How Chrysler's Bankruptcy Plan Threatens Our Markets

I never write about politics. First of all, it bores me. Second, it's guaranteed to upset about 53% of my readers, which normally I would not mind, but since I won’t be able to change their mind why bother. Third, and most importantly, my writing is a byproduct of my investment process – I am an investor who thinks through writing, not a writer who invests. The following article is not meant to be a political one, though I am sure it has turned out as such, but was written to defend free markets.

By shafting bondholders and undermining the bankruptcy system, the Obama administration may change the way investors view risk.

On May 1, the United States took a drastic step toward becoming Russia. Not Russia at its best, not the motherland of Dostoevsky, Tolstoy, Rachmaninoff…

Instead, Russia at its worst, the one that in 1917 took from the bourgeois and gave to the working class; the one that signed contracts with western oil companies in the 1990s when oil prices were low and then — in 2007 when oil prices skyrocketed – blatantly and unilaterally “renegotiated” those contracts.

Wielding the public’s empathy as a weapon, President Obama took Chrysler from its rightful owners: secured loan holders (a.k.a. TARP-tainted banks, the “evil” hedge funds, faceless pension funds). And he gave it to struggling, very sympathetic, $40-an-hour earning (including benefits, this is not a typo), blue collar workers — Chrysler’s employees and the United Auto Workers union. Chrysler, simply, was stolen from its rightful owners.

Fixed-income investors spend an enormous amount of time studying bond covenants, which spell out how assets are disbursed in the event of a bankruptcy. Secured senior lenders have dibs on the secured assets; unsecured, junior bondholders and loan-holders follow (as a part of leveraged buyout Chrysler had no unsecured outstanding bonds or loans); unions and employees are next in line; and equity investors get whatever is left, which in this case would be almost nothing.

The White House fish-fry

For two hundred years our country has had a well functioning bankruptcy-court system that was designed to make sure that division of assets is equitable. Now that system is threatened.

The banks, the ones that received billions of Federal funds, were forced to give up their legal ownership first. Were they told they would fail the recent stress tests (which they recently passed) if they didn’t give up their rights? Or maybe their CEOs were told they’ll be fired if they did not go along? These days you don’t have to be a conspiracy theorist to make these accusations. After all, then-Treasury Secretary Hank Paulson and Federal Reserve Chairman Benjamin Bernanke used the latter tactic to get Ken Lewis, CEO of Bank of America, to lie to his board and shareholders about the purchase of imploding Merrill Lynch. We may never know what happened, but I’ll promise you this — banks did not walk away from billions of dollars of the desperately needed money, not at their own will.

After the big fish were fried, President Obama went after smaller loan-holders — he called these hedge funds and pension funds “speculators” — who put up a fight. Those institutions were not tainted by TARP money, thus the president had to use populist rhetoric, saying that they “endanger Chrysler’s future by refusing to sacrifice like everyone else.” He turned public opinion against the loan-holders, whose only fault was that they financed the dysfunctional automotive sector for too long and maintained fiduciary duty to their investors by attempting to collect what was legally due.

President Obama is popular and hedge funds are not. Thus as the financial and political costs became too high, these smaller fish jumped into frying pan with the banks. The fact that these pension funds and hedge funds invest money for regular folks like you and me is ignored. Average Joes aren’t paying close enough attention to catch that little detail; and unlike the UAW, they did not bankroll Mr. Obama’s campaign.

Losing the empathy contest

The consequences of what took place May 1 are not immediately apparent, but there are consequences. Forget about right or wrong, forget about politics: If any other President had done what Mr. Obama did you would have been reading the same thoughts from me. The rule of law, the bedrock of our system, was chipped two weeks ago. Instead of company ownership being redistributed based on the provider’s place in the capital structure — as the law requires — the asset redistribution took place based on a very subjective criterion, empathy. Banks, hedge funds and pension plans don’t win empathy contests these days, especially when competing with down-and-out workers.

President Obama’s actions will have a twofold impact:

First — and this is certain — they impaired auto companies’ ability to borrow from the fixed income market for at least a generation, and that’s regardless of whether they have secured collateral. A fixed-income investor, when pricing a security, makes certain assumptions of recovery based on the collateral and its place in the capital structure in the event of bankruptcy. The better the collateral and the closer it is to the front of the capital structure, the less money they stand to lose, and thus the lower the interest rate they expect to receive.

In the case of Chrysler, loan holders expected to recover around 70-80 cents on the dollar if the letter of law was followed. After the company was given away to UAW, however, that number dropped to 29 cents. Would you buy an auto company’s bonds in your retirement account if you knew that this industry often flirts with death, the rule of law is suspended and empathetic workers take your money if/when things go wrong?

The second impact is more significant to the US economy, but will depend on future government actions. If the empathetic distribution of wealth stops with the auto industry, investors may look at it as a one-off deal, specific to the dysfunctional auto industry. But if Mr. Obama repeats this even once outside of the auto industry — and he’ll have plenty of chances as we are in a prolonged recession — the political risk of the US will increase. Lenders, be it bond or loan holders, will lower recovery assumptions for even very secured assets, and the risk premium and thus borrowing costs will rise for all companies.

Empathy is an honorable emotion, we feel bad for people losing jobs, but changing the rules, in this case the law, in the middle of the game in most developed countries would be considered criminal, shortsighted and not good for the system. If you don’t trust the rules, you cannot play the game. I hope our president stops while he is behind.

Comments

[Speedspirit:]

Changing the rules and the laws in the middle of the game is a criminal act and this adminastration has been doing alot. Just look to where and how the issued bailout money came about. It was unconstitutional. Tha Patriot Act is unconstitutional.

At least we can hope for an impeachment.

May 13 06:50 AM

[expat in China:]

Obama and Chavez

High speed destruction of a nation!

May 13 07:01 AM

[Moon Kil Woong:]

I tend to agree. There are dangerous precedents being set here. The bankruptcy system is extraordinarily complex and well managed. Let the bankruptcy system run its course.

Despite doomsayers, I'm sure our bankruptcy system could even have handled the collapse of AIG better than the government free $ fest methodology embraced by the former Treasury Hank Paulson who allotted his own pension plan (Goldman Sacs) the lions share of the free loot.

Bankruptcy court treats everyone impartially. Perhaps that's exactly the reason bankers hate it so much.

May 13 07:47 AM

[conceptwizard:]

The Obma admiistration, Treasuries and te Fed, are breaking every legislation, bankrupcy law, FDIC mandates on insolvent institutions, SEC oversight, congresonal approval mandates that they need to support Financial Warlords at the expense of the taxpayer. This is done manipulatively wthout clarity and recourse for abuse of the monies involved. The blank check is unlimited. This is not a responsible response and is criminal as history will disclose.

May 13 08:00 AM

[KIT:]

The Harper govt in Canada had its own damaging rule change converting Unit Trusts into corp structures after a pre election promise not to do so. Many dividend dependant people lost a lot of money in the suprise move. Many are fairly old and cant recover the loss.

I expect the courts to undo Obamas play may take some time but will be a mess when it happens. I think the govt will have to make Bond holder whole..... and rightly so

May 13 08:31 AM

[al1956:]

You are so wrong; our president is doing something that should have started back when steel was in trouble in this country. When these bond holders jumped on buying these bonds of a distressed company they, being business men knew there was a chance that there would be a default. But instead they bought them at 60 cents on the dollar hoping to get the full 1 dollar back or more. I wish I could get that type of guarantee for my 401K but I am not one of the mega rich that can afford to put a minimum of 1 million cash into the hedge or bond fund. It’s another case of the rich and powerful trying to shake down the working class for their own benefit. I bet you those guys don’t even own an American car.
Someone got to start protecting America and its workers from the leaches that are trying to suck everything they can from the people. Are you in favor of going back to the 70”s when we bought a company only to break it apart and sell it off costing millions of jobs so only a few wealthy investor can benefit?
Bottom line is, it has to start somewhere with getting America back on its feet, even if it means the United States has to give money to its own people and companies instead of giving it to foreign countries to develop manufacturing and sell it back to the United States. Many companies across the country are going bankrupt that are non union because on bad management or are moving their work off shore because lawyers and lobbyists infiltrated the government and polluted the laws with giving tax breaks to send work over seas and then have it shipped back. How about tax breaks for companies that make there goods here? Mr. Katseneison, or any other of you highly educated editorialist, why nots take up an American fight and use your intelligence and influence to directing attention and efforts to changing foreign trade laws like this VAT tax. (Where countries pay their manufacturing to ship goods to the United States but then taxes everything from the United States coming to their country at a very high rate to where no one buys it). Other countries pay their manufacturing base a subsidy for manufacturing in their country. They understand that without manufacturing you have no strength. Asian countries pay the companies royalties, a percentage of the cost of the goods to ship them to the United States; Japan pays their auto companies 15% of the production cost for every car that gets shipped to the United States. Toyoda sends the United States a 40k Lexus and then Toyoda gets a check for 6K from their government for being good old boys by shipping it to the United States.

Forget about the hedge funds loosing a few dollars, I am sure they will be fine, lets concentrate on the American companies that employee American workers. Not everyone can be editorialist, lawyers, doctor, or bankers nor can everyone work at McDonalds and Wallmart, we have to have a middle class and most of this work is in manufacturing. This whole country was built on and protected by middle class. The American industrial revolution formed the middle class. It’s the middle class that made the United States the power of the world. It is lawyers and lobbyists paid by foreign countries, for that countries own personal gain that have worming their way into our publications and government system to sway public and government opinion that is destroying America. In my opinion I think you are un-American in you article and you would love to see slavery come back. Protect the few rich and screw the mass.

May 13 08:31 AM

[CautiousInv...:]

The debate whether to save the autos is separate and apart from the issue of how we save the autos. The unions will wind up with 42% of that owed on VEBA and 55% of the new company while the secured creditors will get something like 22%.

Unless you are a politician, this is patently unfair under the code and 363 speccifically.

Appreciating that the unions assisted with Obama's election and there is a desire to maintain employment in the automotive sector, let's say working with the auto companies and forcing them into Chapter 11 is a good idea in the hopes that viable entities will emerge.

With that as a given, why would not Obama and Treasury offer the secured creditors another $1 billion or so to preserve the sanctity of property and contract rights? TARP funding was $700 billion and I am sure they could have come up with money; instead, Obama chose to demonize the non TARP lenders who provide liquidity to various markets.

Unwittingly, he just raised the cost of capital and reduced its availability.

May 13 12:00 PM

[Heckler:]

al1956 - The whole thing undermines basic principles of the Capital Markets. I'm guessing you are probably averse to the legal/bankruptcy system until you need it to work in your favor. You also go on to demonize Hedge funds but fail to realize that Pensions and Unions (blue collar workers) are investors in those funds as well.

The days of the US manufacturing are over - this is now a service-based economy. There is no way to compete with countries that pay workers the equivalent dollars per week. People need to educate/re-train themselves to compete globally. Are you willing to pay twice as much for everything to have it made in the U.S? The days of the uneducated, greedy UAW workers are numbered. They have ridden these auto companies into the ground with higher labor/retiree/health costs and the inability to restructure to meet demand.

I agree we need to rebuild America, but this "Robin Hood" style politics is not the way to do it. Finally, your last two sentences ruined any credibility you had, which is a shame because you almost sounded halfway intelligent.


On May 13 08:31 AM al1956 wrote:

> You are so wrong; our president is doing something that should have
> started back when steel was in trouble in this country. When these
> bond holders jumped on buying these bonds of a distressed company
> they, being business men knew there was a chance that there would
> be a default. But instead they bought them at 60 cents on the dollar
> hoping to get the full 1 dollar back or more. I wish I could get
> that type of guarantee for my 401K but I am not one of the mega rich
> that can afford to put a minimum of 1 million cash into the hedge
> or bond fund. It’s another case of the rich and powerful trying to
> shake down the working class for their own benefit. I bet you those
> guys don’t even own an American car.
> Someone got to start protecting America and its workers from the
> leaches that are trying to suck everything they can from the people.
> Are you in favor of going back to the 70”s when we bought a company
> only to break it apart and sell it off costing millions of jobs so
> only a few wealthy investor can benefit?
> Bottom line is, it has to start somewhere with getting America back
> on its feet, even if it means the United States has to give money
> to its own people and companies instead of giving it to foreign countries
> to develop manufacturing and sell it back to the United States. Many
> companies across the country are going bankrupt that are non union
> because on bad management or are moving their work off shore because
> lawyers and lobbyists infiltrated the government and polluted the
> laws with giving tax breaks to send work over seas and then have
> it shipped back. How about tax breaks for companies that make there
> goods here? Mr. Katseneison, or any other of you highly educated
> editorialist, why nots take up an American fight and use your intelligence
> and influence to directing attention and efforts to changing foreign
> trade laws like this VAT tax. (Where countries pay their manufacturing
> to ship goods to the United States but then taxes everything from
> the United States coming to their country at a very high rate to
> where no one buys it). Other countries pay their manufacturing base
> a subsidy for manufacturing in their country. They understand that
> without manufacturing you have no strength. Asian countries pay the
> companies royalties, a percentage of the cost of the goods to ship
> them to the United States; Japan pays their auto companies 15% of
> the production cost for every car that gets shipped to the United
> States. Toyoda sends the United States a 40k Lexus and then Toyoda
> gets a check for 6K from their government for being good old boys
> by shipping it to the United States.
>
> Forget about the hedge funds loosing a few dollars, I am sure they
> will be fine, lets concentrate on the American companies that employee
> American workers. Not everyone can be editorialist, lawyers, doctor,
> or bankers nor can everyone work at McDonalds and Wallmart, we have
> to have a middle class and most of this work is in manufacturing.
> This whole country was built on and protected by middle class. The
> American industrial revolution formed the middle class. It’s the
> middle class that made the United States the power of the world.
> It is lawyers and lobbyists paid by foreign countries, for that countries
> own personal gain that have worming their way into our publications
> and government system to sway public and government opinion that
> is destroying America. In my opinion I think you are un-American
> in you article and you would love to see slavery come back. Protect
> the few rich and screw the mass.

May 13 03:32 PM

[Osterix:]

Vitaliy,
Generally you are very knowledgeable. I was therefore suprised when you said above that you were not interested in politics. The old fashioned name for Economics was Political Economy. It is impossible to separate macroeconomics from politics. Any political decision has an economic impact and vice versa. I suggest you read some books by John Kenneth Galbraith. At a minimum "The New Industrial State" and "The Affluent Society" This will expose you to the Institutional School of Economics view of the world.
With respect to the Chrysler situation- The normal rules of bankruptcy are intended to apply to normal situations. The collapse of Chrysler could trigger a collapse of the American auto industry which could trigger the collapse of the entire US economy. This is a crisis. The US economy is so hugely dependent on the auto industry that millions of workers are directly or indirectly dependent on it. One reason we are unique compared to other developed countries is we have no mass transit system nationally. Someone recently observed that America has a mass transit sytem that Bulgaria would be ashamed of. The Obama administration realizes this is a crisis and is in a justfiable panic. I cannot understand people like the many commenters who rant and rave about the end of the rule of law, the coming of dictatorship, the end of the free-market system, etc., when we are on the edge of a nationwide economic meltdown. Don't take my word for it, look up the statistics on what percent of the US GDP is directly or indirectly involved with the auto industry. Bear in mind that it is not just the Big Three that are at risk. The huge network of parts suppliers also supply the Transplant foreign producers. There is already a financial crisis with suppliers. They have been filing for bankruptcy in increasing numbers for the past year at least. If they are pulled down by Chrysler and GM they will stop supplying the transplants who will have to shut down their factories until they can figure out how to deal with the new situation.

May 13 04:11 PM

[Vitaliy Kat...:]

Osterix, politics is very partisan, thus discussions about it are not rational. With everything you said I do see justification for giving company away to unions. Mr. President did not have to do that.

May 13 11:34 PM

[Vitaliy Kat...:]

important correction: I mean to say "I DON'T see justification"

May 13 11:35 PM