Which side are you on?

Buttonwood

Oct 11th 2005
From The Economist Global Agenda

Delphi's bankruptcy highlights the danger of ballooning legacy costs—namely pensions and health care—and is further bad news for its main customer, General Motors. The quicker management and the unions stop singing and start talking, the better

THESE are trying times for the Family Buttonwood. Younger Daughter has been down with mumps. Elder Daughter is down with flu. Buttonwood herself would probably be down with both except that Delphi has beaten her to the sickbay.

It’s not the fact that America’s biggest car-parts maker has finally taken its long-trailed trip into Chapter 11 bankruptcy proceedings that demands attention, though it is the largest manufacturer yet to do so. Those who hoped that Delphi could somehow squeeze a deathbed concession out of its unions (mainly the United Auto Workers)—or indeed its main customer and erstwhile parent, General Motors (GM)—were disappointed but cannot have been surprised.
For years, Delphi has been fighting an unequal struggle against rising raw-material costs and high inherited labour costs, including generous pension benefits and open-ended medical coverage. In that, it reflects in microcosm the problems not only of America’s traditional carmakers and metal-bashers but also of a whole swathe of heavily unionised corporations.

Delphi hopes that under court protection it will be able to re-engineer its business, ditching unproductive plants and people (in the United States but not, significantly, elsewhere) that a restrictive collective-bargaining agreement now protects. It wants GM to guarantee monthly purchases of parts worth at least $1 billion, and to persuade workers to accept $16-18 per hour in wages and benefits instead of the current $65. One goal is to emerge with a smaller but still vital business. Another is to avoid throwing up to $5 billion-worth of unfunded pension liabilities into the lap of the Pension Benefit Guaranty Corporation (PBGC), says Steve Miller, Delphi's chief executive, who landed the PBGC with $3.6 billion-worth in 2002 when he was head of Bethlehem Steel.

At the end of the day, Delphi’s move into Chapter 11 seems to have less to do with its imminent demise otherwise than it does with forcing the hand of the United Auto Workers and GM. And here the stakes get bigger, for GM itself is in dangerous territory. In the first half of this year, the carmaker lost $2.5 billion in North America, where its market share is fast vanishing. It wants to cut 25,000 workers and hack back health-care costs from an estimated $6 billion this year, and is getting nowhere with its unions. It hoped it had got rid of a large chunk of problems when it spun off Delphi in 1999 and was less responsive to its main supplier’s pleas for help than was Ford (which agreed to take over some less attractive plants from Visteon). Those problems have come right back.

Reckoning that GM will not be able to escape a) supply disruptions if Delphi plunges into open warfare with its workforce and b) some contribution, perhaps as high as $11 billion, in pensions and benefits to Delphi’s past and present employees, both Standard & Poor’s and Fitch have cut the carmaker’s bond ratings to a deeper level of junk. Interestingly, S&P did not downgrade GM’s cash-cow credit arm, General Motors Acceptance Corporation, sparking rumours that GMAC may be up for sale. But analysts at Bank of America now rate GM’s own chances of going into bankruptcy at 30%, up from 10% pre-Delphi.

GM still has cash and credit aplenty, but the uncertain outlook for the firm that once symbolised American capitalism, and for the car sector as a whole, is once again roiling markets which have plenty of other things to worry about. Shares fell in the first trading day after Delphi’s announcement, pushed partly by a gloomy announcement from another parts maker. The cost of buying insurance against default by GM increased by 10% in the credit-default swaps market. And two rating agencies said they were likely to downgrade a chunk of collateralised debt obligations—bundles of notional debt whose risks are sliced up to suit different sorts of investors—which refer to Delphi credits.

What this all comes down to is how to handle the promises made to their workers by important companies that now find them awkward—and hugely expensive—to honour. The combined unfunded liabilities of pension schemes insured with the PBGC is more than $450 billion, the organisation reckons. The pension insurance fund itself had a deficit of over $23 billion when it last looked. Congress has been considering a bill to shore up companies’ pension schemes in various sensible ways, but it is currently on holiday.

If pension schemes look bad, health-care liabilities are far worse, for they are not funded at all. Defined-benefit pension funds are anyway being consigned to the dustbin, in favour of defined-contribution schemes. Medical liabilities, on the other hand, are spiralling out of sight. GM is now reckoned to be the largest provider of health care in the private sector. How is all this to be resolved?

Delphi has thrown into harsh relief some of the basic conflicts in society today, inescapable trade-offs that we normally turn a blind eye to in the expectation that endless economic growth will somehow bail us all out.

Delphi’s Mr Miller would have us focus on one: the clash between the interests of young workers and those of their predecessors. As he put it stirringly in an interview with the Financial Times, inter-generational warfare looms “as young people increasingly resent having their wages reduced and taxed away to support social programmes for their grandparents’ income and health-care concerns”. Short of flinging the oldsters to the sharks, there is no escaping the demographic trend that has fewer workers supporting more baby-boom retirees in most of the developed world (and part of the developing world). The question is whether the burden should fall on workers in specific firms, on all workers, or on taxpayers in general.

Here’s another conflict, though Mr Miller didn’t bring it up: the one between shareholders’ and workers’ interests. Perhaps GM’s employees, and Delphi’s, do not need our sympathy: for decades they have had the luxury of secure employment and benefits that many in the workforce would kill for. Perhaps their unions were too greedy—and too unrealistic—in the deals they negotiated in happier times. Nor are shareholders in thrilling shape at the moment, with GM’s share price at $26, down from over $40 earlier this year.

But GM was making good money in the 1990s. Like many companies, it stopped contributing to its pension scheme for a while when the stockmarket boom was producing what was reckoned to be sustainable pension surpluses. And at a time when many big corporations were rewarding shareholders (and, no doubt, executives with stock options) by buying back company shares, GM was particularly famous for it. If that money had been put instead into pensions—and indeed into funding health-care obligations—the problem would be less acute now.

But it is acute, and no amount of finger-pointing will change the equally unappealing options. A debt’s a debt, but a dead company cannot pay it. Delphi must cut and run, or go under—unless the United Auto Workers will do a huge deal, losing face but saving jobs. Which side are you on, brother?

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Read more Buttonwood columns at http://www.economist.com/research/articlesBySubject/display.cfm?id=2512631

* “Do Hedge Funds Hedge?”, by Clifford Asness, Robert Krail and John Liew, Social Science Research Network; “Hedge Funds: Risk and Return”, by Burton Malkiel and Atanu Saha, Princeton University; “Systemic Risk and Hedge Funds”, by Nicholas Chan, Mila Getmansky, Shane Haas and Andrew Lo, National Bureau of Economic Research.

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