Tuesday, May 12, 2009

The Ultimate Risk of Governement Influence Over the Private Sector (Part 3)

The more extreme response of the Treasury and the Fed to the BAC-Merrill situation as compared to the AIG bonus scandal represents an escalation in terms of the tactics these entities appear poised to engage in to get the outcomes they feel are proper. (By the way, if you thought to yourself as you were reading that I should make a distinction between the Fed and other government entities because the Fed is “independent,” I am intentionally lumping the two in together. Right now the Fed looks about as independent as an unemployed teenager living at home with his or her parents is financially independent.) The original reason I decided to engage this topic was that I felt the recent escalation required a warning that the government had embarked on a very slippery slope, based both on a legal and practical basis. When I originally developed the concept for this piece I planned only to use the BAC and AIG examples to illustrate my point about the actions of the government could undermine investors’ long term trust in the US a place to invest capital. Luckily for me (but unfortunately for hedge funds and investors worldwide) before I could gather my thoughts Chrysler went into Chapter 11 and the fight to see who would have the pole position for both asset recovery and eventual control began.

The Chrysler bankruptcy and the inevitable GM filing have been some of the more obvious slow-moving train wrecks in this crisis. With demand for cars and trucks way down and legacy liabilities haunting the balance sheets of these companies it was hard to imagine that either company could survive without going through some form of restructuring. What I think none of us, especially Chrysler’s senior creditors, could have anticipated was what the Obama administration and the president himself would be willing to do to get the favored outcome. Specifically, the authorities have apparently moved from the use of the media to shame employees to threatening to fire CEOs to using what look like outright scare tactics to get their way. In the next few paragraphs I will discuss what looks to be the final outcome of the government’s battle with Chrysler’s senior creditors and attempt to capture how severe the long term implications of the methods the government employed could be.

First, I think we should let some people who are likely much smarter than I am weigh in on this issue:

The Economist, May 7th:

Bankruptcies involve dividing a shrunken pie. But not all claims are equal: some lenders provide cheaper funds to firms in return for a more secure claim over the assets should things go wrong. They rank above other stakeholders, including shareholders and employees. This principle is now being trashed… In effect Chrysler and the government have overridden the legal pecking order to put workers’ health-care benefits above more senior creditors’ claims, and then successfully argued in court that the alternative would be so much worse for creditors that it cannot be seriously considered.

Wall Street Journal, May 11th:

At noon the next day, April 30, Mr. Obama said Chrysler would file for bankruptcy. He blamed "speculators" who had turned down the $2 billion offer for their $6.9 billion of debt. A lawyer for holdout firms, Tom Lauria, accused the White House of threatening to destroy the reputation of Perella Weinberg. The White House denied exerting pressure on it.

"The overarching sense of political pressure," Mr. Lauria said, "remained out there till the end."

Wall Street Journal Op-Ed, May 8th:

The sources, who represent creditors to Chrysler, say they were taken aback by the hardball tactics that the Obama administration employed to cajole them into acquiescing to plans to restructure Chrysler. One person described the administration as the most shocking "end justifies the means" group they have ever encountered. Another characterized Obama was "the most dangerous smooth talker on the planet- and I knew Kissinger." Both were voters for Obama in the last election.

One participant in negotiations said that the administration's tactic was to present what one described as a "madman theory of the presidency" in which the President is someone to be feared because he was willing to do anything to get his way. The person said this threat was taken very seriously by his firm.

New York Times, April 30th

The dissident creditors said they had a fiduciary responsibility to seek the best possible returns for their own investors — which, the group said, include teachers’ unions, pension funds and endowments.

“The government has risked overturning the rule of law and practices that have governed our world-leading bankruptcy code for decades,” the group said in a statement Thursday. The creditors suggested banks that had received bailout money were being strong-armed by the administration, a view some of the bankers privately said they shared.

Say what? This is America, right? Did I suddenly move to the USSR without knowing it? With the banks in tow and the dissident hedge funds and asset managers disbanded by a combination of being shamed in the media for protecting their investors and some apparently strongly worded threats, the government got its way. In the end, this is how it looks like it will shake out. The senior creditors who are owed $7B will get $2B and no equity in the restructured company, the equivalent of $.28 on the dollar. The UAW, whose position is lower in the capital structure, will receive $.43 on the dollar for its $11B+ in claims. In terms of ownership, the UAW would own 55% of the company, Fiat would initially own 20% with the right to increase that stake to 35% and the Treasury would eventually hold only 10%.

Fiat? Where did Fiat come from? Has anyone seen Fiat on the list of creditors? Nope. In exchange for providing the company’s technological expertise Fiat could own up to 35% of Chrysler while the senior creditors do not own any equity whatsoever. What happened to our nationalism? We are giving away 35% of an iconic US company to an Italian company at the expense of banks and asset managers who operate in the US? Apparently nationalism is only important when we want to keep Chinese steel out of the US. Let us also not forget that the UAW is a huge contributor to the campaigns of many democrats so of course it is no surprise that it would be able to leapfrog the much chastised financial companies that supposedly had higher ranking claims.

Essentially, the government was able to force the banks to give up their spot in the capital structure by using their TARP investments as leverage and used a combination of threats (allegedly) and the media to coerce the asset managers and hedge funds to do the same. I would argue that this precedent could eventually make it much more costly for certain companies to borrow money because investors will want to get paid for the risk that the traditional understanding of the capital structure no longer applies. If I were offered the chance to buy senior debt of a company that the government also had an investment in I would sure be concerned enough about the government’s potential actions to demand a much higher rate than normal.

After what we learned from the testimony of BAC’s Ken Lewis and the way Congress was willing to special create legislation to tax a certain number of AIG employees, would it surprise anyone if the allegations listed in the excerpts from the above primary news sources were true? I sure wouldn’t as it appears that the current crisis has created situation in which the ends justify the means and just about anything will be done in the name of protecting from a further meltdown. In the process the authorities have turned capital structure hierarchy on its head, tarnished the sanctity of signed contracts, and have ignored the laws of this country. This is all in addition to ignoring the rights of investors and private companies who will eventually be critical in helping the US emerge from this downturn.

Accordingly, it is important to assess the implications of the recent actions of the government. I am a US citizen and investor and I have very little faith that the government would protect my contract and property rights in the current environment if those rights were not aligned with what the government had decided was “best” for the country. I see the capital markets fluctuating based on the whims of the government and that is why I am sitting on the sidelines in cash. In order to invest I would either need to see a situation in which the government was no longer propping up or intervening in multiple sectors of our economy or would like to be compensated for the extra risk I believe I am taking. If I were a foreign investor I would have the same fears. From an outsider’s perspective the US government’s actions look no more consistent or rational than those of the autocratic governments that get so much negative publicity and are vilified by the leaders of this country. Therefore, I would have to choose between investing elsewhere or only investing in US assets that provided a return that was commensurate with the existing political risk.

Finally, I will conclude this long diatribe by sharing some thoughts from Nobel Prize winner Paul Krugman in a recent piece in the New York Times:

But what worries me most about the way policy is going isn’t any of these things. It’s my sense that the prospects for fundamental financial reform are fading.

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street √©minence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.” Hey, that little thing about causing the worst global slump since the Great Depression? Never mind.

Those are frightening words.

This is what worries me most about what has happened as well. We have created this system in which the largest financial companies have a tremendous say in what happens in Washington and have set the precedent that the government can and will do anything it pleases without fear of substantial media and popular scrutiny or political backlash. Right when it appears that we need to embark on a road that includes serious reforms of our financial and government institutions, the stock market has gone back up, the banks have passed their stress tests, the populist furor seems to have died down, and some of the powers that be seem intent on rebuilding what was the status quo prior to the crash. I think this is very dangerous because we need to do something to solve the conflicts of interest between Washington and Wall Street. We also need to make sure the regulators that are watching over the markets and the economy have the power and will to enforce the rules. And we need to examine what role the government should take in the middle of crisis so that we can (in the future) avoid a situation in which the rights of companies and individuals are overlooked to the extent that both domestic and foreign investors are afraid to put their capital to work in the US.