Gross: Why Bondholders Hold the Keys to GM

At a conference earlier this month on the panic of 2008, a group of distinguished academics tried to puzzle out the meaning of the tumultuous events of the past year. Sitting in the Moot Court Room at the George Washington University Law School, I listened to people who possess more degrees than me struggle mightily to shoehorn the bewildering facts into the accepted model and theories that are supposed to govern our world. Efficient markets? Rational actors? Regulatory capture?

The actions in recent months call to mind nothing so much as the scene from "Apocalypse Now" in which Martin Sheen's Captain Willard confronts Marlon Brando's Colonel Kurtz:

WILLARD: "They told me that you had gone totally insane, and that your methods were unsound."

KURTZ: "Are my methods unsound?"

WILLARD: "I don't see any method at all, sir."

The absence of method has been most visible in the way policymakers have treated bondholders—the investors, traders and institutions who purchase debt issued by troubled companies and hold on in the hopes of receiving interest payments or, failing that, gaining ownership of the company should it go bankrupt. One moment, the government is solicitous of bondholders—ensuring that Bear Stearns's debt would be assumed by JPMorgan Chase, or standing directly behind the trillions of dollars in bonds issued by mortgage giants Fannie Mae and Freddie Mac. The next moment, the Feds tell creditors to go jump in a lake, as they did when Lehman Brothers was allowed to fail.

Now, with General Motors threatening to break down, bondholders' representatives have complained they are being shut out of negotiations between the White House auto task force and GM's many constituents: car dealers, politicians, unions. The most recent offer is to swap bonds for stock in the company, which would effectively cancel a big chunk of GM's debt. Bondholders fear that, given GM's many problems, it could still face bankruptcy, which would render their new stock worthless. New York University's Edward Altman notes that half of the companies that conduct such "distressed exchanges" wind up going bust. So far this year, according to Standard & Poor's, 45 companies have defaulted on $74.3 billion in debt.

But GM's bondholders—hedge funds, investment managers, et al.—are currently stuck between a hard place and a harder place. Their position—GM should avoid a bankruptcy filing, the government should put in more cash and unions should take huge wage and benefit cuts —is a nonstarter in this climate. Insisting too loudly upon contractually agreed payments, the circumstances be damned, can get you into trouble. Just ask literature's most infamous creditor, Shylock, who declared: "I have sworn an oath that I will have my bond."

When an entire economy is built on debt, of course, it's important that the rights and prerogatives of lenders be recognized. "We are a country of law," as Larry Summers, the White House economic adviser, put it while justifying the payment of those controversial AIG bonuses. "There are contracts. The government cannot just abrogate contracts."

But theory and high-minded principle frequently founder on the rocky shoals of the market. The bondholders' plan for profits rests in large measure on the United Auto Workers and dealers not enforcing the terms of their contracts with GM. Besides, many of these investors likely also owned bonds issued by GMAC, the finance arm of General Motors. Those investors profited mightily last December, when GMAC's bonds rallied substantially in the wake of the government's $5 billion cash injection into GMAC.

And just as meeting contractual obligations is vital to the American way, as Summers insisted, we also have a long history of not paying debts in full. This quasi-profound thought crossed my mind as I sat in a room a stone's throw away from the White House, which sits where it does only because of a bargain struck over … bailing out bondholders.

In 1790, an intense debate swirled around the debt issued by individual states and the government during the Revolutionary War, much of which had been scooped up big-city speculators after it had plummeted in value. Treasury Secretary Alexander Hamilton's proposal that the newly constituted federal government assume state debts was wildly unpopular among the agrarian types from Virginia. They loathed speculators and the cities in which they congregated, and they viewed the plan as part of Hamilton's scheme to concentrate power in the federal government. As Hamilton biographer Ron Chernow writes, the young secretary tried to steer a middle ground between shoring up the fledgling nation's subprime credit rating and not giving "too bountiful a reward to speculators who had rounded up state debt at cheap prices from small investors." (Plus ça change.) Over dinner with Thomas Jefferson and James Madison, Hamilton cut a deal. The federal government would largely assume the debt. In exchange, the nation's political center would be located not in a financial center like New York but in a new district alongside the Potomac River. Two centuries on, bondholders are still looking to Washington for relief.