COMMENT: Fundamental problem

The US government is pressuring the creditors of General Motors and Chrysler to help the carmakers return to health by swapping debt for equity. That might work if the lenders thought the equity was worth something. And it might be - if the two companies merged and crunched out substantial costs. [This article was provided by breakingviews.com.]

The trouble is the government seems to favour trying to save Chrysler by bringing in Fiat as a minority shareholder. It's easy to see why this option appeals to policymakers. It would potentially leave Chrysler as a standalone business, in theory preserving many more jobs.

But with all due respect to the Italian group's strengths - including competent management - there is a better way to design a viable American car industry. Rather than prolonging Chrysler's dubious future as an independent business, the government should do its best to weld Chrysler and General Motors together.

That may sound counterintuitive. After all how would American manufacturing benefit by shrinking from three to two car companies? Merging under the auspices of bankruptcy protection would produce pain as thousands of jobs would be lost, factories shuttered, brands extinguished and dealerships closed.

Yet reducing capacity is as crucial to helping the domestic car industry regain some semblance of its former mojo as slashing the combined $91bn in debt and healthcare liabilities that bedevil Chrysler and GM.

True, Motown's carmakers have made many cutbacks in recent years. But the fundamental problem remains: they manufacture too many cars and sell too few. And they are still losing market share. Fashioning a partnership between Chrysler and Fiat won't change that. Putting Detroit's number three together with GM could.

It would also make the combination more valuable for creditors. When the idea of a merger surfaced last October, the two companies projected potential cost savings of as much as $10bn a year. But let's assume something more conservative. If GM were to take on Chrysler's light trucks, SUVs and Jeep business - a significant chunk of Chrysler's output - it might be able to save $5bn.

The net present value of these savings would be something on the order of $30bn. That's greater than the $23bn in liabilities that Chrysler is today on the hook for to senior creditors, the government and its employees.

That should be sufficient inducement to persuade Chrysler's and GM's lenders and unions to swap their claims on the company for equity in the merged entity. Here's how. At present these creditors face being offered either pennies on the dollar and some equity - or in the case of GM's bondholders, equity alone.

But the two independent firms would still need to reduce capacity. They would also require tens of billions of dollars more in aid that would, assuming lenders and unions accept the deals, be higher up the pecking order in the event either or both collapse again.

The merger synergies, though, add a significant boost to potential equity value. Let's be charitable and assume GM's operating earnings hit 3% of consensus revenue estimates of $135bn in 2011. After taxes the net present value of these would be some $28bn. Tacking on a slimmed-down Chrysler's potential earnings might boost that to $33bn.

Add on the value of the synergies and a combined GM-Chrysler could be worth about $63bn to the unions, lenders and the US government. Even if Washington stumps up another $40bn to keep the company afloat, that still implies a 50% recovery on the combined manufacturer's liabilities. That's better than current offers circulating among stakeholders - and presents a company with greater survival chances.

The bad news is that it implies the government would lose a chunk of the money it has already plugged into the carmakers since December. But this is already the case. Putting the two together has the public policy benefit of creating a profitable carmaker in a better position to pay some of the cash back.

All wouldn't be lost for Fiat in this scenario. It could snap up some of Chrysler's unwanted factories and laid off workers to build Alfa Romeos and Cinquecentos. And if chief executive Sergio Marchionne is right that there will soon be just a handful of major global carmakers, there's no reason he couldn't still strike up an alliance with a merged GM-Chrysler. Who knows, he might even have a shot at running the place.

By Antony Currie and Rob Cox

antony.currie@breakingviews.com
rob.cox@breakingviews.com