Tuesday, March 31, 2009

Stockholders vs. Bondholders and Autos vs Banks

So by now hopefully you've heard that somebody in Washington finally grew a pair, as President Obama officially rejected the restructuring plans submitted last month by the nation's #1 and #3 auto companies GM and Chrysler. In doing so, Obama pushed longtime GM CEO Rick Wagoner out of the company over the weekend, and has essentially given Chrysler 30 days to finalize its partnership with Fiat in order to receive another $6 billion in funding, and GM 60 days of restructuring financing while both companies must make the "painful changes" required to leave them as viable, growable businesses going forward. Both companies presumably face some sort of organized bankruptcy unless dramatic action is soon taken to align these companies' cost structures with those of their more profitable competitors, and with GM it may not be possible to avoid that restructuring at this point no matter what they do. There are several hundred thousand jobs of hard-working Americans directly in the balance of this industry, and another several hundred thousand in ancillary industries like auto service, parts and distribution, and other things like satellite radio to name a few, so it's a very fine line the President has to walk to be sure. And yet, it seems like this AIG disaster -- more likely the political fallout from it -- has left the President feeling far less generous than he once was when it comes to doling out federal bailout money.

It's interesting to take a look at the different approaches being taken here by the Obama administration with respect to the automakers as compared to the financial firms at the center of the global credit crisis. In December, Citigroup more or less "failed" in that it required some $50 billion in total of emergency taxpayer funds and another $280 billion in emergency government guarantees on bad assets to prevent its impending collapse, with Bank of America coming very close to the same fate and requiring less on both counts, but still requiring a government injection of liquidity in the tens of billions just to prevent the market from swallowing the firm whole. In agreeing to spend all those billions of dollars for the two struggling banks, did President Obama and his team require the leadership of the banks to step down? Somehow, no. Somehow, Vikram Pandit is still the CEO of Citi, and Ken Lewis is still the CEO at Bank of America, despite both clearly failing as leaders, overspending on things like corporate junkets, jet fleets, office renovations and god knows what else, and overseeing the firm's decisions to take on -- clearly -- far more risks than they could comfortably cover should the economy slow even a little bit.

And yet these guys still lead their companies. It's something the Obama administration has taken heat for already since the end of last year at least, despite numerous public mistakes made by each CEO in the general strategy and direction of their firms over several years, both resulting in the need for more taxpayer cash than the combination of GM, Ford and Chrysler so far over the past several months. And now, in an interesting twist, GM CEO Rick Wagoner is pushed out over the weekend, and there still isn't even a plan to save the company at all. Chrysler was allowed to keep its CEO, who unlike Wagoner at GM was only installed a few years ago as part of a private equity buyout of the firm. But Chrysler, too, still has no plan for long-term survival, and still needs to hash out the final details of a proposed partnership with Italy's Fiat in order to get $6 billion more in emergency funding from the U.S. government, and even then we can all imagine how long the $6 billion is going to last Chrysler if the situation does not improve dramatically from the Fiat deal.

So Obama threw out the longtime CEO at GM this weekend, even though absolute public clowns like Vik Pandit at Citi and Ken Lewis at Bank of America have been allowed to keep their jobs despite needing more money than the automakers have received so far. That's an interesting change in policy, and is emblematic of what I am hoping is a key change to representing a much more hard-line approach to the government intervening to save failing companies going forward.

The most significant aspect of President Obama's new harder line with the automakers reagrding government bailouts, however, is something that has bugged the shit out of me ever since these bank bailouts first started, actually since a week or so before the government took over Fannie Mae and Freddie Mac last symmer, and that is the different treatment of the bondholders vs. the stockholders in these failing institutions by the Obama, Geithner et al. As you probably know, the stockholders in failed financial institutions like Bear Stearns, Fannie Mae, Freddie Mac, AIG, Wachovia, Washington Mutual, Citigroup and Bank of America all saw their stocks drop to at least the $2 level, mostly down 95% or more from their recent highs, and many of the above have seen their shares denominated in cents, not in dollars. The stockholders of the truly failed firms like WaMu, Fannie and Freddie, and of course Lehman Brothers, literally lost almost their entire investment as their shares traded at just a handful pennies before all was said and done. Those who invested in the stocks of these companies took an absolute bath, losing in most cases between 95 and 100% of their entire investment, almost without regard to where they bought in anytime in the recent past.

Such has not been the case with holders of bonds in these firms. Other than Lehman Brothers, whose abrupt weekend bankruptcy last September caused bondholders to lose an estimated $110 billion in bonds due to be paid out over the next several years by the failed investment bank, those who invested in bonds issued by the other companies mentioned above have all continued to be paid in full and on schedule. Bonds are by their nature senior to stocks in that, in the case of a threat to a company's viability, its bondholders get paid out first before any stockholders. As a result of this lesser risk involved with investing in corporate bonds as opposed to stock in the same company, bond investors also get lesser returns, but more consistent, secure ones. As a result, bond investors tend to be large asset managers and other funds with a need for solid, steady, if a bit understated, but consistent, secure growth. A bond fund might return only 3% a year right now, but a comparable stock fund returning an average of 10% per year might lose 40% this year (for reals). In theory, the bond fund should not suffer such losses because its income is backed by bonds of companies and other institutions that offer it a steady and secure stream of income that is senior to what is owed to the stockholders of the companies issuing the bonds.

As a result of this, and of constant propaganda from piglets people like Bill Gross, co-CEO of PIMCO, the world's largest bond fund, the bondholders in all those financial companies above that failed last year if not for massive government intervention amounting to more than a trillion dollars system-wide, have yet to lose a dime. Even though the underlying firms would never have been able to continue making their bond payments without the massive injections of taxpayer aid and government guarantees, that taxpayer money has been used in part to continue to make regular payments to all the bondholders of those firms, on schedule and in full. It's almost as if the powers that be in both the Bush and Obama administrations are afraid that "haircutting" the bondholders even one time with one of these companies it has to prop up could lead to some kind of systemic panic as a result of all the large pension and other funds and asset managers who rely on investments in these companies' bonds to pay their steady, secure income streams forever. We let guys like Bill Gross take ridiculous advantage of the system, too. This guy manages the largest bond fund in the world, remember. As Fannie and Freddie spiraled towards armageddon last summer, Gross took a look at the situation, and on July 28, 2008, it was reported: “We like it,” said Bill Gross, who oversees the $128 billion Total Return Fund, the largest bond fund in the world, for Newport Beach, California-based Pimco. “This legislation has indicated to investors that Fannie and Freddie are not implicitly guaranteed, not explicitly guaranteed, but we’re close to that point.” As a result of this feeling that the government would not dare haircut the bondholders in these failing firms, Gross sold most of his treasury and other government bonds, buying up instead agency mortgage bonds from -- you guessed it -- Fannie Mae and Freddie Mac. By the time early September came around, this guy was so sure the government wouldn't let the bondholders in Fannie and Freddie fail that he actually had some $80 billion of his $132 billion bond fund invested in Fannie and Freddie bonds. And as Gross bought up all the Fannie and Freddie bonds he could find, he took to the airwaves, going on CNBC and saying the government had to put up $40 billion to bail out Fannie Mae and Freddie Mac, to protect the companies' bondholders from taking any kind of a haircut at all which he claimed would threaten the entire U.S. and global financial system.

And Bill Gross wasn't done. After making more than $1.7 billion on the Fannie and Freddie bailout where the bondholders' investments weren't touched while the stockholders got essentially wiped out, he then started buying up bonds of the other troubled financial institutions, all those companies I mentioned above, thinking once again that the government would be too afraid of the systemic risk following from any major corporate bond failure like what happened with Lehman Brothers last fall to haircut these other financial firms' bondholders, picking those bonds up at distressed prices fueled by fear, uncertainty and doubt. And once again, the propaganda mill began -- in his monthly newsletter released on February 24, Bill Gross said, "Regulators are overwhelmed as it is, and if you thought Lehman Brothers was a mistake, just standby and see what nationalizing Citi or BofA would do. Our banks remain at the heart of domestic/global financial transactions and daily clearing, while those Scandinavian banks were not. PIMCO would not dispute the need to further capitalize systemically important banks via convertible bonds held by the government, which unfortunately dilute shareholders’ interests. To go further, however, and “haircut” senior debt or even existing preferred stock similar to that issued via the TARP would create an instability policymakers should not want to risk. In turn, forcing creditors to take haircuts would undermine other financial sectors such as insurance companies and credit unions. The goal of future policy should be to recapitalize lending institutions while maintaining the basic infrastructure of credit markets. Outright nationalization and haircutting of creditors will do just the opposite." (emphasis added)

So once again, here is this clown arguing that the bondholders' investments in the bonds of these struggling companies cannot be touched. Essentially, he seeks a guarantee from the government that his fund's income cannot be stripped or lessened, and he invokes the fear from the Lehman Brothers collapse as the end-all be-all reason why haircutting the senior debtholders must never be considered.

Well I got news for ya, Billy. What are you, anyways? You're a bond investor. Say it with me. Bond. Investor. These are investments. They're not guarantees. If they were guaranteed, they would be what we call interest, on FDIC deposits in federally-insured banks under the insurance maximum. Which, by the way, would be paying you what, half a percent a year right now? Less? But no, Bill Gross isn't satisfied with a half a percent a year, guaranteed. He chooses instead to invest in corporate bonds of very weak companies, which may return something more like 3-5% a year, and on occasion will enable him to make billions of dollars in a year like he did in 2008, a several times greater return than he could ever expect from a truly guaranteed investment. Yet he will try to scare the pants off of everybody who will listen about how the government simply has no choice but to protect the bond investors in these firms, and so far the government has listened and obeyed. Why? Because of the fear that, if they don't, then pension funds, income funds relied on by retired people to live on, IRAs, 401(k)s, annuities, insurance companies, banks, credit unions, etc. will all suffer a huge panic due to the realization that their income is not really guaranteed. But this income never was guaranteed! It's an investment. Bonds do have risk, bank savings deposits under the federally insured limit do not. Treating the bondholders like their investments are as untouchable as my savings account in the bank is dangerous, and sets up all the wrong incentives in the world. Why on earth have taxpayers provided $180 billion to keep AIG afloat, its stockholders saw their investment drop as low as 30-some cents earlier this year, and yet those who invested in bonds to be paid over a long period of time regularly by AIG not suffered a penny of loss? How can that be? Why? AIG failed, plain and simple. It's not even arguable. Why did Bill Gross, who bought up $80 billion of Fannie and Freddie debt when he knew the companies were going to fail get to make $1.7 billion when the government forced the total wipeout of those firms' shareholders but protected the bonds 100% of each company? Why?

With GM as well as Chrysler, the Obama administration is now, finally, triumphantly, making it known that holders of bonds -- investors in bonds -- in these companies are likely to suffer along with investors in these companies' stocks. GM alone has over $27 billion of outstanding unsecured debt, with Chrysler adding another significant chunk to that total, so the prospect of a Lehman-esque bankruptcy for GM and Chrysler is likely to result in a very noticeable $50 billion-plus "event" in the credit markets as a whole. Although this is going to be painful for the markets, and for all kinds of investors and in particular those who invest in corporate bonds as a measure of security, I cannot escape the conclusion that it is the right answer nonetheless. Nobody made these funds and asset managers invest in bonds, corporate bonds, or auto sector corporate bonds, right? Especially knowing and seeing what's been going on for the past several months, clearly there has been ample time to exit these positions prior to this week's rejection of the automaker restructuring plans. No, if you have continued to invest in auto company bonds, at this point my position is that you deserve to take a massive haircut in light of their imminent failures. You bought in or held on and greatly diminished prices, taking a gamble -- a risk -- that you could use that beaten-down price to create an opportunity for a big profit if things broke your way. But things didn't break your way, and now you should pay the piper. Investing in bonds is still called investing for a reason, and those investments still carry risk that they will not be repaid in full.

My best hope right now is that a GM and/or Chrysler forced bankruptcy and restructuring will serve as a model for the government to eventually use with all the financial firms it has bailed out over the past few months or will need to continue bailing out in the future. Keeping the bondholders 100% whole, while forcing the stockholders to bear all the brunt of the losses at these flagging financial firms was never fair, and it was never right. It's time we make investors pay for the risks they took in buying all these bonds issued by deeply struggling companies. Remember, they got a greatly decreased price to buy in as a result of the higher risk associated with those struggles; not making them suffer the direct result of that known higher risk puts the entire financial system at unnecessary and unfair strain. It's time that bondholders -- generally large, megabillion-dollar asset managers, hedge funds and the like -- step up to the plate and take on their fair share of risk from their investments in failing financial institutions, especially where the risk of investing in such entities' bonds was fully known at the time of the investment. For a new president publicly espousing this whole "era of responsibility" motif, the move to punish the bondholders of GM, who took a chance on the company's long-term survival right along with the shareholders, is a clear step in the right direction, and one can only hope this move helps him to see the right way to deal with the major banks of this country as well going forward.

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Blogger jjok said...

actually, from what I'm reading.....Chrysler would be a chapter 7 casualty, broken up, and sold to the highest bidder. No reorg there.

Buy our sebrings now on the cheap......um, no.

4:10 AM  
Blogger RedXBranch said...

I agree....bond investments are still investments and carry risk of loss.

Let me preface what follows by saying I have no experience whatsoever in banking or finance, so if this makes no sense or is illegal or something....well....over look my ignorance.

Now I have a question about mortgage backed securities. These securities are, I assume, carried on a companies balance sheet as 'worthless' because of mark to market accounting rules. No one will buy them...there is no market for them....so they are worthless.

Why don't companies that own mortgage backed securities 'unbundle' them? Separate out those mortgages (10% of the total?) that are in default and make one mortgage backed security "bundle" into two "bundles". One of them would be worthless due to default status and could be written off as a loss....the other, approximately 90%, that is not in default and whose underlying homeowners are making payments would then be marketable and could be listed on a balance sheet as worth....something...instead of nothing. Would'nt this 'un-freeze' the credit markets?

8:38 PM  

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