The Chrysler bankruptcy imbroglio illustrates just how conflicted the Administration’s bank bailout policy is. The taxpayers are on at least two, and possibly three sides of this deal: the automakers, their lenders, and perhaps those who hedge lenders’ claims on Chrysler with credit default swaps (CDS). Yet the lenders, many of whom are partially government owned through the Troubled Asset Relief Program (TARP) and/or survive by the grace of government life support through their borrowing from the Federal Reserve under its new extraordinary credit facilities — act as if they are private businesses with full rights to fight for their own claims on their own schedules.
The government is explicitly representing Chrysler, though not its owners such as the Cerberus hedge fund, in Chrysler’s negotiations with its lenders; an alliance in which Fiat would take a minority stake is also on the table. The banks and other lenders are negotiating against the government– aggressively, having turned down the government’s first offer and looking to take this negotiation to the eleventh hour deadlines like creditors in any other potential bankruptcy. They do this while the government is trying to save tens of thousands of jobs, with an economy in a near depression. If the lenders accept losses on their debt, the taxpayers lose to the extent that the lenders are government supported (of course there exist non-bank holders of Chrysler debt who are not government supported, too). If taxpayers pay up to the banks in order to get Chrysler on a sound footing, the taxpayers take a more explicit hit. Meanwhile to the extent that lenders have hedged themselves using CDS, or that other side bettors bought Chrysler CDS as a speculation, taxpayers could even conceivably end up funding payouts to CDS owners, since banks, insurers, and hedge funds are the big providers and users of CDS. It looks like a normal negotiation but in fact we have a two or three sided shell game and a disproportionate share of taxpayers’ money will go to the Wall Streeters who are playing three card monte against us.
Former Treasury Secretary Paulson, who has made dozens of trips to China, knows full well what conflicted banks look like under crony capitalism. One has to believe that in setting up TARP he knew exactly how messes like Chrysler would turn out. He is familiar, for example, with the problem China’s banking system had some years ago, when big borrowers got loans by exerting political influence. But as Paulson also knows, crony capitalism works better in China than it will ever work here, because when the Chinese get it right the government decides what is good for the economy (especially the pieces of the economy that it owns) and gets it done. Here taxpayers fund failed pieces of the economy and failed businessmen continue to fail on our dime.
The very idea of banks negotiating aggressively against the government on Chrysler is Alice-in-Wonderland absurd. Existing law gives regulators plenty of authority to tell banks what to do. Bank examiners can tell banks to stop unsound practices, which gives them a great deal of latitude, even if the bank in question is thought to be sound. Besides, given that many of the majors are insolvent in substance if not in form, the FDIC could (and almost certainly, in our view, should) take over any of the insolvent or near insolvent banks. Under current conditions, with the Treasury owning portions of the large weak banks, that authority should increase. In addition, the Fed has, at least theoretically, plenty of leverage that it would not normally have, given its position as creditor to the banks through the alphabet soup of its lending facilities: TAF, TSLF, PDCF, etc.
Except the government is not about to nationalize big banks now, and the banks know it. The politics surrounding TARP suggest that it’s different this time. As James Kwak points out at the Baseline Scenario, when Paulson structured TARP he bent over backwards to give banks our money without our having much say in how they run their business because that would be “socialistic.” The current Administration has continued to run TARP the same way. That’s why Treasury used TARP to buy non voting shares in distressed banks, and doesn’t even seem to use 36% of the voting power it will soon have at, say C, when its TARP preferred converts into common.
Of course the big banks are spinning the Chrysler restructuring negotiations as if small, adamant regional banks (in other words, country bumpkins who don’t get it) and hedge funds are the creditors’ committee members who are holding out for a tougher deal. Is that true? Such things have happened before, but this scenario is almost too convenient for Chrysler lenders such JP Morgan (JPM), C, Morgan Stanley, and Goldman Sachs (GS). Either way, we don’t like it much.
Another thing we would like to know is, do any of Chrysler’s lenders own CDS on Chrysler debt? As we have noted in the past, credit default swaps (which essentially insure against the debtor’s bankruptcy) distort the bankruptcy process, providing creditors incentive to take a much tougher line against the debtor than they would without the swap. Suppose you own an issue of senior debt that the market thinks is worth 30c on the dollar (this is hypothetical). If the market is valuing the security accurately, you are likely to get 30c worth of something in Chapter 11 bankruptcy, perhaps consisting of some combination of equity and new debt. If you are about to become an equity holder you have incentive to preserve the worth of the underlying business; you might also want to give some concessions to the company (as opposed to forcing it to go bankrupt) if you think that it might have a chance to get back on its feet and pay you back in full. On the other hand, if you hold CDS, you want to push the company into bankruptcy as quickly as you can to collect the CDS insurance payout. We wonder who among the creditors own Chrysler CDS and we think that under current conditions such information should be made public. Fat chance.
Oh, and who wrote the largest amount of CDS and didn’t even bother to hedge them? None other than AIG, which is 80% owned by taxpayers but still lumbering along. Of course banks (again, largely taxpayer funded these days) also wrote lots of CDS. So if Chrysler creditors own CDS and force a bankruptcy, we might well end up footing the bill for at least part of the CDS payout too. Sweet deal for the taxpayer… NOT.
If the Administration had any concern for taxpayer dollars it would shut down the insolvent banks and get on with the business of creating and preserving jobs in the real economy. It would also find a way to force the unwind of existing CDS and prevent new CDS from being issued, so that in the future lenders have at least some stake in borrowers’ well being. But so far it seems that Obama doesn’t understand what is at stake, has caved in to the banks, or just doesn’t care.
UPDATE: The latest from the WSJ now characterizes the planned “alliance” with Fiat as a Fiat takeover, giving the Italian automaker day to day control over the company. So… as things stand at the moment, if the deal goes through, Fiat would have to risk a cash drain to get Chrysler into good shape, they get to own 20% of Chrysler for free after the US parties haggle things out among themselves. Sweet for them… maybe…