Car Creditors Cry Foul

Two of the US top automakers will soon be controlled by their retirees and the Government. Today, Chrysler announced it would file for Chapter 11 bankruptcy. The current plan results in the UAW owning 55%, the US Government owning 8%, and the Canadian Government owning 2%; additionally, Fiat would initially own 20%. Under the current proposal, the UAW and the US Government would own 89% of General Motors. In both cases, the bondholders are crying foul. The secured lenders would like to preserve the integrity of the US capital markets. The table below breaks down the proposals:

Source: Barron's

In General Motors case, the bondholders are looking for a greater equity stake given there secured position. The bondholders’ counterproposal calls for a division of equity in accordance to claims against GM; the bondholders would receive 58%, VEBA (UAW health-care obligation entity) receive 41%, and current equity holders would retain 1%. The Government’s $20 billion loan would remain just that, a loan.

Likewise, a group of investment firms were blamed for the Chrysler bankruptcy. Obama stated,

“While many stakeholders made sacrifices and worked constructively, I have to tell you, some did not,” Obama said. “In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified tax payer-funded bailout.

Where as, the group of 20 hedge funds said they were ‘systematically precluded’ from negotiating with the Government and Chrysler. The hedge funds’ disapproval of the bankruptcy is warranted; Obama felt a group of creditors owning 70% of the debt were cooperating. This group of creditors, Goldman Sachs, JPMorgan, Morgan Stanley, and Citigroup are fresh of long meetings with Congress trying to save their good names. Those entities have received billions in TARP funds and in Citi’s case the US Government is a significant shareholder. Huge conflicts of interest exist with the 'banks.'

In both the GM and Chrysler case, the bondholders’ proposals appear to have fallen on deaf ears. The bondholders have been accused of speculating, but many of these individuals and entities make a living, albeit a good one, restructuring firms. Some of these firms need only a new balance sheet, while others require a significant shift in strategy – the automakers fall in the later. Neither party and neither administration is innocent; the US Government Officials appear to make a living changing the rules in the middle the game, not balancing budgets, and monetizing the debt.

Changing the rules continues to put pressure on the stagnant credit markets. The regulatory risk premium on loans makes it difficult for lenders to put money to work. Credit investing is based heavily on legal documents and understanding the course of action when a debtor breaks a covenant or defaults on their obligation. The most successful creditors have extensive experience negotiating with the debtors for creative structures to allow the companies to continue to operate (hopefully profitably) and continue to service the outstanding or restructured debt. Lenders are perhaps fearful that all new and existing credit agreements can be amended or simply place in the vertical file by the current administration.

Obama’s claim that hedge fund holders are holding out for a bail out may indeed by the case. With the exception of Lehman Brothers, the Government has shown a strong appetite for throwing money at all ‘systemic’ institutions; most of which were financial institutions. The probability of future Government aid was probable, but the restrictive nature is far from preferable. These speculating investment firms likely felt the implicit Government backstop place nothing more than a floor on their investment. A value creating restructuring would provide a far greater return on investment than additional Government equity or loans.

Furthermore, the investment firms often do create value for multiple stakeholders. GM bondholders claim their proposal would save US taxpayers $10 billion; the new structure would enable GM to service the Government debt, ultimately resulting in the return of principle and interest. A prudent restructuring of both Chrysler and GM can at least return a few flagship brands to the world of mediocrity.

The Obama administration is preaching fuel efficiency, the probably should be preaching sales. People are buying Japanese and German automobiles because of style, performance, and reliability. The Government cannot design automobiles, manage a diversified investment institution, or price debt securities. The faithful public servants need to stick to public policy. America’s meteoric rise to the World economic superpower was a rocky road for the first 160 years. After the Great Depression, America was surprisingly stable; short sighted policies today run the risk of stifle the growth and innovation of the next 160 years.

Just as promised

The UAW and Senate Republicans are having a hard time agreeing on what "reasonable" sacrifices must be made by labor to make bailing out the automakers acceptable. Not too surprisingly, the process is becoming highly politicized. Now, imagine repeating this process with bondholders, management, shareholders, suppliers, dealers, etc., with each party peddling influence, votes, campaign contributions, and threats to try to obtain the biggest slice of the pie for themselves.

When decisions normally made by market mechanisms are instead made by politicians, this is an inevitable result. The market mechanisms available in a Chapter 11 restructuring process would be better suited to making these decisions than the political lobbying mess currently being used. This space earlier called for a modified Chapter 11 bankruptcy, and that solution still appears to be best.

The government should provide debtor-in-possession financing and warranty guarantees to the automakers, appoint a systematic risk regulator to ensure the court does not inadvertently endanger the broader economy, and then let the bankruptcy process work. Hopefully Congress has this solution - which, considering its more stringent impact on all players, should be able to pass both houses - in the works already, as it may need to be passed in a hurry if the Unions' and Senate Republicans' game of chicken lasts so long the companies run out of cash.

The lesser of two evils

Lawmakers this evening gave up on talks for an auto bailout, with union concessions (or lack thereof) being the major disagreement. There are numerous problems in the original House bill. By subordinating other creditors to the government's claim, the government has a Constitutional issue with the takings clause. The car czar will be subjected to more political pressure than the governor of Illinois. And it is unreasonable that current equity holders won't be totally wiped out - with 20% warrants, existing equity holders will retain more than half of the equity.

For all of its faults, the bill would ensure that the automakers avoid a Chapter 7 liquidation, a disaster scenario that would wreck havoc on the American economy. Senate Republicans have sensible objections that should be resolved. But that is not an excuse for doing nothing. Both sides need to swallow their objections and find a compromise bill that can pass both chambers. Passing a flawed bill is better than passing no bill at all.

GM's board takes Broadway

GM's board members' current woes would make Avenue Q's concerns in "Sucks to be me" seem manageable. With deteriorating profitability, a bailout looking less likely, and mangled PR, life as a GM board member is not fun these days. Might these board members need to worry about legal liability as well?

Board members are fiduciaries; that is, they must act in the best interests of the corporation and its shareholders. But when facing a possible bankruptcy, the board must give increasing consideration to the corporations creditors, who often end up as shareholders in bankrtupcy.

GM has stated repeatedly it is not considering bankruptcy as an option. But with the company's cash dwindling fast and a bailout - if it materializes - delayed for weeks, is this strategy of brinkmanship prudent? Could the lack of preparation for a bankruptcy lead to great harm to GM's stakeholders - workers, customers, creditors, etc. - in the event that a bankruptcy does materialize?

It is not difficult to make the argument that GM's board is abdicating its responsibility to take prudent measures in the best interest of the corporation. GM's board would be remiss in not pushing for a bailout, but it is equally irresponsible in assuming it will materialize.

UPDATE: The Wall Street Journal is reporting that GM's board is now considering a bankruptcy filing. According to the Journal, the Board is breaking with GM CEO Rick Wagoner in considering the filing, and "is committed to considering all options in light of circumstances as they may develop." Good, consider their fiduciary exposure covered. Now the nation can turn to hoping they make the tough decisions on restructuring required if GM is to pull through this crisis.

Sliding down the slippery slope

The slippery slope is getting particularly slippery in Washington, D.C., especially with an election around the corner. Congress is considering a bailout of the automotive industry, with $25B of government loans up for grabs. Thanks to (unavoidable?) bailouts of Fannie Mae, Freddie Mac, and AIG, Detroit's Big 3 are feeling particularly confident in their ability to secure the loans . Both John McCain and Barack Obama have come out in support of this policy, despite McCain's (and George W. Bush's) previous opposition to a bailout. This support certainly makes sense if you are trying to win Michigan or Ohio (with 18 and 21 electoral college votes, respectively), but does it make sense economically? Perhaps not.

First, there is the sheer cost: the $25B have to come from somewhere, and the government is already straining with a large deficit. Second, there is reputational risk to consider. Is the U.S. as firmly commited to free markets as it urges other countries to be?

An appropriate rebuttal asks why Wall Street (Bear, Fannie, Freddie, AIG, et al) deserves bailouts while Detroit does not? One good reason is that the large financial institutions are being bailed out due to their effect on the rest of the economy. The effect of a Fannie/Freddie/AIG bankruptcy would have far more wide-ranging effects than the failure of a U.S. automaker.

Not only are automakers less intertwined with the rest of the economy, but Detroit is also looking for a better deal than Wall Street. Detroit wants loans without warrants attached, as they were in the Fannie/Freddie and AIG bailouts. And in return, Detroit promises to begin building more competitive products. More importantly than building better cars, Detroit promises to have disproportionate influence on the election in Michigan and Ohio... and it seems that fact is likely to be the deciding factor.

Let's hope the government gets an appropriate deal for taxpayers in the process, one that includes warrants, and, possibly, new commitments to CAFE standards.