Thursday, May 7, 2009

in a downturn, lenders facing losses often say they will get tough and demand higher interest payments to compensate for risk

TO BE NOTED: From the FT:

Painful lessons for lenders in Chrysler debacle

By Nicole Bullock

Published: May 7 2009 19:15 | Last updated: May 7 2009 23:23

George Schultze will think twice before lending to another troubled company such as Chrysler.

Mr Schultze is one of a group of dissident Chrysler creditors who was rebuked by the US president and other lawmakers for tipping the company into bankruptcy. He rejected an offer aimed at slashing Chrysler’s debt in order to allow the carmaker to be sold.

Mr Schultze and other investors – some of whom claim to have received death threats – say the deal is unfair because it does not honour their rights as senior lenders to get paid before other claims, such as a union benefit plan, are met.

They also argue that the deal was orchestrated by the US government, which held sway over the majority of the other lenders, namely a group of banks, following widespread bail-outs.

The question of whether the Chrysler creditors got a raw deal will be decided in a New York bankruptcy court over the next few weeks.

Already, the verdict on Wall Street and in the conference rooms of investment firms round the country is that, at the very least, the situation raises questions about the solidity of time-honoured lending principles and parts of the bankruptcy code. These rules dictate the pecking order for claims to be repaid when a company files for Chapter 11.

“It will increase the cost of credit in the capital markets for lots of companies by tinkering with the well- settled priority system,” Mr Schultze said. “Our firm and many other lenders will think twice about lending to companies who have junior creditors that might get an unfair sweetheart deal.”

The Chrysler saga comes on the back of concerns by mortgage investors that they, too, are having to take losses they had thought would be absorbed by other creditors. The government has made it easier for people to modify mortgages in an effort to mitigate foreclosures, but investors say the details of new laws in effect push them down the pecking order. Mortgage investors, ranging from hedge funds to pension funds, owning the higher-ranking – or first lien – debts have already blitzed lawmakers, and some are considering taking legal action against the government.

Worries about the sanctity of contracts and claims in the US could become a more widespread issue that makes less credit available and raises borrowing costs for companies in general.

“Given that so much of total borrowing across all asset classes is first lien in nature, the damage that would occur to the economy as a result of higher first lien borrowing costs resulting from lenders requiring a higher return to compensate them for an unknown interpretation of claim priorities could be substantial,” says Curtis Arledge, co-head of US fixed income at BlackRock, Inc. “Many lenders make loans by being investors in US financial markets where contract law has been sacrosanct, and deviation from that could have far-reaching implications to the US economy.”

The situation exacerbates the unease that has held some investors back from participating in government schemes such as the term asset-backed securities loan facility and the public-private investment programme, which are aimed at boosting the availability of credit and removing toxic assets from banks’ books.

“It is particularly important at this stage of the distressed cycle for lenders to have confidence in pre-existing contracts and rules. We are entering a period of record corporate defaults and the need for bankruptcy financing and financing for distressed companies will only continue to grow,” says Greg Peters, global head of credit research at Morgan Stanley.

In the Chrysler case, the senior debtholders say they are taking losses while other unsecured creditors, such as the United Autoworkers Union, are getting some recovery even though the senior debt has a first lien on the company’s assets. Senior creditors are getting 28 cents on the dollar in cash; the UAW 55 per cent of a reorganised Chrysler. The other shareholders in the new Chrysler will be the US government and Italy’s Fiat, which is contributing technological know-how instead of cash.

“People are pretty comfortable with the bankruptcy rules. What they are trying to do in the Chrysler situation is unprecedented,” says Jeff Manning, a managing director specialising in bankruptcy and restructuring at Trenwith Securities, the investment bank. “This isn’t the way the game is supposed to be played.”

Investors, including hedge funds, began purchasing loans over the past decade. Previously, this arena was dominated by banks. Either way, the buyer accepts a lower interest rate for the perceived safety of the senior claim on assets.

The fear is that investors will demand a premium for senior debt such as loans, prompting a repricing of unsecured debt and general rise in the cost of borrowing.

“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt.

In legal arguments, Chrysler lawyers said the group was a “wasting asset” that needed to be sold quickly to prevent big job losses. The argument can be made that a liquidation of Chrysler risked worsening the economic downturn – a situation which would damage the value of loans and other debts. It’s also worth noting that the government has lent Chrysler billions of dollars in the last few months.

And, in a downturn, lenders facing losses often say they will get tough and demand higher interest payments to compensate for risk. What is unique in this cycle is the new focus on the government’s role.

“Now there is a new risk: government intervention risk,” Mr Persky says. ”And it is very hard to hedge.”

Additional reporting by Aline van Duyn in New York"

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