The New Masters of the Universe

Back in the early days of the Clinton administration, James Carville was credited with saying something like this:

I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 basball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

The story back then was that bond investors, by buying or selling Treasury bonds, could lower or raise the government’s cost of borrowing and interest rates across the economy, depending on how they felt about government policy.

Today bond investors have discovered a much more direct lever over government policy. I’ve already written about the importance of bondholders in dealing with the financial sector. This week we are seeing their power over the auto industry.

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.

The problem he faces is that the government’s credibility in a situation like this is weak, both because of the political and economic risk of a GM bankruptcy, and because of its flinching in a similar situation involving GMAC in December.

And who is on the other side of the table? Why, it’s PIMCO, the fund manager that has patriotically volunteered to be one of the participants in the Treasury Department’s public-private investment funds to buy toxic securities.

Correction: Nemo points out in a comment below that there was no statement by Obama, just a leak.

52 responses to “The New Masters of the Universe

  1. The implication of the post seems to be that PIMCO holds the whip hand because the Gov’t wants its help with the PPIP program. You can’t really have it both ways: if the PPIP program is a massive boondoggle, designed to funnel billions of dollars to the banks while making private investors in the program tons of money (which I think is a fair assessment, wisdom of such policy aside), then I don’t see how PIMCO holds the cards here. What are they going to do, turn down the opportunity to get that no-recourse Gov’t financing in PPIP just b/c the Gov’t wouldn’t come up with a few extra billion in the GM deal?

    PIMCO doesn’t seem likely to act that way out of pique, frankly.

  2. John Thayer

    Don’t forget GS, JPM, and BAC as bond holders. These are government’s little love-pets. I am sure that they will be well taken care of, even in the case of Chap 11.

  3. I just meant it was an interesting coincidence. (Coincidence isn’t quite the right word, but I can’t think of a better.) PIMCO has been obstructing GM restructuring; at the same time, they appear to be helping out Treasury with PPIP.

  4. The bondholders need to learn a lesson. They are lucky to be offered anything in return for investing in such a badly managed corporation that they think is too big to fail. The government has to be willing to accept the political consequences of allowing GM to go into bankruptcy because it is the right thing to do in the context of a capitalist system. The GM bailout money can be used instead to help those who will lose their jobs and to support the expansion of worthy manufacturing sector businesses.

  5. Manoj Raman

    See this post in Econproph
    March 30, 2009
    Why GM will almost certainly go bankrupt.
    Filed under: Current Crisis — jimluke @ 9:03 pm

    Right now, for GM to avoid a bankruptcy filing, it has to get concessions or “sacrifice” from the “stakeholders”. In plain terms this means the union and the bondholders. The union has already stepped up to the plate. It has sacrificed and offered additional sacrifice contingent on the bondholders. So far, though, the bondholders haven’t agreed to anything. It is the bondholders who are blocking a “restructuring”. Ultimately, the bondholders will force the company into bankruptcy. Why?

    To understand why, we need to look at the negotiation process. There are thousands of GM bondholders: some large, some small, some individuals, some banks, some are bondfunds like PIMCO, and some pension funds. But while there may be thousands (perhaps even millions) of seperate bondholders, the vast majority have no voice in the negotiations. Instead, there is a “bondholders’ committee”. Who is on the committee? The “experts” and the large bondholders: primarily banks and bondfunds. These banks and bond funds presume to speak for all bondholders. But their interests are not in line with all bondholders. We know that there are very large number of outstanding Credit Default Swaps (CDS) contracts on GM. So who likely holds the CDS’s? The very same large banks and bond funds that are negotiating. So, in effect, if GM goes BK, then the bondfunds/big banks are hedged and get full payment via the CDS. If they agree to a restructuring, they get less than full payout. So there’s no chance they’ll agree. Of course, the little bondholders (like Joe Retiree with his $10,000 of GM bonds) loses. He’s not hedged and he has no real voice on the committee. The little guy gets no voice until after the committee approves sending a tender offer. Not likely to happen.

    This is doubly true since AIG, the likely writer of many of those CDS’s, continues to get full bailout from the gov.

    The only chance of avoiding BK for GM is if the Obama administration either: makes a credible threat to stop bailing out AIG –OR– the administration decides to make CDS’s null and void. Neither is likely.

  6. I don’t think it makes sense in this strange new world to assume that the motivations of all bondholders are the same, the way that it used to . . . time was when Chapter 11 generally worked against most bondholders (with a few exceptions such as recent investors in junk but recoverable first mortgages and secured debt, etc) – in the era of CDS, those days are long gone. My understanding is that a significant portion of the bondholders have CDS positions (perhaps unbalanced toward the CDS side) that increase their total payoff if GM formally files for bankruptcy.

    That wouldn’t be hard to do would it? It’s not like there’s position limits in the CDS market or restrictions that CDS buyers must hold the underlying bonds. Why not buy a large bond position that can be used to forestall restructuring give backs AND a much large CDS position that you can force to pay off by helping push GM into formal bankruptcy?

  7. Obama did not actually make any statement. Bloomberg simply cites “people familiar with the matter” describing what Obama believes.

    This is obviously a deliberate leak, plausibly denied, intended to convince the creditors that bankruptcy is a serious option.

    That this was done as a leak and NOT as a statement suggests to me that Obama is not, in fact, serious about forcing GM into bankruptcy (versus giving them more and more and more taxpayer money). We shall know in a few weeks.

  8. but if GM defaults and all the large bondholders go to collect their CDS payments, won’t that BK the writers of the CDS and the bondholders will get much less than what the CDS contracts call for?

  9. John Thayer

    I think you are right. I wonder who will is on the losing end of those CDS trades?

  10. PIMCO is more than willing to take on toxic assets because it knows that the stated price of these assets, if there are any, reflects more illiquidity than default risk. And so we are going to help them restore liquid markets by lending them the money to buy the assets on leverage. econmkts.blogspot.com

  11. No, because the CDS are almost certainly margined, i.e. cash representing the change in their value changes hands to square both writer’s and writee’s positions.

  12. donthelibertariandemocrat

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=axxcb9lRvYP8

    “We’re just not good committee members,” Bill Gross, Pimco’s co-chief investment officer, said in an interview yesterday from his Newport Beach, California-based office. “We have the interests of our clients more at heart than the interests of particular corporations or even the government, I guess, so it’s best that we simply look at the situation from afar as opposed to from inside.”

    That’s William Gross about GMAC. It worked. But, here’s the deal: That’s his job. His job is to make money for his clients. If he doesn’t try and do that, he can be sued.

    One of the main causes of this crisis, from my point of view, is that many investment managers did not do this. They enriched themselves at the expense of their clients. Call it negligence and fiduciary mismanagement.

    This point also applies to Citi. We are shareholders. It is the job of Pandit et al to make us money. This is why TARP is so weird. On the one hand, Citi was given money to lend, while, on the other hand, as investors, we simply expect them to do the best with the money they have. This conflict is inherent in any government/public hybrid plan.

    The main argument for a Swedish type solution, if that were possible now, is that it could clearly have the taxpayer’s interests come first, and avoid most of the conflicts of interest, mismatched incentives, and mixed signals inherent in a hybrid plan.

    Frankly, if you wanted a cleaner version of TARP, you should be for the plan proposed by William Gross in September, in which the government would have hired investors to buy the toxic assets for us. It too would have problems, but one could argue that it would be a cleaner plan than PPIP.

    If you want businesses to voluntarily lose money for the country, then you will need to make sure that their clients agree with that.

  13. Good question. Presumably they’re hedged as well (short GM stock, for instance) – and of course CDS’s usually have margin variation daily so the loss on the CDS to-date would have largely been paid for already.

  14. Interesting perspective.

    Everyone knowledgeable about bankruptcy seems to understand that as the largest filing to-date, there’s almost no chance that a GM Chapter 11 could be done quickly, and if not done quickly would likely turn into a Chapter 7 liquidation.

    I’ve learned never to assume that government officials are in contact with reality, but IF Summers and Geithner are in contact with reality, then they know that the “fast track bankruptcy” option for GM really isn’t much of an option at all. We’ll see, I suppose.

  15. Also while this could be correct “This is obviously a deliberate leak, plausibly denied, intended to convince the creditors that bankruptcy is a serious option.”, I think that many or most bondholders would prefer bankruptcy at this point in order to collect on their CDS contracts . . . . . makes for interesting poker playing on all sides, with Obama (IMHO) holding an unusually weak hand.

  16. >The government has to be willing to accept the political consequences of allowing GM to go into bankruptcy because it is the right thing to do in the context of a capitalist system.

    Well, I suppose. Seems that our “capitalist system” is running like a chevy with bad rod bearing and a few burnt valves.

    What if GM does file bankruptcy – all bets, (union contracts), are off and people are dumped and wages are slashed, (ie, United Airlines).

    Today, another 742,000 “resources” waundered into the unemployment statistics. At the rate unemployment is climbing, we’ll get a million lost job month before long even without this calamity.

  17. >Seems that our “capitalist system” is running like a chevy with bad rod bearing and a few burnt valves.

    To carry my own analogy a bit further, this engine will only get worse, use more oil, be less reliable and ultimately it will fail and cost more to fix the longer one waits.

    At this point, you rebuild and throw out the bad componenets for new, quality management, er, I mean parts.

  18. Take a look at the Fortune piece in February:

    http://money.cnn.com/2009/02/19/news/newsmakers/benner_gross.fortune/

    Mr.Gross makes no bones about running a business to be a patriot. Recall that he has hired ex-Fed Chairman Greenspan as an adviser. And he is not alone. Blackrock, which runs over $70 billion of on balance sheet assets of the NY Fed (Bear Stearns and AIG assets) has as its co-head of Fixed Income Peter Fisher, who is an ex-high official at the NY Fed and Undersecretary of Treasury. These firms have obligations to their clients, but who watches out for taxpayers?

  19. James:

    The challenge is evident if you add up the numbers you cite!

    $27bn of bonds and $20bn of VEBA is $47bn.

    GM has $188bn of liabilities (including $72bn of working capital that has to be rolled over) and $110bn of assets. Plus, the liabilities are understated because the pension plan assumes 8.5% growth and because the dealer contracts are not balance sheet obligations (but are impediments to restructuring).

    If the bondholders agreed tomorrow to walk away with nothing, out of the goodness of Bill Gross’ heart, and the UAW said “forget the VEBA”, GM would still have significantly negative book equity and would still face a future as a cash flow negative company.

    GM is so massively underwater that there are only two remotely possible options: (a) the government just bails the company out wholesale; (b) there is a protracted run through Chapter 11 during which time the company is split, the pension dropped, the dealership agreements torn up, AND the bonds and VEBA crammed down.

    http://tauntermedia.com/2009/03/31/could-this-be-true/

    The impossibility of out-of-court restructuring is why no individual class of stakeholder wants to make a move. Think of it as a multiplayer prisoner’s dilemma – so many parties need to come to the table, and each one contributes so little to the overall solution, that the temptation is to figure that if a miracle occurs, you will take the last seat. Until then, you’ll go to court with your full claim intact.

    Right now I suspect Obama is still bluffing and, when push comes to shove, will just throw government money at the problem. The UAW and PIMCO think so too. But maybe he is not. It would be fantastic if he took this as a real opportunity to fix GM, instead of simply kicking it down the road.

    http://tauntermedia.com/2009/03/30/rare-optimism/

  20. A second option is to sell the Chevy for recycling and replace it.

    Given that we want to maintain our capitalist system, I think we should consider how we behave in response to failure. In my view, the dire consequences of failure (bankruptcy) in a capitalist system should provide an important incentive for management to succeed and for investors to make intelligent decisions based on market and business fundamentals. I think that when we remove or lessen consequences we subvert the system and end up with mediocre managers and more investors that play the markets like casino games.
    One role of government could be to do more to alleviate the human suffering that results from bankruptcy by building a more responsive and effective safety net for workers that lose their jobs and the communities where they live.

  21. adios amigos

    I find it interesting, that today the administration (Obama, Inc.) announced that THEY will be appointing the new board of directors at GM. Well, you are certainly entering new territory over there in the US. This has shades of the old USSR not 20-years ago. The difference? The old communists didn’t have a 100-watt smile like Obama has. At least Obama is going to laugh and smile his way, while he takes over every aspect of your life. The US Government is now appointing the members of the board of directors….I don’t think we’re in Kansas anymore, Toto. I hear they want all of your kids to serve 18-months in some kind of quasi military organization too. You’ll all be goose stepping in only a few short years. I’d break out that old version of Mein Kumpf you have buried in your basements.

  22. Avid Reader

    Simon,

    Please tell me you are going to be writing a book or have one coming out soon that follows the logic evinced by your article in The Atlantic. I want more!

    Do you have any suggested readings, perhaps, that would help me learn more about how the U.S.’s financial crisis and its political dynamics are similar to those of other countries’ crises?

    Thank You!

  23. i thot it was ins. co’s and i-banks that had exposure to CDS loss because for years they simply underpriced the risk and the premiums collected can’t cover the claims. but i don’t know, Zvi posted above (if i interpreted it correct, but i may be wrong) that CDS writers are simply middlemen that connect the two sides of the CDS contract and don’t have much exposure to it and whatever exposure they have can be hedged anyway (through shorting the underlying?). so it’s little to no risk to bondholders if they force a default because that doesn’t have implications on the ability to collect on CDS. i dunno.

  24. “I think you are right. I wonder who will is on the losing end of those CDS trades?”

    You, me, and our grand and great Tgrand children

  25. Per Bill Gross Pimco owns less than 1% of the outstanding GM debt…..it’s almost a meaningless position for Pimco.

    The original offer to the bondholders was for about 24 cents on the dollar and 90% of the equity in the company with the UAW getting 50 cents on the dollar in 9% yielding preferred stock and the rest in cash over 20 years. Since both the bondholders and the UAW are unsecured creditors and would get equal treatment in BK court the bondholders might be better off than taking the offer.

  26. One other possible scenario is that vaporizing Chrysler would help GM and Ford dramatically as all of Chryslers sales would flow to GM and Ford and would help to make them viable. It would also take out about 14% of domestic manufacturing capacity which would help.

  27. Bill makes some good points about Pimco. (I believe the largest bondholders are Franklin and Fidelity.) Pimco has become a symbol to people outside the bond market at this point, much like Goldman Sachs has for other reasons.

    If I were a GM bondholder, I would be thinking less about what I would get in bankruptcy than what I would get from the government by threatening to make this a long and miserable bankruptcy.

    As to whether this is real or a leak, I think the answer is obvious. When has this administration ever had a bona fide plan? All they do is leak a general philosophy, wait for interested parties to shoot holes in said philosophy, then start throwing lots of money around.

  28. adios amigos

    A bit off topic, but I wonder how many of those CDS’s on all the GM debt are held by AIG? Hmmmm. Oh, the tangled web……..
    AA

  29. 1 currency now

    The CDS writer yells “systemic risk” and Paulson/Geithner comes running with taxpayer billions to GS and the big players.

    The game should be clear by now.

  30. Heil Obama!

    Subject: Fuhrer Obama and the auto verkers:
    Obama announce that GM was going to exclusively focus on used car sales since the margins are greater? As such, the bond holders wont need to worry! He promised the board that he would be the exclusive spokesman in all commercials.

    Additionally, he suggested that instead of 10% of the US population depending upon the auto industry, he wants to expand this to 20% and all verkers will be required to take the civil servant exam to be able to qualify for the expanded verk force and all benefits of this new bureau, the Bureau of Used Cars or BUC– he said the expanded employment opportunities will ‘BUC’ up and stimulate the economy!

    Thank goodness for the Obama Reich, HEIL OBAMA!

  31. adios amigos

    Mr. Kwak,
    Pimco, being of sound mind, has probably hedged their GM crud with CDS”s. Chances are pretty good that those hedges are from (guess who?): AIG !!! So, Pimco now knows that the genious’s at The Fed pay off those CDS’s at 100%. Voila! It’s PAYDAY again! Yahoo! (Do I have to figure out EVERYTHING for you guys?)

  32. On a pedantic note: bondholders have always been masters of the universe, in fact in was in relation to Sherman McCoy in Bonfire of the Vanities that the phrased was coined in the late ’80s.

    The notion gathered momentum through the ’90s as these masters evolved into vigilantes. The bond market’s brutal role in policing the long move towards monetary union was nothing short of profound and necessary. When European countries’ policies effecting inflation and debt levels would weaken, their yield curves and their currencies would take the brunt of the punishment. This is when the idea of the ‘bond vigilante’ was born.

    Good article, slightly wrong title.

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  35. Somewhere, someone must have major losses if Bondholders don’t have losses in the event of a GM Bankruptcy? Can someone provide a plausible explanation?

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  38. CDS?

    If the buyers of GM debt bought cover, there is no way they do any deal for less than 100 cents/$.
    GM goes Ch 11, a credit event is triggered and the bond is made whole.
    Enough with the testosterone of the bond holders— they have insurance for this eventuality, no?

  39. I thought that “masters of the universe” referred to bond traders, not bond holders. But I very well could be wrong about that.

  40. adios amigos

    How many of the Masters actually hold these investments long term, James? You know, LONG term? Not many, if any. These bonds are viewed as “product”….held long term by “the suckers”.

  41. Actually James you are not wrong. Or we both are. Sherman McCoy was in fact a bond salesman, so neither a trader nor a holder! I have always taken the epithet to refer to an aggresive player in the bond market no matter whether his horizon was short or long.

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  43. Actually, I was listening to Bill Gross on CNBC and he explicitly states that PIMCO’s exposure to the automakers bonds is “minimal”.

  44. The ghost of Lehman past

    Kindoflike the way Dick Fuld probaly got something REALLY BIG in return for staying quiet and letting all of wallstreet win the “take out Lehman” bet?

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  46. Carville was referring to the bond vigilantes. A group that actually went into retirement the morning of the 87 crash, Black Monday. Rate on long bonds have never again been as high as on that morning.

    Through the 70’s and 80’s as Freiedman’s ‘special’ monetarism took hold, I say ‘special’ because it does not consider asset price increases to be inflation, an obsession with M’s growth and Fed ease had continually sent bond yields higher. Admittedly there was a trend lower after the inflation died, but the vigilantes were always there to spank the authorities when money and credit were deems too loose.

    Then the market crashed on that morning and The Street saw God. Greenspan said he would supply any and all liquidity necessary and instead of killing bonds they took off. The rest is history. The Street figured out that real profits would come from endless and unlimited credit and monetary growth. Especially because they themselves would create it and direct it.

    Admittedly the vigilantes made a brief reappearance when Clinton came along, to serve a political purpose. The gist of which was the government must not borrow money and give it to Negroes. Once Clinton agreed, to that and everything else Rubin and The Street could think of the vigilantes went into retirement.

  47. Rapier,

    The vigilantes may have gone into retirement during the Clinton years in the US, but they certainly did not in Europe. They ‘rode herd’ on monetary union and aggressively punished policies that were deemed lax by the standards imposed at Maastricht in either 1990 or 1991. They made their presence known right until 1999 when currencies were fixed intra europe. These vigilantes were far more aggressive than the crowd that ‘played’ in the US at the time.

    again, pedantic yes – but now that we are down this path….

    k

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