likely to suit them to understanding the complexities of franchising, particularly franchising in the multiproduct context of a car dealer? (Dealers have at least 5 business lines, new, used, service, parts sales, finance & insurance brokering, and often a body shop.) Probably not. This lack of understanding may be further muddied by a comparison of dealer averages between Toyota and GM. That assumes that Toyota does well because of its dealerships, rather than the other way around: Toyota's dealers do well because Toyota's market share has steadily risen, ahead of their dealer count. But Toyota's attempt to sell full-sized pickups has flopped, because they don't have all those small, rural dealers who at GM sell their most profitable product. See David Ruggle's post below on The Task Force. He's actually seen restructuring first hand, and knows more of the specialized skills that entails.
Let me hazard a guess, [after consulting with a friend, almost surely wrong] that the incentive system for GM's factory reps focuses on the number of new cars they sell. For them, an "underperforming" dealer makes them look bad, there's no way they can match the bonus of a rival who drew "better" dealers. The smarter dealers watch the mix of used and new vehicles, and if they can snap up preowned on the cheap at auction and make more money, they'll shift their emphasis in that direction. But the reps who handle the certified preowned side of the business, well, they're kept in the back room, out of sight. Management doesn't see their success. [Again, GM was the one to launch the CPO business, and it's built into their rep system, so that doing well on CPOs was a positive, not a negative to reps.] But that means GM will be cutting their smarter dealers, the ones with the best business skills and feel for the market. Does that make good business sense? I don't think so.
* CEO Fritz Henderson: "GM pays about $1,000 a vehicle for dealer and salesperson incentives, advertising, field sales, service and training, and information technology support, he said." Automotive News. There was no breakdown or support for this $1,000 figure. GM does not have anything to say about salespeople and their compensation; that's up to the dealer, whether they work salary, straight commission, or something in between.

The "Throughput" Myth!

David Ruggles

Much has been written and spoken by the administration and in the media about the bankrupt Chrysler and GM Dealers lack of “throughput” as if it is a big drag on Manufacturer viability. This is used to justify the rejection of “deficient” and “extraneous” Dealers. It was pointed out in the Wall Street Journal recently that Toyota Dealers average 1613 new units per year while Chevrolet averages 643 and Dodge 408. The piece used the word “disastrous” to describe Buick Dealers’ 102 unit per year average, as if “throughput” is a settled issue as a negative. It is common knowledge that the administration’s automotive “task force” views “throughput” as a critical element to Chrysler and GM’s future profitability and is using Toyota as their benchmark.
In truth, new vehicle “throughput” has little to do with either Dealer or OEM profitability. For Dealers profitability has everything to do with the ratio of overhead to overall sales, which includes pre-owned, service, parts, etc. Dealers who have been committed to higher overhead levels are desperate to increase new vehicle “throughput” just to break even. Dealers who have been able to keep their overhead under control are less vulnerable to the vagaries of the overall automotive market and to the fact that Manufacturer offerings run hot and cold. Dealers who have learned to maximize the results of their other profit centers are also less vulnerable. In my own experience I ran the 2nd most profitable Chrysler dealership in the Chicago zone in the early eighties. We never sold as many as 100 units in a month. We were making $50 K a month in 1982 dollars during the peak of the Chrysler bailout crisis of that era. Chrysler had not succeeded in getting us to move into a higher overhead facility and otherwise boost our overhead. The profit leader was a large fleet dealer that had to sell thousands of units a year to beat our profit numbers. During that same era, Long Chevrolet, a Dealership that still holds the record for yearly new vehicle “throughput,” was shuttered and bankrupt. And for Manufacturers, each Dealer is a profit center, not an expense.
Toyota, with their high “throughput,” has one of the lowest J.D. Power “SSI” figures of any Manufacturer’s Dealers. “SSI” is Sales Satisfaction Index. Toyota’s high “throughput” must contribute to the fact that their customers are highly dissatisfied with their purchase experience even though they love their Toyota vehicles. Toyota’s sales numbers have tumbled along with the rest of the industry in recent months. Using Toyota as a model may not be the most intelligent benchmark for the “task force” to use as they have posted record losses recently.
It is widely understood within Toyota, and within the industry, that one big reason for the lack of success of Toyota’s superb new truck, the Tundra, is their lack of Dealer coverage. Adding Toyota Dealers will tend to lower each one’s “throughput.” It has been proven that truck owners, who tend to be loyal to their brand anyway, prefer to drive say 30 miles to their nearest Ford, Chevrolet, or Dodge Dealer than drive over a hundred miles to a Toyota store. Further, court documents in Chrysler’s bankruptcy included comments by Jim Press, ex Toyota exec, which indicate he is aware that shedding Dealers is counterproductive to Chrysler’s profitability. If he’s right, lowering the Dealer count to increase “throughput” is counter productive.
According to Joe Eberhardt, Chrysler’s senior vice president for sales and marketing, when a Manufacturer’s loses a Dealer, OEM costs stay the same and–at least in the short term–it loses that Dealer’s new vehicle and parts sales. “There’s no immediate payback,” he stated.
Arbitrarily stating that high “throughput” is an essential element to the viability of Chrysler and GM may sound good to those who think the “Factory” owns all of its’ Dealerships, but those in the know ain’t buying it. If the “task force” actually believes this, and they are in charge of fixing the two ailing automakers, we’re all in trouble! In the meantime, Ford and other competitors are gloating and making absolutely no moves to raise their Dealer’s “throughput” by reducing their Dealer count. I suspect there will be immediate moves by GM and Chrysler’s competitors to pick up some additional market representation by forming relationships with “rejected” Dealers and by securing abandoned GM and Chrysler facilities.

The Task Force

David Ruggles

I'm a vocal critic of a lot of what is being done in the auto business, but it is clear to me that "corporate restructuring specialists" are a specialized breed and it's quite likely that this skill set is not one held by many car people, if any. An executive from Alix Partners has been appointed to head the GM restructuring. They are the foremost restructuring specialists in the world. The sooner the restructuring is completed and the specialists are out of the way, the better. Putting car business people in charge a complex corporate bankruptcy might not be a good idea. Many corporations that handle it themselves do so under the auspices of specialized consultants, who are highly paid. Having said this, I'm not thrilled with the decision to cut dealers. It's not clear who made that decision. I'd sure like to find out [ad hominem attack deleted]!
But without gov't intervention it would have been Chapter 7 for Chrysler and GM and a shut down of auto production in North America for a period of long months.

More on Dealers: My Opinion in NYT

Mike Smitka

Here are a series of brief items in the New York Times "Room For Debate" online forum on their Opinion page: Link here. My contribution starts:

G.M.’s bankruptcy could still unravel unpleasantly. It’s a big customer for the supplier base, and they’re on the edge. Chrysler’s dealers got 26 days’ notice. G.M.’s franchises don’t expire until October 2010. But that’s remote from our everyday experience...

Everyday People: Why Is Bigger Still Better?

Mike Smitka

Everyday People: Why Is Bigger Still Better? But in order to serve small towns and the many users with different "needs" a car company itself can't be small. Economies of scale in design, engineering and production are large, at this level partially offset by the ability to spin products off of a common "platform". Unlike Europe, the US is spread out – though most people live in suburbs & cities, in the aggregate rural areas remain a big market. Small dealerships are indeed integral to that! Mea culpa: I live in a rural small town.

Downsizing = Exiting the Business: Where Lie Economies of Scale?

Mike Smitka

Jerry Flint, the long-standing auto industry person and later senior editor at Forbes, has a short article in Wardsauto.com arguing that it's bizarre to think downsizing will work. He writes better than I do; see the link below.
Basically, the OEMs are in a high fixed-cost business. But unlike steel, where the costs tend to be at the plant level, in autos they are at the firm level. Fiat's Marchionne is explicit that that is why wants Chrysler (and even more, Opel, GM's European operations). Without sheer scale, Fiat cannot undertake the R&D on new powertrains (such as plugins) and materials (a unibody car is a complex mix of steel and aluminum alloys, made using newish technologies such as hydroforming and with all sorts of complexities in welding or otherwise joining dissimilar metals). Without such clout, Fiat will have a restricted dealer network, in a narrow set of markets, limiting its pallet of vehicles types, and reducing the chance that a bit of sales here and a bit there of niche products will make the underlying vehicle platform a profitable proposition.
This is not to say that GM didn't have excess manufacturing capacity for any near-term volume of sales. This is not to say that GM didn't have unsustainable legacy costs. This is not to say that multiple model lines hadn't been muddied, and that cutting one might be the only way to clean up the mess. [See my earlier post on downsizing.] Some pruning is appropriate. Jerry Flint's argument is that what we see is not pruning, and will kill the tree.

Link to Go Ask Alice About Plans to Save GM, Chrysler and to the auto industry reporting at Forbes.com by Jerry Flint. I corresponded with him years (decades?) ago, and always found his writing based on insightful analytics (even if he spells his models out in less detail than I as an academic do). Time for me to look up and read through his last couple years of work. I stopped doing that, involved in Japan projects unrelated to the auto industry. Events have pulled me back...

Chrysler dies; bailout a success

Mike Smitka

Quite frankly, I don't expect Chrysler to last the year. Indeed, I would be surprised if the "new" Chrysler, to be announced before the end of June, will be successful in relaunching production. Too many of its suppliers are on the wrong side of the brink. At the low volumes of production that will prevail while 100 days of inventory remains in the system, it won't pay for them to keep the parts flowing to Chrysler's assembly plants. All it takes is one crucial supplier to say "no" – or to be unable to finance restarting production – and it's the end of the line. In several senses.
Nevertheless, I judge the Chrysler "bailout" to have already been a success.
Why? Well, let's think of the timing. Back in December 2008 the financial system was still close to implosion, as was General Motors. Confidence across the economy lay somewhere between gloom and doom. At the time Chrysler clearly was not viable – not that that has changed, with or without Fiat. The "rescue" is in that sense a bit of a misnomer, because the patient will never be resuscitated. With the final denouement, billions in government funds will vanish (I don't want to count, but remember there is indirect lending via the government-owned GMAC, not just the direct "bailout" money).
But given the timing, a Chrysler collapse Christmas 2008 would have been a present worse than a lump of coal in a child's stocking. It would have been fat on the fire of prevailing fear, marginal financial institutions burned critically. GM would have seen suppliers shut their doors, and once that happened, Toyota and the other new entrants ("Detroit South") would likewise have had to shut their assembly lines. Three-quarters of a million workers would get the post-Christmas message that for the time being they had no job to return to. The spin-on from that ("multiplier effect" in economist's lingo) would have been horrendous; unemployment would have jumped almost overnight to double-digit levels.
Now the economy can handle Chrysler's liquidation, and (with less assurance) that of numbers of key suppliers. GM will not collapse; financial panic has been quelled, and that Chrysler was expiring would not be news. Detroit would be in mourning; even I might shed a tear, since I paid college tuition with summer jobs at Chrysler plants. But the economy would not be pushed over the brink.
And I might be wrong. Chrysler has lived from crisis to crisis. But this time around I don't think they'll make it.

PS: David Ruggles, who sometimes posts here, makes a parallel argument from the "downstream" dealer side: no responsible financial institution will make loans to a Chrysler dealer to finance their inventory (offer "floorplan" in industry jargon). Nor should they finance consumers at more than (say) 50% of purchase price, given the uncertain value of Chrysler products as collateral. If indeed banks behave as banks (GMAC, under government ownership, isn't), then Chrysler will have no dealers left to whom they can sell vehicles. End of story.
I made this point in a forum at the Auto Finance Risk Summit in Miami on 20 May 2009, organized by Royal Media Group. Thanks to a discussion forum there for stimulating me to make various "devil's advocate" arguments. I've concluded that this line of argument is (sadly) more than just a good debating point.

Dealers: The Industry's Lifeline

Retailers are still the Detroit 3’s most valuable asset. Forget over dealering. It’s a dead-end debate. It’s almost impossible to find two people who agree on what is the right number of dealers in any given market. The market itself determines the correct number.
And it should be up to the individual dealer, as an independent business owner, to decide if and when it’s time to get out of the business. Nevertheless, an extraordinary amount of media attention has been focused recently on the number of auto dealers that sell the brands of the Detroit 3 (GM, Ford and Chrysler). There’s nothing wrong with that – except when assertions are made and studies are cited that are flat inaccurate. Consider this. The Detroit Free Press cited a CNW Marketing Research study, which has not been made public, that claims the cost of “excess dealers” to the Detroit 3 is nearly $4 billion. Now that’s a number that gets your attention. But is it right?
It certainly doesn’t appear to be. For example, the first item that’s listed as an additional expense to the manufacturer is “the cost of delivery of the vehicle to the dealership.” Dealers everywhere must have shaken their heads in disbelief when they read that, and everyone else who knows this business must have done the same thing. I’ve been a dealer for more than 30 years. I’ve paid the delivery costs for every vehicle delivered to my dealership. Every vehicle. So has every other dealer in this country. And we’re not talking about a small amount; the average freight charge per vehicle these days is around $700.
Let’s take a look at some of the other costs that the dealer pays:

• Delivery of parts
  
• Communications
  
• Training
  
• Special tools and diagnostic equipment
  
• Land, showrooms, service bays, dealer lots, etc.
  
• Advertising. Dealers contribute hundreds of millions of dollars each year toward advertising controlled by the manufacturer.

I could go on and on. Dealers, for example, often use a manufacturer’s captive finance company for floor plan loans and retail customer credit; both are profitable enterprises for the manufacturer. And let’s not forget that it is the dealer who buys the vehicles from the manufacturer in the first place. Without the revenue that dealers provide to the manufacturer, the factories’ assembly lines would fall silent. This is why manufacturers describe their dealer networks as their most valuable asset. Each dealer location that a manufacturer loses could also result in a loss of market share. That’s what happened to General Motors when it eliminated Oldsmobile and more than 2,700 Olds dealers.
So, the real question is whether the Detroit 3 will drastically lose market share if they drastically reduce the number of their dealers. Dealers are the entrepreneurs, the risk-takers. They provide good jobs to 1.3 million Americans, the kind of jobs that can’t be outsourced overseas. They are at the forefront of child passenger safety and are active in almost every charitable endeavor. The value that they bring to their manufacturers and to their communities is priceless. And some dealer families have been at it for more than 100 years.
The current automotive retail distribution network in the United States is the most efficient the world has ever seen. It provides competition and convenience, which benefit millions of car buyers every year. Given the fact that the dealer pays for just about everything he or she gets from the manufacturer, it’s easy to see why the cost to the manufacturer for its retail dealer network is minimal. In fact, research at GM found that a dealership only needs to sell 10 new vehicles a year to pay for the cost of supporting that dealership.
Profitability counts. The National Automobile Dealers Association represents more than 93 percent of the dealers in the country, both domestic and import. Anti-trust laws impose restrictions on trade associations advocating actions that would reduce competition, so it is inappropriate for NADA to take sides in the debate over dealer numbers.
What’s important is to take the long view. The industry is inevitably and notoriously cyclical; the manufacturer that’s up today can be down tomorrow. In other words, the marketplace is constantly changing. It’s not just the number of dealerships that counts; it’s whether a dealership is profitable. And that’s where our focus is: making dealers more profitable, so they can survive the good and bad times and be in a stronger position to service the customer that much better.

The preceding commentary by GM Dealer and 2007 National Automotive Dealers Association Chairman Dale Willey is available on the here on the NADA web site and was also published in Automotive News on July 30, 2007.

Is there a GM without Opel?

Can GM sell off assets such as Opel and remain a going concern? I have my doubts.
At one time, while GM assembled cars in most major markets, these operations were largely autonomous. After all, GM expanded outside the US more by acquisition than by organic growth. For example, it entered the UK market through the 1925 acquisition of Vauxhall, which had started producing cars over two decades before, in 1903. Similarly the core of its continental operations is Opel, which began producing cars in 1900 but was not purchased by GM until 1929, while it acquired the Australian firm Holden in 1931. The most recent such acquisition was in 2002, when GM took over the core operations of the Korean-based firm, Daewoo (which turned out its first motor vehicle in 1937, during the Japanese colonial era).
That is no longer the case; GM is now a global firm, rather than a collection of national operations. Beginning in the mid-1990s it began to focus more carefully on developing a set of core platforms to serve as the basis for the vehicles it manufactured around the world. The next step was to lessen duplication, reducing the number of platforms, and then creating engineering centers that concentrated on specific products. Holden in Australia worked on rear-wheel-drive cars (though those programs are currently in abeyance); Opel in Germany worked on compact and mid-sized cars. The US focused on light trucks and larger front-wheel-drive vehicles. Finally, Daewoo focused on subcompacts. And consistent with that, Vauxhall in the UK no longer develops its own product; instead its vehicles are all engineered in Germany.
The geographic lines reflect in part the nature of the markets in which the engineering takes place; Europe, not the US, is the core market for compact cars, while subcompacts are more important Asia, Eastern Europe and the developing world, where Daewoo's strengths lie. In the current global structure each of these design centers then works with the various regional and national operations (such as North America) to develop vehicles specific to those markets. In the US the new Aveo is from Daewoo, which now handles the Gamma II platform, while in 2005 the engineering of GM's Delta platforms (e.g., the Malibu) was centralized in Germany. Paralleling this development of "world" platforms is the globalization of GM's supply chain; companies that wish to sell parts to GM need to be able to work with the relevant engineering centers, and to be able to produce their parts in multiple regions.
So, can GM then sell off Opel, and remain an ongoing operation? GM will be beholden to the new owners for core vehicles, as it will lose all independent ability to engineer small and mid-sized cars. Opel's products are a real strength to GM; they are one core of its surge in China, where sales jumped 50% in April 2009, and are essential in the US as well if (when!) high gasoline prices return. Unless the purchaser of Opel cooperates wholeheartedly with GM — grudging fulfillment of a contractual obligation won't do the trick — then, sooner rather than later, GM will collapse.
Now such cooperation is not impossible. Fiat's revival under Marchionne was dependent on product engineered jointly with GM's Opel subsidiary. They can and have worked together successfully, culture clashes or no. Second, Fiat has no presence in North America, and so can only gain from continuing to develop vehicles for GM in its home market; Fiat is also weak in China, where GM is the market leader. (They do compete head-to-head in Brazil, where Fiat is the market leader.) Should Magna, the other bidder for Opel end up carrying the day, there in fact are no such conflicts, as it has no independent OEM operations.
Losing Opel does not necessarily spell the end of GM as an ongoing business. But any car company that ceases developing new product has in effect declared that sooner rather than later it intends to close its doors. GM truly is a global business, and splitting itself up puts all of the pieces at risk — including Opel — because they are no longer standalone operations. The German government is nervous contemplating Fiat as the new owner of Opel. It should in fact be nervous about anyone other than GM owning Opel — and Obama's car czars should be as well.

In Defense of Dealers

A few years back Michael Dell was quoted as saying he thought the auto industry should adopt elements of his “build to order” PC business model. He predicted that consumers would someday purchase new vehicles directly from the Manufacturer. Obviously, he didn’t put much value on what the Dealer adds to the Consumer / Manufacturer equation. But after making a pass at Asbury Group Mr. Dell is now a Dealer himself, having partnered with a former head of Sonic to buy dealerships. While we haven’t heard much about that venture recently, we do recall Mr. Dell’s comments about Dealers being an unnecessary and expensive link in the distribution chain. Not long after, Mr. J. D. Power made a similarly negative comment in an interview with the Wall Street Journal and was greeted with tremendous blowback. He was rumored to be a pariah at his company’s own hospitality suite at that year’s National Auto Dealer Association convention. It was not long thereafter J. D. Power and Associates came to be owned by the McGraw Hill Companies.
It seems it has become common for self appointed experts to lecture the industry on how to best retail and service new vehicles. We recall Ford Motor Company’s ill-fated attempt at being a Retailer. Ford purchased all the Ford Dealerships in a number of markets, including Tulsa and Oklahoma City. This experiment took place under the Jacque Nassar regime and provided additional evidence that manufacturers probably don’t know how to retail new vehicles profitably. Ford couldn’t make the venture work even as they owned all the Ford stores in the market! The Ford Auto Collection experiment, and the Saturn experiment at GM, didn’t burnish the concept of “One Price Selling” either. After their short and costly experiment, Ford decided it was better to sell their Dealerships back to genuine Retailers.
People outside the business typically think the secret to success in auto sales is to keep cutting the price and make it up in volume. Real Dealers know they have to make gross profit wherever they can. During their time as Dealers, Ford focused on selling new vehicles. After all, Ford is a Manufacturer. A Dealer knows that selling new vehicles is likely to be a losing proposition at times, especially Detroit 3 Dealers.
They structure their business accordingly. For that reason they learn to make up profit in their other departments. This allows them to sell new vehicles at a net loss when necessary, but still maintain overall profitability. Ford thought they could increase volume with “One Price” and regarded the pre-owned business as a necessary evil. The result? They actually achieved lower new vehicle sales at lower gross profits than before, and gave their pre-owned business away. It’s no wonder they didn’t make money!
Now the “authorities” in charge of the economy assert that GM and Chrysler would be better off with fewer Dealers, as if Dealers add significantly to a Manufacturer’s costs. This is not to say there hasn’t been significant “over-dealering”, especially in metro markets. But “over-dealering” impacts Dealer’s profitability, not the Manufacturer’s.

The Other Side
Let’s look at it from a Dealer’s perspective. Dealers these days have typically been pressured by their Manufacturers into ever more expensive and expansive facilities, despite the fact that a consumer’s Internet screen is now their “showroom” of choice. More and more consumers go to the “brick and mortar” Dealership to view inventory, acquire information, take a test drive, and perhaps get a price quote. The consumer then goes back to their PC to obtain price quotes on their desired vehicle. A Dealer’s conventional sales staff is often competing against its own Internet department, as well as other Dealers, when it comes to price! Moreover, new vehicles are pretty much a commodity these days. An excellent book on the subject is Dale Pollak’s Velocity. He points out that the new vehicle business has been an “efficient market” for years. To economists, an “efficient market” is one where both buyers and sellers have equal information and neither has any significant advantage. According to Wikipedia, “The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.” In other words, there is significant downward pressure on Dealers’ new vehicle gross profits and they are often a loss leader. Velocity is primarily about the pre-owned market, but the principles of market efficiency have applied to new vehicles even longer than to pre-owned.
The current discussion in Washington includes forcing GM and Chrysler to shed Dealers as a condition of receiving “tax payer backed” loans. For some reason, some members of Congress think getting rid of Dealers will save money for GM and Chrysler. They obviously don’t know that once established, there is very little, if any, cost to the Manufacturers for their Dealer networks. As a matter of fact, Dealers are the Manufacturer’s customers, not the buying public. The buying public is the customer of Dealers! Is it logical to try to increase sales by reducing customers?
In addition to selling new vehicles and parts to their Dealers, the Manufacturers also sell them special tools, equipment, furniture and numerous other expensive programs. The Manufacturers have transferred immense costs and risk to their Dealers. The risk of real estate, receivables, inventory and inventory financing is all born by Dealers, not by Manufacturers. In fact, a recent study commissioned by NADA stated, “Far from being a burden to the Manufacturer it represents, the Automobile Dealer supports the Manufacturer’s efforts by providing a vast distribution channel that allows for efficient flow of the Manufacturer’s product to the public at virtually no cost to the Manufacturer. The independently owned and independently financed franchised Automobile Dealer network is a critical asset to the Auto Manufacturers. U.S. Auto Dealers have $233.5 billion invested in their businesses. This capital is supplied by 20,700 independent dealerships that employ and train over 1.1 million people.” According to Dr. Michael Smitka, Professor of Economics at Washington and Lee University and an auto industry expert, “Dealer profitability based on their $233 billion dollar investment and a reasonable 8% return should equate to an 18 billion dollar return for Dealers in aggregate. We’ve seen no evidence that target has been met over the years.”
Further, Dealers provide the resources to stock inventory. They take trade-ins. They arrange financing. They collect and pay billions of dollars per year in taxes. Combined, they represent 20% of all retail sales in the U.S. Unknown to the general public, Dealers collectively have more money invested in their business than their Manufacturers have invested in theirs! Someone needs to explain to me how a Manufacturer can morally and/or legally push major investment and risk on their Dealers/Franchisees and then arbitrarily stop supplying them with product, outside of bankruptcy.
GM killed Oldsmobile by first starving it for product. What was once GM’s most profitable division received “me too,” “badge engineered” vehicles to sell, at a higher price than the same vehicle from other GM divisions. At the same time they backed these less than wonderful vehicles with a marketing campaign that stated, “It’s Not Your Father’s Oldsmobile.” This only further alienated their already aging customer base but failed to turn on younger buyers to their “me too” vehicles.
The money that should have been invested to bolster Oldsmobile was spent on a revolutionary new idea named Saturn. Saturn NEVER made money and Oldsmobile died a slow death. But at least Oldsmobile Dealers received a measure of compensation from GM. It is reported to have cost GM over a billion dollars to shed Oldsmobile, in yesterday’s dollars.

The Upside to Saturn
The best thing to come out of Roger Smith’s Saturn experiment is the Saturn Dealer network and their franchise agreement. This franchise agreement is unique in the U.S, but common in other some other countries, including Japan. It grants distribution rights for an area or region, rather than an individual market. GM has refused to allow Saturn Dealers to dual with other makes. A Dealer friend once said, “When you can’t pay the rent, you have to take in boarders!” But GM has denied this option to Saturn dealers despite the fact they haven’t provided vehicles to Saturn Dealers that the market wants in enough volume to allow its Dealers to be viable. From the beginning they were provided a line of mostly “tepid” vehicles to sell. While the recent Aura and Sky are great vehicles they haven’t been enough to save Saturn!
Besides, the Detroit 3 have never been able to consistently make money selling small vehicles. Consumers had some renewed interest in Saturn’s offerings when fuel prices spiked but that quickly waned. Imagine the result if the Detroit 3 were to design and build only smaller fuel efficient vehicles, as mandated by Congress, and the price of fuel stays low.
Nevertheless, Saturn Dealers are a resourceful bunch and have learned to survive by being excellent operators, focusing on the pre-owned and service ends of the business. They “kill their customers with kindness!” Now they have officially been notified that they will be starved for new products and will soon be phased out. Let’s hope their innovative franchise setup and professional Dealer body attracts a buyer that gives them the opportunity to represent a line of compelling vehicles, whether they be from China, India, Italy, or wherever. I wonder what might happen if Fiat decides they are better off buying Saturn instead of partnering with Chrysler? Saturn Dealers all have substantial investments in facilities that have little value if a successful automotive franchise isn’t operating in them.

Beyond Suburbia
We should also have a special appreciation for “country” Dealers. These Dealers are also resourceful and have learned how to make money in the pre-owned and service business. This has been out of necessity as they typically have not had access to any real quantity of their Manufacturer’s “hot merchandise” when their OEM produced a “winner.” Many have become dependent on their Manufacturer’s Certified Pre-Owned (CPO) offerings. Without a franchise that allows them to buy CPO caliber “program vehicles,” their futures are in doubt.
What does an Auto Dealer do for a community? Aside from local employment, local service, safety recalls, warranty repairs, local charitable work, etc., Dealers collect Sales Tax! A portion of that Sales Tax goes to local government. If a Dealer goes out of business in a community and vehicle buyers are forced to drive out of the locale to make their purchase, the local tax revenue stays where the vehicle is purchased, depriving the previous municipality of its tax revenue. This is a major issue! There are many circumstances where local government has provided financing and other support to maintain a local Dealer and its associated tax base. Imagine a municipality guaranteeing a loan for a local Dealer and the Dealer’s Manufacturer arbitrarily cancels or terminates the franchise agreement or stops supplying product. In this case the Manufacturer probably forced the Dealer to make substantial investments before shutting off product. I can hear the attorneys licking their chops.

What’s Next for the GM & Chrysler?
GM and Chrysler are between a rock and a hard place! They are afraid of Chapter 11 (re-organizational) bankruptcy. They feel few consumers will buy a vehicle from a bankrupt Manufacturer with no real assurance of warranty or resale value. If they don’t go Chapter 11, they are obligated to honor their contractual agreements, including their franchise agreements.

On a macro level, a Manufacturer bankruptcy would drop billions of dollars of pension and health care obligations on the federal government. The United Airlines bankruptcy dropped 6.6 billion dollars on the Pension Benefit Guaranty Corporation! (read that Federal Government.) Imagine GM, Chrysler, and a slew of suppliers hitting that system at the same time. The PBGC was already 23 billion dollars in deficit BEFORE the record UAL bankruptcy. It’s no wonder the government is proving fairly easy to work with for two of the Detroit 3.

On the Bright Side
Fortunately Auto Dealers do have some “aces in the hole!” They have protection from state AND federal laws protecting Dealers and/or Franchisees from their suppliers. These laws are based on “fairness” and cannot be merely swept away by mandate from Congress, a Car Czar, or a committee. Auto Dealers have effective lobbying groups in the form of their state trade associations, Political Action Committees, and most importantly the National Auto Dealer Association. Dealers are victims of many of the circumstances that led to the demise of their Manufacturers, but Dealers had nothing to do with the melt down of the U.S. financial system that dramatically impacted them. They had nothing to do with the sudden spike in fuel prices that rendered much of their inventory “sale proof” and decimated the value of their used vehicle inventories.
Dealers don’t dictate to their Manufacturers what to design and build. Many are currently victimized by Manufacturer sales incentive programs that require the Dealer to order additional vehicles for inventory as a price of admission to the program. These programs may serve the Manufacturer’s purpose but are catastrophic to a Dealer who is sitting on a 150 days (or greater) supply of inventory.
At the same time, the same Dealer is probably facing the prospect of having to “curtail” floor planned vehicles as a result of frequently arbitrary and frivolous mandates from lenders - often the Manufacturer’s captive. This comes at a time when working capital is a most precious commodity. This practice often puts the dealer in the position of having to decline program participation and face the market with a serious cost penalty versus other Dealers selling the same brand. Many of these Dealers are already on “finance hold” due to too much inventory and/or deterioration of their balance sheet. So now they face having a serious cost penalty in selling the inventory they purchased in good faith from their Manufacturer months ago.
Many Manufacturer programs are frequently designed to give the OEM a “free float” on the Dealer’s working capital while at the same time demanding immediate payment from the Dealer for the monthly parts statement.
In summary, Dealers are not only important, but absolutely necessary to a Manufacturer’s survival and ongoing success. Shutting down an entire division may make economic sense to a Manufacturer, if they cannot afford to design and build vehicles to supply that Division’s Dealers. But it will be quite expensive to do so. Merely thinning out Dealers as a method of increasing Manufacturer profitability is a totally flawed concept and strategies designed to force Dealers out of business should be dealt with sternly.

A reprint of the Ruggles Report February 2009

Fiat to the Rescue?

Chrysler, heavily dependent on light trucks (jeeps, minivans, pickups), was whipsawed by the spike in gasoline prices in summer 2008. Then came the credit crunch; when its access to lease financing disappeared, it lost 20% of sales overnight. As cash drained, it attempted to work out a deal with its many creditors, and failed. Assuming the firm emerges from Chapter 11 – rather than collapsing into liquidation as dealers and other creditors play "chicken" in hopes of a bigger slice of a rapidly shrinking pie – what will it need to survive?
First, Chrysler has neither the cash – nor after a mass of white-collar buyouts, the people – to develop new cars. It strikes me as unlikely that it will receive an infusion of cash and the stability to rebuild its famous design and engineering capabilities. Fiat doesn't have the money. Nor does it have the people, because it has no expertise in large cars, SUVs and light trucks to supplement whatever remains of Chrysler's historically famous but leanly staffed product development organization. Chrysler thus faces a long 2 years, until new product arrives via Fiat.
It will then face the challenge of selling Fiats. The new product will consist almost entirely of small cars, because as a company firmly rooted in southern Europe and strong in Brazil and other developing markets, that is Fiat's core strength. But neither Chrysler, nor any other company operating in the US, has been able to make a go of that on a consistent basis.
On paper we have policies to encourage a domestic market for small, fuel-efficient vehicles: CAFE, or Corporate Average Fuel Efficiency requirements, in place since 1977. Under CAFE, in order to sell a large car, firms must sell small cars, or they will exceed the average "mpg" standards that legislation imposes. The problem Americans have not bought into that policy: they want power. Given separate, less stringent standards for trucks, the entire market shifted towards light trucks (which for CAFE includes jeeps and minivans, and not just pickups). Small cars remain a small slice of the market, but in 2012 Chrysler's jeeps and minivans and pickups will be dated; small cars will be the only "new" product they will have on offer.
Absent a polar shift in American politics, to enable a stiff gas tax, Chrysler will not survive to 2015.
Now in the longer haul they need to not just survive, they need to gain back at least a modicum of market share. To stay in the auto business will require the cash to continue funding new product develop. That is in itself not an insuperable barrier. But in the background firms also need to be able to fund supporting research and development so that they can bring a range of new technologies to market, particularly electric vehicles (whether they run off of batteries, small "hybrid" engines or fuel cells). At present Chrysler is wholly incapable of doing that by itself. Fiat is probably too small as well. A beefy combination of the two might be another story, particularly as a smaller company has greater leeway to buy technology from independent suppliers. (Larger companies want to withhold core technologies from larger rivals, but Fiat-Chrysler may be viewed as a way to leverage their own investment, rather than as a threat.)
That too appears unlikely. Over the past 15 years vast improvements in engineering tools -- computer design and simulation, specifically -- have enabled car companies to spin off vehicles from their core platforms more quickly and at lower cost than ever before. And the U.S. market is so large that it supports a plethora of firms -- 14 at last count. From how many varieties does a consumer need to choose a minivan? Or mid-size car? Or whatever type of vehicle? Hundreds of models are on offer. There is no reason to assume Chrysler cars will improve so markedly that they will be able to pull away from the field and secure more sales than the company does today. Or that they will make money: given the competition, profits were falling across the industry even as sales boomed. There's no reason to think they'll recover.
And no sales pitch from President Obama will change that.

Thanks to JJ and DR for the back-and-forth behind this.

Autos and Economics: Cash for Clunkers

Further to my early post on Cash for Clunkers, see the blog on the Morgan Stanley Global Economic Forum of April 28, 2009. It adds the point that if the market value of a used car is already (say) $2000 and the "clunker" subsidy is $4000 then the net effect is smaller, similar to putting an extra $2000 rebate on a car. Plus it would be further muted by the various strings attached to the two main pieces of draft legislation winding their way through Congress. The bottom line is that it will cost a lot but won't boost sales much. Their blog includes methodology and estimates.

Follow the Money

The news today is of efforts to cut the cost side of the OEMs, Chrysler of course but also General Motors. Is this good news? To frame that question we need to do two things. First, what of the revenue side? Second, what of the overall value stream? – after all, the OEM slice is a quarter or less of total, not including the aftermarket, consumer finance and so on. The way I read it, we do not yet have any good news, because focusing on costs while revenues slide is chasing a will-o'-the-wisp. And the upstream and downstream segments are on the brink of a deep precipice – but I'm not sure which side of the brink.

To my mind, the key variable at the moment is the residual (resale) value of a vehicle. As long as it remains low, it cuts into the arteries, and staunching the bleeding is hard. A low residual value means that purchasers are more likely to be "under water" on their current vehicle, with a trade-in value less than their loan balance. A low residual value means that leasing is dead, and a straight loan has to be priced higher, to cover the poor value of a vehicle as collateral (never mind the current recession-driven risk that the borrower's income may disappear). And a low residual value means that even if the buyer will pay cash (or has equity in their current car), they will shy away from a great vehicle in favor of one that because of its nameplate will hold its resale value. [I will post this before digging up sample numbers, say of a Toyota Titan and a comparable GM pickup – comments, please!] If the 4-year-out resale value of one vehicle is 50% of purchase price, and of another is 30% – well, no OEM can afford to discount their vehicles up front enough to offset the different.

So how to pull up residuals? Unfortunately the cutback in fleet sales at GM is too recent to have cut the flood of used cars that has depressed their residuals over the past several years. [Or so I assume -- ADESA or various used car guides could provide data.] In a year or two the impact would have been tremendous, had the recession not intervened. After all, GM has the car of the year and good ranking in the JDPowers quality surveys. (Ditto the combination of VEBA and retirees hitting age 65 to handle legacy costs on the cost side come 2011.) But luck was not with them. Maybe the biggest help the government could give is using its purchasing dollars not on new vehicles but on 2-, 3- and 4-year old vehicles to pull up their resale value.

Low residuals hurt other portions of the industry. If a dealer closes its doors, the normal franchise agreement obligates the OEM to repurchase inventory at cost. For the bank that finances this inventory ("floorplan") that is crucial. No bank is prepared to accept 200 cars on a lot when a loan forecloses. But if GM faces Chapter 11, it would no longer be obligated to make dealers (or their lenders) whole. Now if the residual value of GM vehicles was high, lenders could at least figure out what such collateral would be worth. As it is, no lender in their right mind would extend additional financing to a GM dealer (much less a Chrysler dealer). And no dealer would order a new car. That means that these companies will have zero revenue, because even if consumers flock to dealership lots, GM sells cars to dealers, not consumers.

That's of course the downstream viability story: GM may not have any dealers left, due to the collapse of financing, and they certainly won't have dealers buying cars. Costs cuts can never offset such revenue cuts. Of course if GM goes, and there is a massive firesale, Honda and others will face crisis, too, because consumers will have the choice of a new GM vehicle at 50% off – who knows? – and why in such a situation would you buy a used Honda? or a new one?

Now the upstream parts sector is in as bad of shape, maybe worse. While GM is closed they will be ordering no parts (remember that the factories of parts firms employ about 3x the number of manufacturing jobs at GM and its peers). With no orders, no revenue. Now the strategic imperative for suppliers the past decade was to diversify their customer base. But how can they keep their factories open if Honda and Toyota are 25% of their revenue, and GM and Chrysler 75%? And how can they fund the engineering effort on new vehicle models and basic R&D needed to garner orders for vehicles launched in 2012 and 2013, when sales will hopefully have rebounded? I don't think they can. My own feeling is that the downward spiral is not letting up. The tide is still building, and the whirlpool is getting harder to escape.

So, even if a bailout is arranged that temporarily keeps GM out of bankruptcy, if the downstream and upstream both collapse, well. I want to avoid thinking about what that might look like, and how the industry could start up again. But my quick attempt to follow the money suggests it's flowing down the drain, and the flow is slowing to boot.

thanks to DR and JJH and TK for stimulation

I will try to add numbers later

Downsizing

While interrupted from time to time by the business cycle – exceptionally so at the moment – automotive demand has expanded steadily since the end of WWII in the US, Japan and the EU. As a consequence the normal challenge for auto companies has been expansion. That process was not always orderly, as the different divisions of the larger firms fought for product for their dealers. Such product overlap is particularly severe at Toyota and GM, with the most sales channels. For dealers there is modest downside; additional models mean additional inventory. But each dealer hopes to pick up some incremental sales. Unfortunately that includes sales cannibalized from other sales channels – Pontiac sales robbing from those of Chevrolet – and so the benefits to the manufacturer are smaller. Overall however the bias (as in most franchising systems) is to have too many sales points and too many products from the standpoint of the system as a whole. As disorderly as the expansion path may appear, with firms responding to "hits" by their rivals with product that may mesh poorly with the overall vehicle lineup, reversing that process is much more difficult. Doing it in an orderly manner is well-nigh impossible.

Financial implications aside, trimming capacity presents formidable strategic challenges. First, the menu of vehicle programs must be developed with a 6-8 year time horizon. The allocation of engineering resources is a complicated dance, and has to also mesh with assembly capacity. A firm can work on only 1-2 vehicles in a size class at a time, and delaying a program until later then means some future program must be moved forward or otherwise shifted. So the dance has to position the players with a vision of where the firm wants to be 8 years down the road. That is hard enough when most vehicles programs are merely (?!) developing a replacement to existing product. Downsizing will almost inevitably mean that a firm is set to develop the wrong vehicles in the wrong order.

Second, if products are located rationally in consumer space, canceling one model creates a hole in the overall product lineup. That means that there are greater benefits from moving adjacent vehicles to the head of the development queue. So one less model increases the pressure to re-engineer two or more adjacent vehicles. Doing that of course costs money rather than saves money, so a hole must remain. Such a hole affects dealerships; if a particular sales channel is starved for product, then it will be more difficult for the dealers to maintain the presence in the market in overall staffing and advertising needed to support vehicles that ought to sell well. Downsizing, in other words, can amplify an initial decline in sales. And that's without taking into consideration any negative publicity from media coverage of the process.

Third, developing vehicles entails teamwork; downsizing means breaking up teams. Trying to "cherry pick" the good engineers is hard, and hurts morale – and of course a team without spirit is not much of a team, as is a team that has never played together before, even if (especially if?) it is composed of all-stars. Voluntary buyouts may force a company to "buy back" workers if too many in a give area quit. And in either case a firm will find it difficult to continue recruiting young engineers and other functions where learning the trade takes time.

Fourth, uncertainty looms large. CAFE (fuel efficiency) mandates skew incentives for where to allocate resources, with an impact that varies from firm to firm depending on their mix of domestic and imported vehicles. "Green" incentives that accrue to vehicles that may in fact not be very efficient, the lack of an energy policy that creates uncertainty in the path of energy prices (and which in the US makes diesel more expensive rather than cheaper than gasoline), and the presence of state and local economic development incentives that make a new plant for a company with an expanding market share cheaper than an old plant for a firm with a declining share all make life more complicated.

Then there are legacy costs. Incumbents in the US already had large number of retirees, due to the cumulate impact of increases in longevity and increases in productivity, that left them with an unfavorable ratio of retirees to workers. Downsizing makes things worse. New entrants have no such problems. They have virtually no retirees, their healthcare costs are further lowered by the relatively young age of their workforce, and they have "modern" benefit plans rife with deductibles and co-pays, things that were of little or no concern when such benefits were negotiated by the incumbents in the 1950s.

Finally, what scale is needed for survival? Electric vehicles, hybrid diesels, hybrid gasoline vehicles, natural gas vehicles, fuel cell vehicles – it is unclear which of the next generation of propulsion plants will prove fruitful. All require significant expenditures now that will not generate revenue in the near term. A large firm can have multiple platform teams, very small cars in Korea, small cars in Germany, midsized-cars and light trucks in the US, real-wheel drive projects in Australia, and so on. There are potentially large benefits from that, though to date the track record of "world" cars is poor, in part because regulatory barriers and variations in manufacturing infrastructure make it expensive and time-consuming to adapt a European car for the US market.

Of course there is excess capacity in the market alongside too many models. The ease of entry means that will not change in the medium term – remember, there are 14 producers in NAFTA, not to mention importers. Dealers face their own problems, particularly for those in urban areas, as the internet undermines the value of a large, expensive physical footprint. Downsizing individual firms affects suppliers in an uneven manner, but few suppliers depend on a single customer. Viewed from the other end, a Toyota or a Honda is reliant on the health of suppliers for whom one or another Detroit firm is a major customer.

In short, downsizing can unravel along multiple dimensions. And probably will.

Too Big To Fail

A quick line, a take on Paul Krugman's latest (April 2, 2009) NYTimes Op/Ed on China and the US:

Their stance -- and that of the rest of the world -- is that they don't like what they see [US macro fundamentals], but we (the US) are too big to fail.

Supplier hiccup

Working on another installment of my "core" analysis. In the meantime, see the extended comment by David Ruggles on my second post.

Note too the closure of Chrysler main minivan plant (in Windsor Ontario, just across the river into Canada from Detroit). Automotive News reports that financial difficulties led a supplier of critical parts to stop shipments. Given "just in time" production, the assembly line stops pretty quickly. But if Chrysler isn't assembling vehicles, they aren't ordering parts from other suppliers (or shipping finished vehicles). So no money coming in, no money going out. For other suppliers who need cashflow, this is really bad news. And since suppliers ship to more than one auto company, this potentially could snowball throughout the industry. A couple more suppliers shut their doors temporarily, and more assembly plants shut, and a few more suppliers ... it would be very hard to stop once started, and very hard to get everyone back up producing. Unit sales are down roughly 60% from the 17+ million peak (2006?) to under 9 million. Not many firms can survive a sales drop of that magnitude. And of late banks haven't been eager to provide bankruptcy financing, while the government has only set aside a trivial $5 billion for suppliers. But suppliers employ far more the workers of the OEMs (nearly 3x more).

Back to the Beginnings

Well, today came the first steps towards the de facto reorganization of GM without going through the de jure process of bankruptcy court. The game has switched from softball to hardball ... squash. No more finesse, whoever has the most power wins. It's not GM's bondholders and it's not the UAW. But it may be the collapsing economy that proves the most powerful, not the Obama administration.

Arguing that issue will take time -- my outline is 5 single-spaced pages, not the sort of thing for which a blog is suited. Instead let's do a little applied IO (industrial organization), beginning about a century back. The auto industry evolved in a manner familiar from that perspective, at least in its stages if not the overall process.

After the formative years of playing with multiple technical standards and marketing strategies, as well as corporate structures, Henry Ford latched onto a combination that worked. He assembled parts and sold his Model T to dealers, collecting money up front, and paid suppliers in arrears. Vanadium steel alloys and ultimately the moving assembly line enabled him to push down the weight of his car, and up the speed of assembly. Inventory turns, all that -- though since the old man hated accountants, there are no books to trace the financial evolution of the firm. In any case, he soon dominated the market, in the US, in Europe, in Asia.

Now Henry owned the firm, or at least he did after forcing out the other shareholders, something he'd done twice before in the forerunners to the Ford Motor Company. (He was not a nice man.) No one could dissuade him from his policy of ever-lower prices as he improved the basic model and (for many years running) lowered his costs. But there was a bottom to how low he could push costs, and others began attacking his position from upmarket. GM succeeded, and the Model T began a gradual decline, until in 1926 Ford was forced to pull it from the market while he rushed the development of the Model A. By the time he launched it in 1927, Chrysler had also emerged as a player. Monopoly power made Henry insensitive to the shifting market, and the lack of outside shareholders meant there was no restraint on his whims. Ford was free to give away market share; if he wanted to bankrupt his firm, that was his business.

Fast forward 50 years for a variation on that story, to which I will provide another spin. From the early 1950s into the early 1970s GM was the dominant firm in the US auto industry (and with the exception of Japan, number one or two in the markets that mattered outside the US). For twenty years running it was the most profitable manufacturer (and often the most profitable firm) in the world, earning a 20% return on assets. But with just over 50% of the US market, antitrust considerations constrained additional expansion; it had to allow Ford and Chrysler a share of the market. Through price leadership it could nevertheless coordinate pricing policy with them; its economies of scale were considerable, and it was the low cost producer. The other two firms thus wanted to avoid a price war; though they could set prices below GM's umbrella, they could not be unduly aggressive.

Eventually such high profits did encourage new entry. Via imports the Scandinavians had a modest presence, as for a while did British, Italian and French firms. Of course there was also American Motors, an amalgam of US firms that emerged -- or rather merged -- after WWII. More successful was the German firm VW, particularly when a fad for small cars swept the US in the late 1960s, making the Beetle a hit. But as had happened in the late 1950s, the small car fad passed and the market for that low-profit segment shrank. Detroit was relieved, because if they all entered, it would have been a bloodbath: flooding the market with low-margin products was not an attractive business proposition. When there was another swing towards small cars in the late 1970s, following the first and especially the second oil crisis, VW stumbled and it was Japanese firms that captured the small car market. Again, the Detroit Three wisely sat on the sidelines. But US government policy worked against GM and the others. Ronald Reagan's VER ["voluntary" export restraint] policy effectively asked the Japanese government to organize a cartel to raise prices in the US. Carter's CAFE [corporate average fuel economy] standard and the earlier Clean Air Act bolstered the position of these new entrants, because they favored small cars and imports. The profits of the VER and the breathing space of other policies gave the Japanese time to build a distribution network and to move upmarket. We know the rest of the story.

Back to substance: over the next quarter century GM steadily ceded market share to these and other entrants. (At present 14 firms assemble vehicles inside NAFTA -- ignoring equity ties, two are Korean, three German, three are Detroit-based, and six are Japanese.) Doing so was rational. GM could have lowered profits to preserve share. But why should it do so when it was so dominant? The modest increment garnered by the new entrants was no more than a burr on its side, and shareholders would rightly have screamed if it gave up its bounteous profits that it earned on its 50% share of the market in an effort to scare off these entrants. Henry Ford was irrational in his strategy. But GM was rational in its refusal to fight. Making way for fringe firms to enter the market is the only sensible strategy for a dominant firm.

Eventually a dominant firm thus will cease to be dominant. So it was with GM, though it hung onto the most profitable segment, light trucks, and did well thereby. That would be the end of the story if downsizing was easy in the auto industry. Even then it might not have mattered had GM not had to shoulder pensions and especially healthcare obligations for its increasing numbers of retirees. Such aspects must await another post.

Let me reiterate the central point. GM's management certainly made many mistakes. This included such bone-headed investments as Saturn, billions spent on automation and other hoped-for "magic bullets" that ignored basic operational competence, and an overarching role for people with a background in finance rather than manufacturing, engineering or marketing. Nevertheless its core strategy was consistent with earning high levels of profits for its shareholders. Indeed, it was sufficiently successful in this that going into the current recession it was Toyota that was mimicking GM in its strategy in North America, rather than the other way around. Another year or two of breathing room would have made all the difference.