Chrysler Bankruptcy and Demagoguery

Some of Chrysler's creditors rightfully objected to bankruptcy plan that gave most of the company to holders of unsecured claims (the UAW) above the secured debt holders. The bankruptcy code calls for absolute priority in any Chapter 11 reorganization. In the case of Chrysler, this means that the senior secured creditors must receive at least what they would have received in liquidation before anyone else is paid. The art and science of valuation plays a key role in determining the estimated liquidation value and the value of the non-cash settlements distributed to claimants.

Politicians have used the Chrysler bankruptcy for demagoguery and seek to bypass the usual legal processes. Michigan Congressman John Dingell stated, "the rogue hedge funds that refused to agree to a fair offer to exchange debt for cash from the U.S. Treasury – firms I label as the “vultures” – will now be dealt with accordingly in court." The governor of Michigan said, "It also came in spite of a few greedy hedge funds that didn't care how much pain the company's failure would have inflicted on families and communities everywhere. Their refusal to share in the sacrifice forced bankruptcy proceedings to begin." Finally, Obama said that they were "a small group of speculators" who "endanger Chrysler's future by refusing to sacrifice like everyone else."

Ultimately, a bankruptcy that violates absolute priority based on political pressure sets a bad precedent on a couple of levels. First, it is damaging to the rule of law. The bankruptcy codes and precedents are well-established. While there are technical issues in valuation, the spirit of absolute priority is the central issue. The dissident claim holders in the form of the non-TARP lenders had every right to demand their fair share. Politicians have no right to demand that secured lenders sacrifice so that the UAW or anyone else could get a better deal. It does not matter at all that these creditors were "rogue" hedge funds or that many did not pay face value for their claims -- the rules of the game are already set for this bankruptcy. To blame "speculators" and hedge funds is nothing less than classic demagoguery. Second, the consequences in the capital markets may be far-reaching. How will debt be priced if security is meaningless in practice and determined by your favor with politicians? It is similar to the cram-downs on mortgages. It sounds like a way fix the housing markets in areas where many are under water on their mortgages, but it would be difficult to expect that mortgage rates in the long-term.

Some defend the "speculators" because of they are pension funds representing ordinary workers.

Far from being speculators, these funds represent retired public employees, including cops and teachers. The funds paid a premium to buy "secured" status, only to discover that they were politically outranked by the United Auto Workers in the White House hierarchy.
WSJ 5/21/09

This is a true statement since the financial markets affect wealth far more than direct holdings indicate. However, this cannot be the major point of the defense. It does not matter whether the claim holder is a "rogue hedge fund" or a fund for widows and orphans--the bankruptcy courts are not a place or charity. To do anything other than follow absolute priority is to ignore rule of law.

A Problem Made For Bankruptcy

There is a set of laws already in place to deal with GM's bondholders, suppliers, unions, and anybody else who has a claim on the company's assets. The bonds are widely held, there are many suppliers and other obligations. In order to get all of these constituencies to the table, the bankruptcy court is the best way to settle it. The court would follow established precedent and priorities to pay out claims or reorganize the company rather than a popularity contest playing to political concerns. A successful bankruptcy reorganization will result in:

1. Creditors paid in a fair and equitable settlement in accordance with absolute priority. The ones that will make "sacrifices" will always be the ones with lower claims.
2. GM going forward with a less burdensome debt enabling the company to compete better with other automakers.

Bankruptcy allows the creditor classes to vote(1/2 in number and 2/3 in amount) on a plan that is binding to all parties, effectively solving the holdout problem. Even if a class holds out, a bankruptcy plan be crammed down.

Chapter 11 was designed to force all the claim holders together and giving nobody what they want. That's what GM needs to move on.

Markets at Work

In some cases, the principal on loans is already being reduced by players in the market without government assistance or encouragement. For sure, there are many scams out there claiming to reduce payments and principal, but there are some legitimate negotiations taking place. Hedge funds have bought speculative mortgages and they have approached borrowers in order to make a deal.

This recent article in Bloomberg gives an example of a hedge fund that purchased a mortgage for 60 cents on the market and renegotiated the terms of the loan. The hedge funds have worked proactively to protect their investments.

"Greenberg says she warmed to NAD’s proposal after Hussion explained that the value of the house had fallen well below the amount of the loan, and that it was in the company’s interest to head off a default by reworking mortgages like hers."

A relatively small percentage of "under water" mortgages have been renegotiated so far by the free market. The Obama administration has pledged support for changes in bankruptcy law that would allow judges to "cramdown" and force changes in the terms of mortgages. This idea raises a few questions in my mind

1. Are there in fact too few reductions of principal taking places in the market? In some cases it might be most efficient to foreclose and sell the house to another investor.
   
2. What will the long-term effects of changing bankruptcy law to allow "cramdowns" on mortgages? I suspect higher interest rates and worse terms for home buyers in the future.
3. What changes in regulation could make the market-based renegotiation of mortages more efficient?