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 last week. 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.
Vitaliy N. Katsenelson
About the author:
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).