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.