Debt revamps hindered by credit default swaps Dealscape

Chrysler files bankruptcy.  Let’s be clear about who is responsible here.  It is the banks, bondholders, and Wall St. that created the derivatives and Credit Default Swap (CDS) monster.  Derivatives have already created the current economic depression (Bear Stearns, Lehman, Merrill, etc).  Now the presence of CDS’s distorts the normal workings of a market economy and prevents the proper functioning of institutions.  In times past, the threat of bankruptcy (itself a centuries-old institution) worked to make all stakeholders: labor, capital, and management work together through difficult and unforeseen times.  Now, no longer.  Now capital demands full compensation with no risk.  It demands sacrifice by all others, but not itself.  It kills the goose in order to get a larger share.

THE DEAL PIPELINE SNEAK PEEK: Credit default swaps are complicating efforts to work out bank, auto and other restructurings outside of bankruptcy.

As the holders of billions in credit default swaps against a bankruptcy of General Motors Corp. and Chrysler LLC, the automakers’ lenders have so far rejected the government negotiators’ demands to greatly reduce their claims on the car companies.

Emboldened by credit default swaps, bondholders in other restructurings have resisted efforts to reduce the amount of money they are owed or refused to accept offers to swap debt for equity in hopes of at least sweetening the deal after a bankruptcy filing. They also are fighting to reserve their right to CDS payoffs, bankruptcy experts and analysts said.

The prevalence of credit default swaps has been blamed for at least worsening the financial crisis. Now they are complicating efforts to clean up balance sheets, ease debt burdens and unwind the tangle of financial obligations between financial firms and their counterparties — critical steps in reviving the economy.

GM: Some Bondholders Want Bankruptcy – BusinessWeek

Business Week catches up to Econproph from last month.

The barriers to getting a deal done with GM bondholders, and negotiating away enough of that debt to strike a deal and avoid a planned, government-assisted bankruptcy, remain very big, with five weeks to go before the deadline.

…And second, some of the bondholders own credit default swaps, which amount to an insurance policy against the debt and pay them in full if GM defaults. Those bondholders actually fare much better if GM goes into bankruptcy.

Why GM will almost certainly go bankrupt.

Right now, for GM to avoid a bankruptcy filing, it has to get concessions or “sacrifice” from the “stakeholders”.  In plain terms this means the union and the bondholders.  The union has already stepped up to the plate. It has sacrificed and offered additional sacrifice contingent on the bondholders.  So far, though, the bondholders haven’t agreed to anything. It is the bondholders who are blocking a “restructuring”.  Ultimately, the bondholders will force the company into bankruptcy.    Why?

To understand why, we need to look at the negotiation process. There are thousands of GM bondholders: some large, some small, some individuals, some banks, some are bondfunds like PIMCO, and some pension funds.  But while there may be thousands (perhaps even millions) of seperate bondholders, the vast majority have no voice in the negotiations.  Instead, there is a “bondholders’ committee”.  Who is on the committee?  The “experts” and the large bondholders: primarily banks and bondfunds.  These banks and bond funds presume to speak for all bondholders. But their interests are not in line with all bondholders.  We know that there are very large number of outstanding Credit Default Swaps (CDS) contracts on GM.  So who likely holds the CDS’s?  The very same large banks and bond funds that are negotiating.  So, in effect, if GM goes BK, then the bondfunds/big banks are hedged and get full payment via the CDS.  If they agree to a restructuring, they get less than full payout.  So there’s no chance they’ll agree.  Of course, the little bondholders (like Joe Retiree with his $10,000 of GM bonds) loses.  He’s not hedged and he has no real voice on the committee.  The little guy gets no voice until after the committee approves sending a tender offer.  Not likely to happen.

This is doubly true since AIG, the likely writer of many of those CDS’s, continues to get full bailout from the gov.

The only chance of avoiding BK for GM is if the Obama administration either:  makes a credible threat to stop bailing out AIG  –OR– the administration decides to make CDS’s null and void.  Neither is likely.

Surprise: Bush sort of does the right thing for GM/Chrysler

I’ll admit I’m surprised.  My inner cynic suspected the Bush administration would try a pre-packaged Ch. 11 bankruptcy for GM or Chrysler, or that they would dither and play Hamlet so long that the Chrysler, GM, or some big Tier 1 would end up in bankruptcy anyway for Christmas.

Instead, GM/Chrysler get their bridge loans.  See NYTimes (registration reqd) or FreePress.

The good side is that the package includes restrictions and a March 31 deadline that will enable the companies to play hardball with their debt holders (especially the banks), as well as dealers and the union.  The union has already shown a willingness to help & play,  but contrary to what some Republican Senators and Wall Streeters believe, the problem now isn’t so much the union contract as the debt-laden capital structure.  The banks haven’t shown a willingness to play yet.  Maybe now they will.  With the fed gov money getting priority over all other debt, a fed gov decision in late March that the restructuring hasn’t happened will greatly raise the risks for current debt holders.  The balance of power in the game of chicken between firm and banks just changed.

The downside is the timing and amounts. See the FreePress.  It seems Bush/Paulson want to tempt fate.  There’s no slack here folks.  That’s tight.  If the economy takes another surprise hit in the next 40 days, this might not work.

Industry Matters: Why Chap 11 Bankruptcy Won’t Help GM

The NFL should watch out.  Armchair quarterbacking while watching football on TV is being challenged by a new couch potato activity: armchair management. It seems that nationwide people, pundits, Wall Street analysts, and even U.S. Senators have the solution for GM and the U.S.-headquartered auto industry:  file chapter 11 bankruptcy and “re-structure”.  It worked for airlines and others they say!

No! say the defenders (?) of the Big 3.  A Chapter 11 bankruptcy would immediately turn into a Chapter 7 liquidation because customers won’t buy cars from a bankrupt automaker.

NOTE for Students: “Chapter 7” and “Chapter 11” are different parts of the U.S. bankruptcy code.  In ch.7, a firm is liquidated – it shuts down operations, all the assets are sold, the creditors are paid what money is left, and the company is no more – it is a “late company” in Monty Python parlance.  In ch.11, a firm is allowed to continue to operate and the court protects it against claims from earlier creditors. The court then negotiates/forces the creditors to take less then than what’s owed them.  The court can also tear-up an re-write union/employee contracts. Eventually, the firm “emerges” from ch. 11 as a financially restructured company.

The truth, like always, is more complex than these simple soundbites.  In my opinion, chap 11 bankruptcy is not a viable option for the Big 3, but the reasons are more complex than just “customers won’t buy from a bankrupt automaker”.  Let’s look at why chap.11 won’t work and why a ch. 11 would quickly become ch.7 and a cascade that brings down other automakers.  But in fairness, we’ll also look at what benefits ch.11 would bring.

In addition to the customer reluctance argument, there are four other reasons why ch. 11 won’t work for autos, even though it “worked” for airlines and some others. All of them involve the economics of the auto industry as compared to other industries.  The auto industry has high hard fixed costs, it has a long product development cycle with large sunk costs, purchased components are a large part of value, and it’s a credit-based business.  Airlines and other firms that have successfully navigated ch.11 don’t have these characteristics.

  1. A significant number of customers won’t buy from a bankrupt automaker, unlike airlines.  It doesn’t matter if some customers, or even most customers, would continue to buy.  If you run a high fixed-cost business, any significant drop in volume will doom your operation and necessitate liquidating plants.   Despite what advocates of ch. 11 argue, it’s perfectly rational for consumers to fly a bankrupt airline and not buy a car from a bankrupt automaker.  A plane ticket is a service that’s delivered over a few hours.  I only need to know that the plane is safe (I know the FAA & insurance is watching) and that the airline won’t shut down during the time I’m flying.  That’s a risk most people will take since it’s low probability.    A car from a bankrupt automaker is a different thing.  I’m buying a large asset (second largest asset I’ll likely own).  My “investment” depends not only on whether I think the automaker will be there for parts in 2-3 years, but also whether future buyers of my used car will think the parts/service is available.  The safety (recalls) are dependent on the automaker, not the FAA or an insurance company.  In buying a car, I’m buying a relationship with the company & dealer for several years.  Yes, some car fanatics will buy anyway and maintain it themselves, but even if only 20-30% are scared off, it’s doomsday for the automaker.
  2. Autos have high “hard” fixed costs, unlike airlines.  In ch.11., it’s normal that sales volume declines somewhat.  For any business, the risk to profitability/viability of a sales decline depends on whether costs are fixed or variable.  High fixed costs = trouble when sales decline.  High variable costs mean costs come down with the sales decline.  I define a “hard” fixed cost as some cost that can’t change easily regardless of sales  volume.  A “soft” fixed cost is more like a step-cost.  Opportunities exist to lower the costs.  It’s fundamentally a question what size a “chunk” of capacity is. Airlines are often thought of as high fixed costs, but in reality they have soft, step-fixed costs.  An airline essentially has three major costs:  lease on the plane (hard fixed), the fuel for each flight, and the labor/maintenance.  Airlines can reduce costs in small chunks – if there aren’t enough tickets for the Chicago-Albuquerque flight, cancel it. You save the fuel costs and possibly some of the labor costs.  GM, on the other hand, can only realistically cancel an entire plant or a whole model line – these are permanent shutdowns.
  3. Autos have to plan ahead, airlines don’t. Under the best of conditions and the most flexible automakers, what’s on the showroom floor has been in planning, development, and production for at least two years.  To do a significant “re-structuring” requires planning ahead.  In airlines, reaction is a lot faster.  Witness how fast airlines adjusted to fuel cost changes in 2nd qtr 2008 or traffic declines in 4th qtr 2001.  Can’t do that easily with autos. In autos, if you start reducing costs today in 2008, you lower the cost of the car available in 2011.  2009’s costs are largely set already.
  4. Purchased components & the supplier network. A bankruptcy court can tear-up a union contract.  It can force a bond-holder or bank to write-off part of their investment and take a loss.  A bankruptcy court CANNOT FORCE a supplier to make and sell parts.  Without parts, no car. Without a car, no sales, and no automaker.  70% of the value of a car is parts/components purchased by the Big 3.  It’s not just a question of whether customers will buy from a bankrupt automaker, but also will a cash-strapped supplier sell and deliver parts to a bankrupt automaker.  There’s not much evidence to indicate they will.  What’s worse, is even if 95% of suppliers are willing, the 5% that might not can shut down the whole thing.  For most auto parts and components, the tooling is unique to each model.  It takes months, even years to switch the supplier of a particular part.  For an automaker to survive Ch. 11, ALL the suppliers need to be involved and taken care of.  Not likely to happen.  In airlines, on the other hand, the airline needs fuel.  If Exxon won’t sell it, BP can easily substitute. Different industry.
  5. Autos are built with credit, airlines fly on cash. An automobile is really a credit vehicle.  The automaker buys the parts on credit. The tier 1 supplier buys on credit.  The dealer buys on credit. The customer buys the car on credit.  Nobody gets paid until and unless the car gets sold and GMAC, FoMoCredit, the credit unions, the banks, etc deliver the money.  In chapter 11, the certainty and risk of being paid changes drastically for everybody.  A bankruptcy court can easily tear-up existing contracts, but it can’t force customers, suppliers, or dealers to enter new ones on credit.  A bankruptcy court also can’t supply credit.  And in the current 2008-09 environment, it appears the banks can’t/won’t either.  Airlines, however, pay cash or near cash for the only really large purchased production component:  fuel.  Customers also pay cash (or do their own financing with Visa/MC). Different industry.

A chapter 11 bankruptcy for automakers would have one positive effect.  It would make it easier and cheaper to break and re-negotiate the contracts with the dealer networks.  This would allow GM and Chrysler to skinny down the dealer network  –  a critical element for long-term survival.  Right now, this is a tough task because a patchwork of state laws and anti-trust court decisions makes it difficult for the automaker to unilaterally cut dealers.  Today, automakers have to essentially buy-out dealers with a $ carrot to get rid of them.  Presumably (I am not a lawyer), a federal bankruptcy court trumps state dealer franchise laws.  Again, even here, the contrast to airlines is stark.  Airlines don’t have to “buy-out” an airport or travel agency in order to stop doing business with them.

If the GM or Chrysler end up going chapter 11, I don’t see anyway that survival is possible in any practical form.  Instead, a chapter 11 will really be a chapter 7 with additional paperwork and attorney’s fees up front.  And a disorderly liquidation of any one of them, puts key Tier 1 suppliers at risk and the risks production at Ford, Toyota, Honda, Kia, Hyundai, etc.

Unfortunately, it seems that our economic policy leaders are touched with the Wall Street disease:  armchair management.  They don’t understand how the business works and don’t want to learn, but they want to prescribe management policy anyway.  I don’t have a problem with people (or their elected representatives) wanting to prudently put limitations on their investments (and that’s what the auto loans should be), but we need fact-based, intelligent analysis, not simplistic soundbite solutions that don’t won’t pass Econ 101 or Mgt 201.