Public Perception of Potential Bankruptcy Can Affect Bottom Line
December 17, 2010
The public’s increased perception of the likelihood that General Motors would go bankrupt during the recent financial crisis may have cost the company 21 percent of its North American book value, said Chad Syverson, professor of economics.
“We find a fair amount of evidence that auto makers’ financial distress does affect customers’ willingness to pay for their products,” Syverson said during a Becker Brown Bag Series presentation, sponsored by the Becker Center on Chicago Price Theory, at Harper Center on November 22. “We see larger effects for cars with longer lives remaining on their service warranties.”
Syverson discussed research conducted with Ali Hortacsu, professor of economics, Gregor Matvos, assistant professor of finance, and Sriram Venkataraman, assistant professor of marketing at Emory University, on some 6.2 million used cars sold during auctions conducted between January 2006 and November 2008.
Their study determined that a 10 percent increase in the market’s perception that a company will go bankrupt will decrease a car’s sale price by $68, Syverson said. With an average sales price of $13,062 per car in the wholesale used car auctions studied, this increase in perceived potential to go bankrupt drops prices by about .5 percent, he said.
The longer the life of the warranty remaining on a car, the larger the effect of this perceived distress, Syverson said. “That’s what you would expect if you expect this longevity story is correct,” he said. “The cars that are going to be around longer are going to see a bigger hit to their price because there is more of this service or product provision the buyer is going to lose if the company goes belly up.”
For a car “just driven off the lot,” this factor yields a $140 drop in prices for a 10 percent increase in perception its manufacturer will go bankrupt, Syverson said. Extrapolated to 100 percent likelihood of bankruptcy, the cost is $1,400, about what a customer pays for a warranty on a new car, or 6 percent of the average sale price of $25,000 for new cars, he said.
Near the end of 2008, credit markets rated the chance of bankruptcy at GM and Ford at 80 and 50 percent, respectively, Syverson said. Even assuming 50 percent of both perceptions was based on “market panic,” the perceived likelihood differential of 30 percent for GM implies a loss of $417 of margin per car for the automaker, Syverson said.
Between 2006 and 2009, GM’s largest accounting margin on car sales was 7 percent, he said. Based on average prices, this was $1,750 per car, Syverson said. As a result, that 30 percent increase in the public’s perception of the likelihood of GM’s bankruptcy “wiped out 25 percent of GM’s margin,” he said.
“That’s not trivial,” Syverson said. “Is it big enough to create the same type of phenomenon as a bank run where the market’s perception of bankruptcy can lead to financial distress that otherwise doesn’t exist? We’re working on that now. But it’s not chump change to lose a quarter of your margin.”
Syverson and his team found their results were not affected by the possibility that GM dealers bought fewer of their own company’s cars, nor by possible “fire sales” for new cars that might drive down used car prices, he said.
Syverson’s research successfully tested the government’s explanation of bailing out GM to save the company from the public perception that it might go bankrupt, said Kyle O’Meara, first-year student in the Full-Time MBA Program who has taken one of Syverson’s classes. “This could be a valuable tool in testing the need for future government intervention in markets,” O’Meara said.