Bo Peng's  Instablog

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 a great deal as some opined (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 benefit. What role did the adminsitration play 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 remerging from Chapter 11 would provide more value to the debtholders than a forced firesale liquidation, especially in this climate. Furthermore, Chrylser loans had been trading at $0.15 on the dollar prior to the govnerment 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.

I just caught up with the Chrysler story today. What I found out shocked me, for the implications could be mind boggling.

Here're some key facts I've gathered that are relevant to what I'm about to say. If you think I got any of them wrong, correction is appreciated.

Fiat will pay $2B for 20% of Chrysler, with options to go up to 35% but it's not yet clear what Fiat would pay to exercise them. UAW's retiree health trust, VEBA, will effectively exchange the $10B cash owed by Chrysler into a 55% equity ownership. 70% of senior debtholders (about $4.8B of $6.9B total) have agreed to a 32% recovery cash offer. The remaining senior debtholders have announced they will fight the sale to Fiat in court, hoping to get better recovery at the end of Chapter 11. If they fail to stop the sale, they'd get 29% recovery. The US and Canadian government will provide another $8B financing on top of $4B earlier, get 10% equity, and offer subsidy to Chrysler in the form of honoring warranties as well as help to UAW in the form of guarantteeing part of their pension and health benefits, valued at least billions (Pension Benefit Guaranttee Corp alone is worth $2B). The existing majority equity owner, Cerberus, gets nothing for their 80.1% stake.

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivize stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

Recently there's been a wave of blogosphere opinion that USD is a win-win bet. It goes like this: if the world economy gets worse or stays in the dumps, then USD will remain strong, as demonstrated by its performance since Sept 08; if the world economy rebounds, then USD will of course be strong.

It is the "of course" part that I have a problem with. There're two scenarios under which USD will drop, and only one under which USD will remain strong in the intermediate term (a year or two). But even under the last scenario, USD is likely to drop in the longer term.

1. The world economy stabilizes. Make no mistake, we're not there yet. It won't happen until at least the clouds of CEE debt/currency crisis, US/European banking and credit crisis, housing price, unemployment, and consumer demand start to dissipate. But when that happens, the world will be shifting away from USD assets. Furthermore, it is very unlikely that the Fed has enough political will to siphon the massive amount of USD cash it will have printed off the system early enough and fast enough to pre-empt the surge of inflation once the economy stablizes and credit starts to flow again.

There's no doubt the current sucker's rally is a mini-bubble, at least in stocks, treasuries, and USD. But the Force is strong, as demonstrated repeatedly over the past few weeks by the market taking bad news as no-news and not-extremely-bad news as great news. And bubbles can last much longer than possible, as demonstrated by many great Prophets of Doom having predicted ten crises out of three over the past decade.

While it may be futile to predict the timing of bubble burst, it's at least somewhat amusing to imagine how it could take place. So here I go, if only as intellectual masturbation.

1. Current earnings season turns out bad. But this is unlikely, judging by the market's bias of BadNews=GoodNews. It may dampen the sucker's rally, but it'd take a few disastrous earnings from heavyweights to prick this bubble. Since several heavyweight financials, including GE (that's a joke haha), have already released earnings and Market saw that it was good (haha again), I bet earnings is not it.

1. Set up Company, go IPO.

2. Sell $1B bond.

3. Spread rumor of Company's demise. Or better yet, actually run Company almost into ground. Quickly.