Nearly a year after the financial system melted down, we are beginning, finally, to get some clarity. The stress tests, though rigged and negotiated, have given investors faith that many big banks won't have to file for bankruptcy, and have spurred the banks to raise fresh capital. (As such, the stress tests have functioned as yet another Wall Street stimulus package: Investment banks are poised to rake in hundreds of millions of dollars in underwriting fees on the new stock offerings by firms like Wells, Fargo.) Meanwhile, it's clear that firms that are simply beyond repair—quasi-government entities like Fannie Mae and Freddie Mac as well as private companies like GMAC—will get more federal support. The market is beginning to separate the living from the dead. Or at least put some money on which will be which.
Things are also shaking out in the troubled auto sector. Chrysler has filed for Chapter 11. Ford, which always seemed best positioned to weather the storm, just announced its intention to sell 300 million shares, which, at current prices, would raise more than $1.5 billion. The fact that investors are willing to buy Ford's stock, which is guaranteed only by the company's future, is a real vote of confidence. That leaves General Motors, which faces a June 1 deadline to restructure its massive debts—including $27 billion in debt owed to bondholders—or face a possible bankruptcy filing.
If Money Culture was a betting column, our money would be on GM joining Chrysler in the Chapter 11 junkyard. And if it does, it might be further evidence of the empty-creditor syndrome. We first discussed this theory a few weeks ago. New financial innovations, specifically those that allow investors in corporate bonds and debt to purchase insurance on that debt, may make some investors prefer that their investment go bankrupt. Such insurance pays off only in the case of a formal default, and might make bondholders less willing to swap their debt for stock—and more likely to engage in the sort of brinksmanship that pushes firms into Chapter 11.
GM seems to be shaping up as a textbook case of empty-creditor syndrome. With an assist from the U.S. government, which has already provided significant financing to GM and stands ready to provide more if GM can cut its debt, GM has offered stakeholders a grand bargain. Rather than file for bankruptcy—a move that would precipitate liquidation or an expensive and lengthy fight over how to pay off creditors—GM wants to give ownership stakes in exchange for wiping out debt. Under the proposal, the government would get 50 percent, the U.A.W. health-care fund would receive 39 percent, existing stockholders would get a measly 1 percent, and bondholders would get 10 percent.
The bondholders don't find this to be a particularly grand bargain. Why? Well, for the swap to work out, bondholders must believe that a company that is controlled by a consortium of government and union officials can thrive in a hypercompetitive global marketplace. In addition, many of the bondholders are empty creditors: that is, they stand to gain more from a bankruptcy filing than from an effort to reduce the company's debt outside of bankruptcy.
Henny Sender explains the situation in The Financial Times. Bondholders are being asked to swap debt that once had a face value of $27 billion, and now has a market value of about one-tenth that amount, for a chunk of stock in GM. If a deleveraged GM manages to make a go of it, that stock could turn out to be worth a fair chunk of change. If GM doesn't make a go of it, the stock could turn out to be worthless.
As Sender reports, many bondholders have bought insurance on the bonds in the form of credit default swaps (CDS), which pay off only in the event that GM formally defaults on its debt. The Depository Trust & Clearing Corporation, Sender reports, "estimates that CDS holders would receive net payments of $2.4 billion if GM were to default." If they swap the bonds for stock, there's no default, and the insurance policies they've bought on the debt become worthless. So bondholders face a choice: If GM defaults, they will receive guaranteed fixed cash payments in June. If GM avoids bankruptcy, they will receive a slug of stock that may or may not be worth something.
Which will they choose? Before answering, remember that people who invest in bonds — also known as fixed-income investors—prefer specific, guaranteed returns to the non-specific, non-guaranteed returns stocks provide. If you're betting on a bankruptcy filing by GM in June, you're not the only one.