Another Reason Bailouts are Bad

I think the incentives issue has been beaten to death pretty well, but there is another problem with bailout:  They leave the productive assets of the failed company in essentially the same hands that failed to make good use of them previously.  Sure, the management has changed, but a few guys at the top of these large companies don't really mean squat.  To this point:

A corporation has physical plant (like factories) and workers of
various skill levels who have productive potential.  These physical and
human assets are overlaid with what we generally shortcut as
"management" but which includes not just the actual humans currently
managing the company but the organization approach, the culture, the
management processes, its systems, the traditions, its contracts, its
unions, the intellectual property, etc. etc.  In fact, by calling all
this summed together "management", we falsely create the impression
that it can easily be changed out, by firing the overpaid bums and
getting new smarter guys.  This is not the case - Just ask Ross Perot.
You could fire the top 20 guys at GM and replace them all with the
consensus all-brilliant team and I still am not sure they could fix
it. 

All these management factors, from the managers themselves to
process to history to culture could better be called the corporate
DNA*.  And DNA is very hard to change.  Walmart may be freaking
brilliant at what they do, but demand that they change tomorrow to an
upscale retailer marketing fashion products to teenage girls, and I
don't think they would ever get there.  Its just too much change in the
DNA.  Yeah, you could hire some ex Merry-go-round** executives, but you
still have a culture aimed at big box low prices, a logistics system
and infrastructure aimed at doing same, absolutely no history or
knowledge of fashion, etc. etc.  I would bet you any amount of money I
could get to the GAP faster starting from scratch than starting from
Walmart.  For example, many folks (like me) greatly prefer Target over
Walmart because Target is a slightly nicer, more relaxing place to
shop.  And even this small difference may ultimately confound Walmart.
Even this very incremental need to add some aesthetics to their
experience may overtax their DNA.

David Leonhart (via Carpe Diem) argues that this was exactly the long-term downside of the Chrysler bailout:

Barry Ritholtz "” who runs an equity research firm in New York and writes The Big Picture,
one of the best-read economics blogs "” is going to publish a book soon
making the case that the bailout actually helped cause the decline. The
book is called, "Bailout Nation." In it, Mr. Ritholtz sketches out an
intriguing alternative history of Chrysler and Detroit.

If
Chrysler had collapsed, he argues, vulture investors might have swooped
in and reconstituted the company as a smaller automaker less tied to
the failed strategies of Detroit's Big Three and their unions. "If
Chrysler goes belly up," he says, "it also might have forced some deep
introspection at Ford and G.M. and might have changed their attitude
toward fuel efficiency and manufacturing quality." Some of the
bailout's opponents "” from free-market conservatives to Senator Gary
Hart, then a rising Democrat "” were making similar arguments three
decades ago.

Instead, the bailout and import quotas fooled the
automakers into thinking they could keep doing business as usual. In
1980, Detroit sold about 80% of all new vehicles in this country.
Today, it sells just 45%.

As I wrote about GM:

Changing your DNA is tough.  It is sometimes possible, with the
right managers and a crisis mentality, to evolve DNA over a period of
20-30 years.  One could argue that GE did this, avoiding becoming an
old-industry dinosaur.  GM has had a 30 year window (dating from the
mid-seventies oil price rise and influx of imported cars) to make a
change, and it has not been enough.  GM's DNA was programmed to make
big, ugly (IMO) cars, and that is what it has continued to do.  If its
leaders were not able or willing to change its DNA over the last 30
years, no one, no matter how brilliant, is going to do it in the next
2-3.

So what if GM dies?  Letting the GM's of the world die is one of the
best possible things we can do for our economy and the wealth of our
nation.  Assuming GM's DNA has a less than one multiplier, then
releasing GM's assets from GM's control actually increases value.
Talented engineers, after some admittedly painful personal dislocation,
find jobs designing things people want and value.  Their output has
more value, which in the long run helps everyone, including themselves.

  • Jim Collins

    But wouldn't that make all of those Union labor contracts null and void? Gee! We can't have that happen. Where are all of those political donations going to come from?

  • Sandman

    I'll add one more to the pile of reasons to avoid bailouts - the effect on competitors. So you're Goldman Sachs, and you did a decent job managing risk. Not perfect mind you, but certainly better than your competitors. It's a difficult time, and you'll lose money, but you're still surviving. Your competitors did a much worse job, took bigger risks, and failed.

    But instead of reaping the rewards of a temporarily less competitive market, your competition is bailed out. And because of the difficult times, you teeter on the brink of failure. The dominos start falling.

    It reminds me of the airline business, where we seem unwilling to let anyone go out of business. Constant bailouts of terribly run airlines with horrible union contracts make it harder for efficient airlines to stay profitable.

  • morganovich

    i can only think of one possible good rationale for the bad loans bailout that looks to be coming, and oddly, it might be a good rationale, but it's going to depend on how it's executed.

    recall that paulson was a prop desk trader. perhaps he is thinking like a trader and realizing that this is a great opportunity to act like a sovereign wealth fund.

    consider: the major issue is illiquidity. all the the "toxic" debt still has value, but it's difficult to say how much, therefore, no one wants to trade it. but more of this has to do with the pervasive perception of fear than with actual value. even if 20% of the mortgages in a cdo go bad, it still has value and is collateralized. anything is a good investment at a price.

    so maybe it's worth 40 cents on the dollar. if paulson steps up and buys a trillion dollars worth at 20 cents, this is going to be a hell of a deal. the US can just sit back and soak up the income stream of loans and make a trillon in profit and wipe out 20% of the national debt in one shrewd trade. this would earn him a place in history alongside the great financial wizards.

    alas, given the stupidity and cupidity of our government, i fear it is unlikely to work out so well. we'll over pay and wind up owing or we'll make some money but squander the profits on random pork and poorly considered entitlements.

    but this is an amazing opportunity if the debt can be bought at a good price and we put it all in a trust that is required to spend all proceeds paying off the debt.

    it is a sad testament that we are unlikely to seize it properly.

  • Jody

    They leave the productive assets of the failed company in essentially the same hands that failed to make good use of them previously.

    A similar effect causes inefficiencies in wealth redistribution (taking from the most productive and giving to the least productive).

  • Scott

    Agree with Morganovich. Maybe Paulson can hire Larry Fink to buy all the paper for 5% of the profit with a 10 year realization period. More likely they'll mismanage it and someone like Leon Black will make a fortune on the other side, like he did with the RTC.

  • Mesa Econoguy

    Find this guy quickly…..

  • Allen

    I'm with you on the DNA thing. My gutt feeling is that once a company has a long period of doing poorly, a lot of the talented cogs leave. Those remaining either aren't good enough to find a job with a more successful company or couldn't care less. Bailouts for the big auto manufactures aren't going to change things.

  • morganovich

    alas, given the comments i am hearing from pelosi and obama, this is going to be a money pit. both are demanding "protecting homeowners" and "defending main st" in order to support a bailout.

    astoundingly, neither seems to care about protecting the taxpayer, though given how few americans actually pay taxes and both the aforementioned parties long term commitment to taking their money and giving it to the "deserving poor" perhaps this is should come as no surprise.

    i still think this could be an amazing boon to the US if handled properly, but the machinery of government is simply too far removed from a profit or accountability motive to even be able to conceive of such. i would wager that the immutability of corporate DNA is nothing compared to that of government...