The Creditor’s Story: Just What is ‘Fair’?

There is a sub-text in the current storm of bankruptcy activity. In the interests of fair play I should bring it to your attention. It is the fate of creditors. These are the people who go on search of less risky investments and so lend to companies in the form of bonds or other debt, rather than equity. The Chrysler bankruptcy case has become something of a cause celebre for such people.

The essential point is this: American contract law has always been very specific about the rights of creditors during a bankruptcy proceeding. When a company cannot fulfill its contractual obligations it seeks the protection of the court while it tries to renegotiate with its creditors. That’s what Chrysler is doing right now. The normal sequence is that creditors can expect better treatment than equity holders, and within the range of creditors those with ‘security’ can expect the best treatment of all. Unsecured creditors rank lowest on the totem pole, just above the shareholders.

So the Chrysler bond holders argue, how is it that the UAW, an unsecured creditor, seems to have ended up with a better deal than they did?

The Chrysler re-organization plan, the one the government endorsed and the judge has to decide whether to allow to go forward, produces a post-bankruptcy ‘New Chrysler’ in which the UAW would own 55%, with the US government and Fiat owning the rest. In the meantime the bondholders would get about 28 cents on the dollar for their debt. Some of them think they would get more than that were the government’s heavy hand not involved in the deal.

As a result companies and investors are beginning to rumble that the government is wrecking the ‘time honored’ order of things in American bankruptcy proceedings.

The Financial Times has an excellent discussion of the problem in today’s edition.

My first reaction is not to cry too much for the bondholders. They invested in Chrysler. Many of them specialize in ‘distressed debt’ which means that they know full well the risks they are facing. They probably even knew that the company was headed to bankruptcy. What they forgot was that Chrysler is also a very important employer and has significance as a major component in the US auto industry, which is in need of overhaul. The bondholders played no part in encouraging change, indeed they appear, some of them, to be expecting to profit from the company’s failure. Hedge funds that buy ‘distressed debt’ are not active participants in constructing healthy businesses, they are engaged in rummaging through the carrion for profit.

Not that such activity is wrong. We need folks to pick over our corporate corpses. But we shouldn’t get misty eyed about them. They seek to exploit the contract law for profit rather than use the contract law as protection.

That might sound too nuanced, but I think is an important point: creditors who provide vital financing so that companies can grow need to know that their investments should be treated appropriately. Being treated preferentially in bankruptcy is the inducement that gets them to invest: bondholders are a risk averse bunch. Distressed debt buyers are a different group. They are seeking the bonds precisely because the return on the bonds has been driven higher as the company in question fell into crisis. So they knew what they were getting into. This a priori understanding of the heightened risk sets them apart, in my opinion, from ordinary bondholders. They were buying junk and then want to be treated as if they bought the good stuff.

How that gets resolved I don’t know. As ever in America the lawyers will parse it all out and make a fortune along the way.

My take is that we need to treat the original bondholders carefully: they provided the original cash that the company is responsible for repaying. But bottom feeding hedge funds designed to get high returns from ‘distressed debt’ are high risk takers. They are useful in that they provide a market for bad debt. That I acknowledge. They now own the rights that the original bondholders were given. That I also acknowledge. But don’t try to tell me that they didn’t know what they were getting into.

Look at it this way: Chrysler has been tottering along the edge of bankruptcy for years. Buying its debt was always a risky proposition. Buying it when it was distressed is even more risky. Getting 28 cents on the dollar seems like a decent payoff. Why? I doubt that they bought the debt at par. If the debt was distressed it was selling well below par. Maybe not to far from 28 cents on the dollar. Maybe even lower. Meanwhile the interest payments have been extraordinarily high when expressed as a percentage of the cost of the debt.

Here’s an example:

I buy $100 of debt that pays 8% per year interest at par, i.e. $100. I get $8 in interest each year so my annual interest rate earned is 8%. Now the company gets into trouble and I can only sell my bonds for $50. But the new owner still gets $8 in interest on those bonds. So now the new owner’s annual interest rate earned is 8/50 or 16%.

It is this high rate of interest that attracts the ‘distressed debt’ investors.

And notice one more thing. In my example the new bondholders paid $50 for a bond that is worth $100. So were they paid 60 cents on the dollar in bankruptcy they would actually be making a profit of $10. The loss on the bonds has already been suffered by the original holders who sold the debt.

This is a simplified version of what’s going on with Chrysler. Which is why its hard to get worked up on the side of the current bondholders.

Nonetheless their story needs to be told.

Sometimes economics and economies need to take into account things like ‘fairness’, and not simply stick rigidly to the laws. After all laws are often written to benefit certain groups within society rather than society as a whole. What is ‘fair’ and what is the law are often two distinct things as we all know.

The Chrysler bankruptcy has served to highlight the conflict between the rights of the workers whose lives depend upon the company; the bondholders whose profits depend upon the legal process; and the taxpayers at large whose rights are represented by the government.

I am sure everyone thinking this through has an opinion about what is ‘fair’.

I also think that restoring an element of more socially acceptable fairness is one of the primary goals we must undertake during the next few years. I, like many others, perceive a great ‘unfairness’ in the way our economy distributes its wealth. The rules and laws seem to be bent against the regular folks and in favor of those who have the skills and cash to game the system.

Bond traders and distressed debt hedge funds: both taking risks. Both acting in their self interest. Both ‘just trying to make a buck’. And both reviled by the public. If we think their roles in the economy are worth protecting then we have to find a way to make them look more fair. Hem them in a little perhaps. Make them pay appropriate taxes – hedge funds I am looking at you. And soften the edge they have acquired of being just leeches on the ‘real economy’.

In any case, it is only ‘fair’ to tell their side of the story.