Citi's TARP Convert and Chrysler's Indiana Bond Holders

Includes: C, FMCC, FNMA, GM
by: Bruce Krasting

A big sigh of relief for the Citi (NYSE:C) convert transaction. The resulting dilution puts a cap on the stock price forever. The Preferred holders (C.P) took a bath. The end result is that Citi’s balance sheet looks a lot better. Net-net call it a Green Shoot.

Treasury was a big part of the deal. They converted $25 billion of TARP pref into 36% of the common stock. That is not a Green Shoot. That is a loser.

As of this writing C’s market cap is a tad over $19 billion. 36% of that is $7 billion. Therefore the Treasury convert cost the taxpayers about $18 billion. It will be interesting to see if Treasury recognizes this loss. It is quite likely this will stay on the books at the original cost of $25 billion. Mark to market has not caught on in D.C. yet.

Sadly, I have been in this position before. The cram down solution stinks for the investor. The State Treasurer for Indiana will confirm that. The other holders of GM (GMGMQ.PK) and Chrysler bonds know how it feels also.

Corporate bond defaults and busted Pref stock are as old as Wall Street. But we are setting some new records for the Guinness book. The business with the Supreme Court and Chrysler turned out to be just a head fake. Having said that, when was the last time the Supremes got involved in a case like this? Look for more of this as the Government's involvement in the private economy grows. Brown Shoot.

To some degree we seem to be following the paths set by the bankruptcy courts. Equity and subordinated creditors get crushed. Senior creditors become junior creditors and stockholders. From this process new life can be formed. It is painful but it works. Generally speaking there is an ‘equitable’ resolution.

The Indiana bondholder suit had me going. I thought they had a case. No bankruptcy court would have subordinated the rights of secured bondholders to end up behind the UAW. It does not work like that. But it did. The conclusion reached is that the theory of “The Greater Good” has prevailed against the rule of law. There is a lot of that going around.

I see two situations today where the idea of a restructuring is going to be focused. One is in mortgages in general; the other is the Federal Agencies, Fannie Mae (FNM) and Freddie Mac (FRE).

There has been a great deal of noise from the financial community and the Feds about what a great job they are collectively doing about helping underwater homeowners. The lenders have been providing better terms to a lot of borrowers. They lower the rate and defer principal payments. But they tack on a bigger principal amount and the loan modifications are only good for a few years. The end result is that borrowers are more upside down then ever. Sure they can afford to be there a little longer as a result, but there is no longer an upside to their ownership. On a macro basis, upside down borrowers are by definition bad credits. The Modified Loan default rate of 50% proves that. Borrowers have no incentive to pay. That obvious conclusion must be staring at everyone in Wall Street and in D.C. If you apply the resolution of the Chrysler/Indiana bond holder suit where senior creditors fall to the back of the bus, then you have set a very dangerous precedent for secured 1st mortgage holders.

Assume for discussion there is an individual borrower in Indiana who is deeply in debt. They have 1st and 2nd mortgages. The value of the home is less than even the first mortgage. Assume further that there is credit card debt. Today, the first mortgage holder would get the collateral. The other creditors would have to stand in a very long line and probably would end up with little to show for it. If Justice Ginsberg were to opine on this she might divvy the assets up in a different way. As soon as she strays from the bankruptcy process the Senior lenders get hurt. Nothing like that is priced into the mortgage market today.

Fannie and Freddie would also face a different outcome if Justice Ginsberg were to opine on the fairness of the receivership structure. The preferred stock of the Agencies was wiped out. At the same time junior subordinated bondholders were made money good with a government guarantee. There is nothing equitable about that settlement. The receivership structure is precisely the opposite of the resolution for Chrysler and GM. The uncertainty that this situation creates is a decidedly brown shoot.

Approximately one month ago, William Ackman of Pershing Square Capital was on CNBC. James B. Lockhart, the head of FHFA, joined him. On air, Mr. Ackman proposed a restructuring of the Agencies debt. Specifically, he proposed that the bondholders would get new debt and equity. A twist to make it work was that the equity would have a put back to the government in 7-10 years. In Mr. Ackman’s plan the bondholders got hurt, but they were money good over time. In theory it would have been possible for an ‘upside’ result. The plan made sense to me. The Agencies, like Citicorp, have to have some of their liabilities converted into equity. It is the way our system resolves these problems.

Mr. Lockhart laughed at the suggestion. I believe he may have ‘chortled’. “We would never do that to our bondholders” was his response.

Mr. Ackman and Mr. Lockhart are very bright guys. In this case, one of them is dead wrong. The resolution of the Chrysler/Indiana/Supremes story suggests Mr. Ackman’s views may be more credible than Mr. Lockhart contends.

The government orchestrated the GM and Chrysler outcomes. The consequences to bond holders in those cases are the exact opposite of the outcome for the Agency’s bondholders. This big inconstancy will have to be addressed sooner or later. The government’s feet appear to be firmly positioned on both sides of this fence. The legal status of $12 trillion in 1st lien mortgages will be caught up in the fray. A very brown shoot.

"Wheat Fields", Vincent Van Gogh

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