What if Chrysler Holdouts Overhedged with CDS?

As I thought more about Chrysler after my previous post, I realized there's a whole new possibility.

First of all, I'm not sure at all UAW got as great a deal as some opined (and as I first thought) it to be. If we take the valuation at $10B, 55% recovery of UAW's VEBA's $10B owed by Chrysler doesn't look that good considering it's in stock of a company going into bankruptcy. Even if they got good terms in the current contract, relative to other unions in bankruptcy situations, they've severely handicapped themselves in future contract negotiations: if they play hardball, they'd be killing their own retirement health benefits. The role the administration played in persuading/arm-wrestling UAW to go with this arrangement remains an intriguing question.

But more interestingly, the holdout debtholders are pushing for liquidation (this is a critical factor I failed to think through in my last post). This by itself is not outrageous. But from a long-term perspective, and considering the administration's declared determination to save the US auto industry, you'd think a viable company reemerging from Chapter 11 would provide more value to the debtholders than a forced firesale liquidation, especially in this climate. Furthermore, Chrysler loans had been trading at $0.15 on the dollar prior to the government offering $0.32, no bid/offer spread or commission. That's a 113% instant jump in mark-to-market. Why would they turn it down and risk a prolonged court battle? What's their upside even if they win in court, $0.35? After adjusting for risk and time value, that $0.35 is probably worth no more than the prior market price of $0.15.

Don't tell me they just want to fight for the principle of absolute priority. That's so complicated it'd require a rewrite of human psychology and behavior, and throw away the whole belief system called evolution. There is a much simpler plausible explanation.

What if the holdouts over-hedged their Chrysler loans with CDS? They probably bought the loans for $0.5~0.7 on the dollar. Maybe by accident/mistake they bought protection on the full notional, which would translate to a 40~100% over-hedge.

What happens when your house is insured for $2M but worth only $1M? You pray something really terrible happens to it. Prayer apparently works because there've been a mysteriously large number of automobile fires erupting in Europe and the US since the crisis began. It's a risky strategy, though. Unless you're really sure it's God's work, chances are you'd be thrown in jail.

But not when it comes to bonds/loans with CDS or equities with options/swaps. You can buy $1B bond/loan, hedge with $2B worth of CDS, use your representation of the $1B debt in pre-bankruptcy negotiations to drive down the recovery, and claim your insurance. The lower the recovery, the more you win. It's perfectly legal, and equally perfectly f***ed up.

Which brings us back to my earlier proposal: hedged debtholders/shareholders should have their representation adjusted for the hedge. If you over-hedge, it's your bet (I fail to see the reason why naked shorts/CDS should be banned, but that's another topic). At least you can't leverage your phony "economic interest" to benefit from unnecessary damage.

What happened in Chrysler's case may not be reversible. What's important is GM.

Would the same scenario play out in GM? Somewhere in the world, someone surely has over-hedged her GM bonds/loans, even if only by mistake.

Comments

[CorradoCam:]

I do not see Chrysler amongst the top 1000 reference entities of DTCC for CDS written against it, only "DaimlerChrysler AG":

www.dtcc.com/products/...

Did I miss something?

(As far as I know, if a buyer of protection buys a CDS to guard against a "credit-event" (Such as a bankruptcy) of an entity, that entity is called a "reference entity")

Disclaimer: I am not a financial expert at all.

May 05 06:52 AM

[hoffman23:]

Who wrote CDS's on Chrysler? AIG? Even those idiots weren't that stupid. Anyone in the car business knows why they held out. They would have to admit to a loss instead of having "the good fight". they overplayed their cards. More morons in charge of someone else's money.

May 05 08:16 AM

[john s. gordon:]

author has raised an interesting possibility.

hoffman: do not underestimate the stupidity of certain people.
> jack

May 05 08:41 AM

[shootpar2001:]

Even Idiots at AIG could have made this mistake.....
They could have sold CDS's on long term debt from 10 years ago.
Remember CDS's are not something magically new; because you have not heard about them before. They have been around longer than you think. This question is much more relevant to GM and the mortgage securities that the gov't is trying to get the banks to sell.
Why can't the gov't get the banks to sell their 'toxic' debt for 40 cents- on-the-dollar?
Because they bought insurance from AIG; which is now backed by the gov't. The IDIOT politicians are trying to negotiate with themselves and do not even realize it!!!!!!!!



On May 05 08:16 AM hoffman23 wrote:

> Who wrote CDS's on Chrysler? AIG? Even those idiots weren't that
> stupid. Anyone in the car business knows why they held out. They
> would have to admit to a loss instead of having "the good fight".
> they overplayed their cards. More morons in charge of someone else's
> money.

May 05 09:29 AM

[Bo Peng:]

CorradoCam, I'm not sure how DTCC classifies ref entities. DaimlerChrysler papers are still traded but the current Chrysler loans are traded under "Chrysler Financial" and I have no idea the reason why it's not on the list is because it's not big enough, LCDS are not included in DTCC stats, or lumped under DaimlerChrysler for some reason.

hoffman23, people write CDS on Chrysler/AIG for short-term bets. It all depends on the price. It may look stupid in retrospect but there's a technical problem -- you can't trade in retrospect. In any case, trading wisdom of anyone is irrelevant.

May 05 09:57 AM

[henarl:]

If the bondholders volutarily agreed to a cramdown that would probably invalidate any CDS coverage they have whereas, if they are stiffed by the bankruptcy court, these CDSs would probably still be valid. Of course if the CDS issuer is also bankrupt, that might not help them much.
BTW: I agree that naked CDSs should not be illegal any more than a casino bet should be illegal. However, losers on a casino bet can't expect to be bailed out by the govt., as in the case of AIG.

May 05 12:38 PM

[Gravedigger:]

They just paid too much and don't want the loss. Their position is not lost yet. The issue whether this deal can be implemented through a Section 363 sale is not a "no-brainer". Until the order is entered authorizing the sale, they can bargain to extract a douceur in return for withdrawing their objection. Pricing of the douceur depends on whether some other similarly situated party files a timely objection, thus diluting the play.

May 05 02:19 PM

[Anthony B:]

"hedged debtholders/shareholders should have their representation adjusted for the hedge." seems like the right answer. However, I bet it wouldn't be difficult for debtholders to hide how hedged they are.

May 05 02:45 PM