Why bonds rule
Secondly there’s this post on the Baseline Scenario:
The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again. Or almost: it is possible that the Federal Reserve’s massive efforts to provide liquidity to the banking system will be enough to keep banks functioning. But who wants to take that risk?
This is why, for the last five months, the government has been doing everything it can to imply that bank creditors (at least for “systemically important” banks) will be protected, without saying so explicitly, because that would suddenly increase the potential liabilities of the government by trillions of dollars.
So what changed this week?
Simon’s theory is that the semi-forced conversion of Citigroup preferred into common shares was taken as a sign that the government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt, and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. Now, Tim Geithner could come out and say, “Yes, we forced a conversion of preferred into common, but we’re going to stop there and not do the same to creditors.” But no, actually, he can’t say that, because that would constitute an explicit guarantee of all bank liabilities. So the market is left wondering, and we know by now that markets don’t like uncertainty.
Each time the lines on that chart above have spiked upward, the government has taken some action to imply that creditors will be protected, without making any promises. Chances are we’ll see another action along those lines. At some point, though, the government may lose credibility.
Secondly there’s this post more recently on the leverage GM’s bondholders have over the administration:
GM faces roughly the same problem as the banks we have been talking about so much. Its assets, broadly speaking – not only factories, designs, and patents, but its general ability to make money by selling cars – don’t cover its liabilities. Those liabilities are largely bonds ($28 billion – I believe that excludes the recent bridge loans from the government) and union contracts ($20 billion owed to a health care fund, along with ongoing payroll). In order for GM to avoid bankruptcy, the creditors (bondholders and the union) need to voluntarily give up some of their claims. This is what is known as restructuring.
Now why would a bondholder do this? Right now you are holding a piece of paper that says GM will pay you $100 million plus interest. Why would you give that up for $8 million in cash, a new piece of paper saying GM will pay you $16 million plus interest, plus about0.3% of the equity (stock) in GM, which is apparently the deal on the table?
You would only do this if you think the alternative is worse. The alternative, in such a situation, is bankruptcy, where a judge will decide how much you get. And clearly at least some bondholders are afraid of this alternative, since bonds were trading around 16 cents on the dollar on Monday. But this is a special case, since we know that for both political and economic reasons the Obama administration does not want the American auto industry to disappear, and many commentators (Yves Smith, for one) think that a bankruptcy would have that outcome.
The result is a high-stakes game of chicken. Bondholders are betting that President Obama will not take the risk of forcing GM into bankruptcy. If that is true, the government’s only option will be to sweeten their offer to bondholders, or to give up on restructuring and bail out GM the old-fashioned way (large low-interest loan, equity injection, etc.). Either way the value of GM’s bonds would go up.
Obama, by contrast, has to show that he is serious about the bankruptcy option, if he is to have any hope of scaring the bondholders into agreeing to a restructuring. I think this is the most likely explanation of his statement that bankruptcy might be the best medicine for GM and Chrysler – which drove one series of bonds down from 19 cents to 10 cents in trading today.
So is the Obama administration really trying to scare bondholders more than anything else? Well, I don’t know. Make your own judgement.