The problem he faces is that the government’s credibility in a situation like this is weak

TO BE NOTED: From The Baseline Scenario:

"The New Masters of the Universe

with 12 comments

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.

Written by James Kwak

April 1, 2009 at 12:38 pm"

Me:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=axxcb9lRvYP8

“We’re just not good committee members,” Bill Gross, Pimco’s co-chief investment officer, said in an interview yesterday from his Newport Beach, California-based office. “We have the interests of our clients more at heart than the interests of particular corporations or even the government, I guess, so it’s best that we simply look at the situation from afar as opposed to from inside.”

That’s William Gross about GMAC. It worked. But, here’s the deal: That’s his job. His job is to make money for his clients. If he doesn’t try and do that, he can be sued.

One of the main causes of this crisis, from my point of view, is that many investment managers did not do this. They enriched themselves at the expense of their clients. Call it negligence and fiduciary mismanagement.

This point also applies to Citi. We are shareholders. It is the job of Pandit et al to make us money. This is why TARP is so weird. On the one hand, Citi was given money to lend, while, on the other hand, as investors, we simply expect them to do the best with the money they have. This conflict is inherent in any government/public hybrid plan.

The main argument for a Swedish type solution, if that were possible now, is that it could clearly have the taxpayer’s interests come first, and avoid most of the conflicts of interest, mismatched incentives, and mixed signals inherent in a hybrid plan.

Frankly, if you wanted a cleaner version of TARP, you should be for the plan proposed by William Gross in September, in which the government would have hired investors to buy the toxic assets for us. It too would have problems, but one could argue that it would be a cleaner plan than PPIP.

If you want businesses to voluntarily lose money for the country, then you will need to make sure that their clients agree with that