An easy way to backstop the auto sector

News item from the DTM:

Ottawa is willing to go to the aid of teetering auto companies, but will consider help only for plants that are thought to be “sustainable,” Finance Minister Jim Flaherty said yesterday.

“The key is sustainability, a look to ensuring that the industry is sustainable long term, not in short-term fixes,” he said in an interview after meeting in Brazil with finance ministers and central bankers from around the world.

Mr. Flaherty recognized that the U.S. administration is poised to put together a rescue package for the major U.S. auto companies. He is under pressure to offer a similar package for Canadian branches of those companies so they do not close their shops in Canada to save money and consolidate where the government subsidies are.

Given the importance of the auto sector to Ontario and Quebec, this decision makes sense. The question will be, what form should this support take? Rather than provide the auto parts folks equity or a traditional loan, why not employ a novel structure to protect the taxpayer from the downside that may come should General Motors or the like hit the wall, as forecast earlier today by Deutsche Bank when it slashed its GM stock-price target to zero.

The idea of “last money in, first money out” is how many a distressed lender would play the auto trade right now. If the taxpayer is the court of last resort, then it strikes me that the feds would be well advised to consider a similar structure. In a bankruptcy proceeding it would be called a DIP loan, for “debtor-in-possession”. The federal government would be well served to find a mechanism to provide these important funds, without falling into the trap of being the last putz to keep the lights on — sans belt and suspenders.

The U.S. government has tried debt plus warrants (think AIG), they’ve tried prefs (think Citibank, JP Morgan, etc.), they’ve tried the TARP program, but none of these fit the bill for the Central Canada auto sector.

Investing in their equity, or even convertible equity, is a non-starter. Providing a loan makes sense, except for the reality that each auto maker and their part suppliers are about as leveraged as the financial markets will allow. Let’s assume that any new debt via a government loan would normally go in junior to the existing banking relationship. Which means that every new debt dollar going in is actually “equity”, even if it is being called a loan.

Wrong, wrong, wrong.

If the government wants to support the sector solely to preserve the plants and the jobs, which I applaud, the mistake would be to do a deal that also bails out the existing lenders. That’s why a finesse of the principle of DIP financing rings true. Create a fund; if the players want to access the fund, they have to do so based on a simple principle.

If the government is going to be the last money in, they should be the first money out, as well. Otherwise, taxpayer capital is really just supporting the existing lender group, who in turn are supporting the auto parts firms in question by not calling their current loans (until they do that is; think Progressive Moulding).

Which means they’ll be out long before the taxpayer is paid back if things don’t improve; which is counterintuitive given who has the money, and who needs it.

MRM