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Published on Leave a comment on Should I Stay or Should I Go?

On Wednesday, we learned of the agreement between General Motors and the United Auto Workers regarding a buyout plan:

G.M., staggering under the weight of $10.6 billion in losses last year, said it would offer buyouts and early-retirement packages ranging from $35,000 to $140,000 to every one of its 113,000 unionized workers in the United States who agreed to leave the company.

When firms are in financial distress, they need to get their creditors--typically private banks and public debtholders--to write down the value of their claims. If existing creditors are willing (or can be coerced) to do this, then the firm faces a better prospect of getting new creditors to help it finance value-enhancing projects. (I am still waiting to see what these might be for G.M.)

In a standard workout from financial distress, the firm enters an agreement with a bank and then makes an exchange offer to its public debtholders to give them new securities in exchange for their old ones, if a sufficient number of them accept. For an exchange offer to work, it typically has to shorten the maturity or raise the seniority of the new debt relative to the old. Those who opt for the exchange have to be able to "get in line" ahead of those who don't in the event that not all of the firm's creditors will be repaid in full. The more workers who take the buyout, the less money will be available in the near future for those who did not take it, in the event that G.M. doesn't recover.

In G.M.'s case, its labor contracts are so costly and so rigid that its unionized workforce resembles a major creditor, and what they have been offered resembles an exchange offer. So each of the 113,000 workers is making an individual assessment of whether they are likely to receive more money by taking the sure payment now or by seeing what uncertain payments they get when G.M. enters bankruptcy or recovers. As a Reuters story points out:

Several union officials said workers who have been thinking about a career change or those worried about the auto industry overall are the ones considering the offers.

The story also notes that employee reactions are mixed:

Reactions to GM's buyout offers, announced on Wednesday, varied among workers, with younger employees worrying about their future because the offers would not include health benefits, and some older ones getting ready to retire.

But some senior GM workers might just refuse to go.

Terry Brumley, 63, who works at the Corvette plant in Bowling Green, Kentucky, has been with GM more than 40 years.

"I'm not taking the money. I can raise a garden, go to dinner with my wife and go fishing, and still have a job. So why should I retire?'' he asks, adding that he sees himself working for at least another 10 years.

And, to show some of the problems with getting in the habit of offering buyouts, consider:

"Members of high seniority are very interested,'' Eldon Renaud, president of the United Auto Workers Local 2164 in Bowling Green, Kentucky, said. "There were a lot of people that were ... holding on to see if there was going to be a buyout offer.''

On this sort of dynamic inconsistency, more later.

Published on Leave a comment on Dartmouth Divests, Sort Of

From this morning's press release, in the wake of a Board of Trustees meeting over the weekend (with my emphasis) added:

Based on recommendations by the board's Investment Committee and the College's Advisory Committee on Investor Responsibility (ACIR), the trustees voted to direct the College's Investment Office to avoid investments in six companies deemed to be directly complicit in what the U.S. Congress and Department of State have determined to be genocide in the Darfur region of Sudan. As a result, Dartmouth will avoid investing in ABB Ltd.; Greater Nile Petroleum Operating Company, Ltd.; PetroChina Company, Ltd.; Sudanese White Nile Petroleum Company; Petroliam Nasional Bhd (Petronas); and Sinopec Corp., all of which are involved in oil drilling or oilfield services in Sudan. The College does not currently hold stock in any of these companies.

"Divestment and screening are steps that should be taken infrequently and only in the most compelling circumstances," President James Wright said. "This decision reflects Dartmouth's concern about the Sudanese government's campaign of atrocities against civilians, which Congress and the State Department have described as genocide. This campaign has created a humanitarian crisis of major proportions in Darfur and Chad."

Board Chair William H. Neukom thanked the ACIR and the students involved in the Darfur Action Group for bringing the issue to the board's attention, and for their work in researching and analyzing the Darfur crisis and the activities of companies doing business in Sudan. Neukom said the board encouraged the administration to support additional educational programs concerning the Darfur situation.

So divestment apparently didn't require the College to actually sell a stock. That may be a first, but it does abide by the claim I made in an earlier post: for divestment to have any impact through the capital markets, it has to focus on new rather than old capital. In that post, I also suggested that the critical element in using markets to punish the offenders is to work through the product markets--to boycott the products rather than merely ownership of the assets.

It will be interesting to see where the divestment movement on campus goes from here.

See also the article in today's Dartmouth and some comments over at Joe's Dartblog.

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Published on Leave a comment on Some Economics of Divestment

Much has been made about divestment of Dartmouth's endowment from companies that do business in the Sudan. I applaud the sentiment, but I think the arguments overstate the case for what divestment by itself is likely to accomplish.

Here's an example from The Dartmouth's editorial board from last spring:

Dartmouth's investments in Siemens and Alcatel, both of which hold government contracts and are categorized by the Darfur Action Group as being tacitly complicit with the genocide, present a cause for concern. Though the Advisory Committee on Investor Responsibility is not prepared to recommend divestment in these companies for lack of information, we recommend that it obtain the needed information as quickly as possible. This issue should be a pressing concern for every human being. In particular, ACIR needs to consult the Conflict Securities Advisory Group, which specializes in these situations. Should CSAG provide evidence that Dartmouth's endowment in any way facilitates the genocide, Dartmouth must divest immediately.

The last sentence makes the ethical point quite well, and I couldn't agree more with the recommended course of action. Two paragraphs later, the editorial continues:

Dartmouth's divestment, moreover, could have a ripple effect upon the financial decisions made by similar institutions. A wave of divestment would put pressure on the Sudanese government to take action to end the genocide and would deprive the Janjaweed rebels of much-needed funds. Moreover, according to the report submitted by the DAG to ACIR, the companies in which the College invests restrict most of their activities to Khartoum and provide non-essential services, thus ensuring that divestment would not harm those it is meant to help.

This paragraph confuses old and new capital, to the detriment of its argument. Once a share of stock is issued, then who collects the cash flows due to ownership is largely irrelevant to the operations of the company. I don't believe that the sentence that I highlighted in red, particularly the part about depriving the rebels of funds, is true. Consider the following simple example:

Suppose that, based on the projected cash flows from selling its products, the company in question is worth $100 per share. Now imagine that a large group of current shareholders decide that they are going to divest the stock. What happens to the stock price? Let's say they are very successful, and it goes down to $80. Since the business operations of the company have not changed, the future cash flows of the company still have a present value of $100 per share. All that the divestment has done is to open up a $20 per share profit opportunity for a new investor in the company. The most natural candidates to see the opportunity and take advantage of it are the existing management or the remaining (less ethical?) shareholders.

Continuing to focus on the capital markets, the way to damage the company is to deny it access to new capital, not to spend a lot of time debating who should own the shares on the existing capital. The $80 share price would matter, for example, if the company intended to issue new equity and had to take a 20% capital loss on all new shares. But very few companies issue new shares in a given year, and for well capitalized multinationals, there are other financing options that don't even require the equity market. So I am very doubtful that the capital market can be used productively in this endeavor, contrary to the conjectures of the editorial. (Similar conjectures are made in a well intentioned op-ed yesterday.)

Moving beyond the capital market, the way to get the company's attention is to boycott its products, which does change its business model because it lowers the future cash flows that support the $100 per share price. That's real pain to existing capital owners. And it would involve real sacrifice to those advocating for reform--doing without some products that they would otherwise consume, rather than engaging in fair-market value transactions and excluding a few companies out of several thousand from their portfolios. But that is to be expected if you intend to be an activist for positive change.

So whenever I hear of calls to divest, I think that the emphasis has been misplaced, and what is really needed is a boycott. But, of course, if you are planning to launch a boycott, the prudent investment strategy is to divest first.

Hat tip to Joe's Dartblog for bringing this issue to my attention.

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Published on Leave a comment on Should Airlines Hedge Fuel Costs?

A discussion about corporate hedging developed in the comments to an earlier post on the impact of Hurricane Katrina. It seemed like a useful topic to follow up in a new post. The issue at hand is why Southwest seems to be the only major airline that hedges a large part of its fuel costs. It could be that they are just speculating in the fuel market and got insanely lucky here, but I doubt that. Southwest's management is extremely shrewd--if they were making a bet, they knew what they were doing.

An economic approach to the issue would be to start by identifying the conditions under which hedging would be irrelevant. If trading is costless and markets are completely efficient, then hedging wouldn't add value. Under these assumptions, any transaction that the firm does can be undone by the shareholders outside of the firm at the same relative prices. So we look for market imperfections of one sort or another to explain hedging.

In most cases, the market imperfection is the cost associated with financial distress or bankruptcy. If unexpectedly high operating costs need to be covered by borrowing, and if borrowing is costly when done on short notice, then it makes sense to smooth out the variation in operating costs. Hedging--in this case, locking in a forward price of a key input to production--allows that to happen. This theory cannot explain why Southwest hedges its fuel costs and the other airlines don't, because it is in the best financial shape.

Perhaps we can tweak it a bit (as was being done in the comments) to suggest that Southwest is one of the few airlines mentioned where the stockholders are actually the residual claimants. The other companies are much closer to bankruptcy, when the equity holders get essentially nothing and any assets get assigned to the debtholders. Refusing to hedge in this case is a form of risk-shifting onto a financially weak firm's creditors. It may also be that the weak financial position of the other airlines doesn't allow them to enter into the long-term contracts involved with hedging next year's fuel costs.

Another possibility is that Southwest has a very unusual business model and is a $10 billion company because it rigorously applies that business model and looks for ways to improve it. If they lock in the price of their fuel, then fluctuations in the price of fuel won't interfere with their ability to figure out what routes are profitable, what schedules improve efficiency, or what the next city on their route map should be. Variation in performance month-to-month will better reflect choices they made rather than fluctuations they couldn't control.

But maybe this is overthinking the problem. Two months ago, David Grossman wrote in USA Today:

Southwest reported a profit of $235 million and saved approximately $351 million during the first six months of this year. If Southwest hadn't hedged, that profit would have been a $116 million loss and the first time in 57 consecutive quarters that the company did not report a profit.

Maybe they hedge to keep the streak alive.

This topic comes up any time fuel costs increase. About a year ago, Jim Garven noted most of these points and provided links to empirical and case studies of fuel hedging. Some other good discussions are here and here at the Conglomerate blog.