The “B” word along with “GM” and “Chrysler” often appear in the same newspaper articles. Bankruptcy is failure. Bankruptcy is bad news. For now, let us define bankruptcy as a situation where an entity is in default with their debt obligations. When you see the “B” word again, just think of it as news that’s neither good nor bad. Think of it as just a piece of information.

Chapter 11

When you read about bankruptcy in the United States, you will probably see the term “Chapter 11” somewhere in the article. What exactly is Chapter 11? When an entity files for Chapter 11, it is actually under protection from its creditors and a complex restructuring process begins. The restructuring process attempts to fix the entity so that it will resurrect in a new form and “go back to business as usual”. It will involve creditors to forgive the entity’s debt, often exchanging for equity positions. It is not surprising that creditors that become shareholders reclaim a measly 20 cents on the dollar on the investments.

In the meantime, the entity could re-negotiate some other contracts that are outstanding. Chrysler was in constant talks with the Union to adjust their hourly wages to more competitive levels for example.

Bankruptcy proceedings can be a messy business as there are many parties of interest involved. The creditors will want a bigger share of the company. Workers will want to keep their wages and benefits. The Bankruptcy Court decides on what is fair or not. Otherwise, the process will never end.

Chapter 7

There is no need to write much about Chapter 7, though it is a term that is less heard of. This is when an entity’s assets are liquidated and paid out to its stakeholders according to the pecking order; you know, secured debt holders get first dip, then the unsecured debt holders, and then the shareholders. Each level would get something only if the level above has something left for them. For this reason, shareholders can be fairly sure that there is nothing left for them. After the liquidation process is complete, the entity is forever gone.

Bankruptcy and the Detroit Big Three

Chrysler has filed for bankruptcy, GM is not far away, and Ford says it has enough cash to burn for just another year. I think bankruptcy is actually helping Detroit to take the fast lane in getting out of its darkest days.

Chrysler and GM are or will soon be under Chapter 11 protection. This means that stakeholders believe they will benefit by turning the company around instead of dumping everything at fire sale price before they lost everything. Think of the Chapter 11 process as a student who is failing his classes in school, but the teachers believe that she still has the potential and imposes disciplinary actions on her. Chapter 7 is equivalent to expelling the student because she is hopeless.

Chapter 11 will definitely help Detroit migrate to the next automotive era, but this does not mean that they will shine like the stars that they once were. Detroit failed to realize that they had entered an era of innovative competition, especially in the arena of fuel efficiency. Toyota got a head start in Hybrid technology, and the Germans dominate in diesel. Unless they catch up very quickly, they will be making products that don’t stand out and will survive because they managed to cut costs from restructuring efforts. As discussed in my last article, innovation will drive the next winner and this company in Los Angeles has a very promising technology. The U.S. auto industry might shine again if L.A. meets Detroit in a productive way. They also need to establish a bigger presence in China where the auto industry is experiencing explosive growth.

Was it right to bailout the Big Three? What about the Banks?

In response to K’s comments, I agree with you that the laissez-faire approach would’ve saved the taxpayers a lot of money. If we are looking at the issue purely from a financial point of view, it is not hard to tell that the government is subsidizing Detroit and not investing in it. And yes, if the Big Three are out, the parts suppliers will go out of business and cause even more unemployment. The decision to bail them out is based a political decision, not a financial one.

If I were part of the think tank, I would not recommend bailing out the Big Three. If the patient is gravely ill and surgery is inevitable, operate on the patient. Why prescribe her with a few months of pain killers and then perform surgery that would have to be done anyway?

The financial industry is a different story. Ben Bernanke is counting on his quantitative easing plan to revive the economy and needs the banks around to do the work for him. Let’s say that all but one bank stayed afloat. The Fed could push the rates as low as they like, but it doesn’t mean that the only bank would follow suit because there is no competition. This happened in Canada when the banks refused to follow the Bank of Canada’s lead after the latter had cut its rate. The more banks there are, the stronger the Fed’s army.

These zombie banks still have value in them as vehicles to help circulate money in the economy. Once the economy stabilizes, the Fed can make the switch to a laissez-faire approach and let the market decide who can stay. By bailing out the banks (at least temporarily), the U.S. government is acting like a market player because they are pursuing their self interest of maximizing GDP and hence, their tax revenues.

In the end, you still can’t beat market forces.