Should GM be saved? From a free market perspective, the answer is clear: "Heck no!" Unfortunately things just aren't that easy...

So the members of the G20 met over the weekend, and it was pretty much as expected: A big shiny photo-op that didn’t really produce much except hot air. (If you’re wondering what the G20 is, The New York Times has created a decent primer.)

The G20 leaders said the type of things you would expect them to say – “we hope and expect and urge a swift resolution to the crisis blah, blah, blah” – but they didn’t make any truly substantial decisions.

Most notably, the group agreed to meet again on April 30, 2009 (after President-elect Obama has had time to settle in).

This really isn’t surprising. Those who thought some big sweeping change might arise from the gathering forgot one key fact: George Bush has effectively become one of the lamest-of-lame-duck presidents in all of history.

In terms of moral authority, gravitas, and all around ability to get things done, “W” functionally ceased being President the moment the November 4th election ended (with nary a hanging chad to spoil the psychological transition).

We’ll talk some more about the G20 and the Bretton Woods chatter another day.... For now, the question du jour is, “Should General Motors be saved?”

(As an aside, the topic has a little bit of a personal dynamic. Your humble editor will be flying to Detroit for Thanksgiving later this month. The Litle clan has roots in Grosse Pointe, MI and kin in Ann Arbor, MI. Though I was born in Motor City, it will be my first trip back in what feels like a decade.)

To clarify, the question “Should GM be saved?” is not a moral one. That is to say, it is not a question of fairness, rightness or wrongness as we ask it here.

Instead, it’s more a question of which will ultimately cost more – throwing tens of billions more down a rathole, or letting the rathole morph into a giant failure vortex.

Bankruptcy Basics

First let’s reconsider the case for letting GM go bankrupt – which requires a quick recap of the bankruptcy system itself.

The moral side of the ledger seems clear. In a free market capitalist system (or at least a quasi-free market system, like the one we aspire to maintain), failed businesses should go ahead and fail as a matter of principle. They should not be propped up like zombies, draining resources from taxpayers and dogging competitors with subsidized competition.

It’s just a bad way to go.

We also have a bankruptcy system in place for a reason. It didn’t take long for Americans to realize that the old school way of doing things – throwing people into debtors’ prison – wasn’t very conducive to the long-term health of a dynamic and growing economy.

Entrepreneurs and well-established companies alike need to be allowed to take risks. And that means sometimes they need to be allowed to fail. If all the risk takers were thrown into debtors’ prison, soon you would have no more risk takers (and no more dynamism). So a “fresh start” provision – the bankruptcy system – came into being to help things along.

When failure does occur, the bankruptcy system is designed to salvage the workable parts of a business. Sometimes the business is allowed to continue operations without a hitch, so that customers and suppliers don’t have to face a disruption. (You’ve probably noticed how the major airlines have dipped in and out of bankruptcy over the years without taking planes out of the sky.)

The bankruptcy process usually (and rightly) wipes out the shareholders. As investors in the failed enterprise, they willingly took that risk. The failed companies’ creditors usually take a major hit too.

When bankruptcy is declared, there is a tally of all the companies’ assets – pretty much anything that’s worth a buck. Those assets are then divvied up among the creditors on the books. The “senior” debt holders get paid X cents on the dollar first. If there is anything left after that, the next tier of debt holders gets paid... and so on down the line. (Equity shareholders are last in line, which is why they usually get nothing.)

If the business is still viable after all that, the company can get a fresh start – usually with wholly new management.

Drowning in Debt

Those who think GM should bite the bullet and go bankrupt point to the folly of throwing good money after bad. The real problem with GM is what’s known as the “capital structure” – meaning the company’s ratio of equity versus debt.

Simply put, GM has a less-than-$2-billion market cap (that’s the equity part) compared to more than $45 billion in debt (which includes pension funds and other employee obligations).

That’s an eye-popping debt-to-equity ratio of more than 22 to 1. For a normal company, a debt-to-equity ratio of a mere three or four to one would be considered speculative, because debt is a lot like leverage. (Scratch that, debt is leverage.) So a ratio of 22 to 1 is just insane. It’s like an elephant sitting in a folding chair.

What’s worse, what little remaining cash GM has is in the bank is being burned up by money-losing operations. (This is why GM has warned it will go under in 2009 without a cash infusion, and why GM’s managers urged employees to participate in a letter-writing “beg congress for money” program.)

In finance terms, GM is not unlike a man with a $40K per year income and $900K in mortgage and credit card debt. A modest loan would not help such a man any more than another few billion would help GM. The money would simply be tossed into the gaping maw of the creditors. As far as long-term outcome goes, the inevitable would be delayed only slightly if at all.

And so why, the bailout critics ask, should taxpayers give GM more cash just so that GM’s inept managers can hand that cash over to long-standing creditors – especially when 1) the company dug its own hole, 2) saving GM in its present form is “mission impossible,” and 3) this kind of thing is exactly what the bankruptcy system is for?

Not That Easy

So it’s decided then... let GM fail, right? Let the free market sort itself out and the bankruptcy system do its work? Unfortunately. it’s not that easy.

We know that throwing money down a giant hole is generally a dumb thing to do. What we don’t know is whether GM could become another Lehman Brothers.

Lehman Brothers, one of the top five investment banks in days of yore, filed for the biggest Chapter 11 bankruptcy in U.S. history (over $600 billion) back in September. Given the circumstances, Lehman certainly “deserved” to fail in the free market sense. They made their bed of leverage, and the Treasury and the Fed let them to lie in it.

Unfortunately, it was the aftermath of the Lehman failure that proved breathtakingly disastrous.

When market historians look back at the panic of 2008, I believe they will widely agree that letting Lehman fail outright was one of the biggest mistakes the Fed and Treasury could have made given the circumstances.

It is this type of risk we run repeating with GM.

Trust Evaporates

Before Lehman Brothers, there seemed to be a logical pattern to Uncle Sam’s crisis efforts. With the Bear Stearns rescue, it seemed clear that the government would allow equity shareholders to be wiped out, but holders of counterparty risk – the third-party actors who had contract dealings and accounts with Bear Stearns – would see their assets shielded.

When Lehman was allowed to fail point blank, shielding no one from the fallout, that’s when Wall Street (and by extension the world) went into deep freeze.

This is because Lehman was deeply intertwined in both the hedge fund world and the credit default swap market. By letting Lehman fail outright, the government allowed hundreds of billions worth of third-party assets to be thrown into limbo – frozen solid by bankruptcy proceedings.

This bone-headed move on the government’s part – the equivalent of yelling “Surprise! You’re screwed!” – caused trust in the financial system to evaporate. All of a sudden nobody, and I mean nobody, knew what the government would do next (or who was in danger). No counterparty felt that their assets were safe. Seemingly no investment bank (or regular bank for that matter) could be trusted.

It wasn’t just that hundreds of billions in third-party assets were held hostage by Lehman’s Chapter 11. It was that now, all of a sudden, anybody’s assets could be subject to the same out-of-the-blue fate.

And thus it was this sense of total uncertainty as to what would happen next – a terrifying lack of clarity as to what the “rules” were in a time of turmoil – that caused the global financial engine to seize up completely.

(You may recall, too, that the first AIG bailout came hard on the heels of the Lehman failure. Hank Paulson barely had time to pat himself on the back for letting Lehman “get what they deserved” before having his face shoved into humble pie.)

The Risk of Lehman Redux

So getting back to GM... the risk in letting GM fail, as odious as it might feel propping them up, is that GM could become another Lehman Brothers in terms of creating a new “run on the banks.”

Except in this case it would be more of a “run on Motor City” – and all the industries associated with it.

Wilbur Ross, a distressed assets investor dubbed “The King of Bankruptcy” by Fortune, says a GM bankruptcy would be “a total mess.”

In an interview with Bloomberg, Ross voiced his view that, if the overall environment were better, a GM bankruptcy “wouldn’t necessarily kill” the auto industry. But with things looking as bleak as they are, a fallen GM could cause the other big automakers to topple like dominoes.

On top of that, there is the real risk that GM wouldn’t be able to continue operations. As we’ve seen with the airlines, large companies often keep their doors open while going through bankruptcy. Most who assume a GM bankruptcy is the best route further assume the car maker wouldn’t have to shut its doors.

But a company’s ability to keep the doors open in bankruptcy requires access to financing and the prospect of a reasonably bright future – two things GM just doesn’t have right now.

So if GM’s doors were to close, we don’t know when they might open again... if ever... and we don’t know how devastating the blowback would be for all those auto industry suppliers hanging on by the skin of their margins.

And again, on top of the vast Motor City supply chain, what would happen to Chrysler and Ford? What about the homes, the restaurants, the small stores, and the tens of thousands of other unrelated businesses indirectly supported by auto industry employees? How would the country deal with mass shutdown on such a scale? Would the state of Michigan itself need a bailout? Would other states then line up?

We just don’t know.

What Will Obama Do?

President-elect Obama knows that the choices in regard to GM amount to bad and less-bad. He laid out his thoughts in a TV interview on Friday.

For the auto industry to completely collapse would be a disaster in this kind of environment,” Obama told 60 Minutes. “Not just for individual families, but the repercussions across the economy would be dire.”

Unfortunately, “bad and less-bad” are the kinds of choices one is left with after allowing a problem to fester for decades.

Will pulling the plug on GM be any easier a year from now than today? Hard to say (but probably not). Will GM be able to stagger to the Jan 20th finish line in time for the Obama administration to throw a lifeline? Or will emergency action be pulled off before then? Guess we’ll see.

The bottom line is, saving GM has no longer become a matter of right and wrong. It’s become a matter of choosing the lesser of two serious evils. It’s another form of payback for our past excesses – the need for government to apply “necessary” stopgap provisions that have great long-term cost themselves.

Obama’s interview touched on long-term costs too, if only by accident... “We shouldn't worry about the deficit next year or even the year after,” the President-elect said.

If only our foreign creditors would show such patience.

Sound Off!

So what’s your opinion on GM? Should they be saved? If your answer is a firm “yes,” why? If a resounding “no,” what about the risk of letting the rathole turn into a mass failure vortex?

Or maybe you don’t have a firm opinion either way – which is fine too – and just want to rant about how badly the whole thing sucks. All comers can weigh in here: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

Don’t Forget Consumers

Last but not least, in regard to the just-mentioned President-elect...

On another somber note, President-elect Obama has an even more pressing concern on his plate than GM. He is going to have to wrestle with the decline of the U.S. consumer.

Here is the issue in a nutshell: U.S. consumer spending has long accounted for two-thirds of U.S. GDP (the traditional measure of the nation’s output). Thanks to an indefatigable joi de vivre – or rather joi de shopping – the U.S. consumer has acted as the de facto “engine of growth to the world” for roughly the past quarter century.

In that time, Americans bought more crap – er, stuff – than anyone else in the world, and they mostly bought it on credit. Now the cycle of ever-greater consumer spending has hit bottom... and a new cycle of saving and frugality has begun. This is a huge, HUGE shift. The impact can hardly be understated.

That’s why we here at Taipan Publishing Group think of it as something called the “Consumer Shockwave.” The Consumer Shockwave will have an ongoing ripple effect, and countless areas of the U.S. economy will be impacted (or already have been impacted).

Zach Scheidt (a.k.a. Cash McDash) and I have just wrapped up pre-production on a Free Web Summit (length thirty minutes, give or take) on the Consumer Shockwave topic.

We’ll talk about what it is, specific impacts it will have, and how it could have a dramatic impact on your investments. We’ll also talk in terms of industries and sectors, focusing on big losers and big winners from the Consumer Shockwave phenomenon.

And, last but not least, we’ll give away some free trading and investing ideas too. This Free Web Summit airs this Friday, November 21st, at 11 a.m. Eastern Time. I hope you get a chance to tune in!

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