Friday, May 1, 2009

law is unambiguous: senior secured creditors should be paid before junior unsecured creditors and employees

TO BE NOTED: From the FT:

On Wall Street: Chrysler saga sets dangerous precedent

By Francesco Guerrera

Published: May 1 2009 20:15 | Last updated: May 1 2009 20:15

Il fine giustifica i mezzi. (The end justifies the means.) Thus wrote Niccolò Machiavelli, the grandaddy of all political consiglieri, in instructing his prince on how to seize and retain power.

It is unclear whether Barack Obama, the US president, heeded this timeless advice in deciding Chrysler’s fate this week.

But if Mr Obama hasn’t read it yet, Sergio Marchionne, the Italian-born head of Fiat and Chrysler’s boss-to-be, should send him a copy of The Prince. Bank executives and investors should also skim the book as they could be in for some Chrysler-like treatment soon.

Regardless of its literary influences, the Obama administration’s decision to give unions a big stake in the ailing Chrysler while strong-arming banks into forgiving a huge portion of debt is a sign of the times.

A nearly bust carmaker, several lenders that owe the government billions of dollars (and, in some cases, their survival) and an interventionist president eager to be seen to be tackling the nation’s economic ills: welcome to the United States of America 2009.

I have heard the arguments supporting the decision to short-change debt holders and carve out Chrysler between the unions (which get 55 per cent but just one board seat), Fiat (up to 35 per cent and three board seats) and the government (most of the rest of the equity and four board seats).

They boil down to this: extraordinary times require extraordinary measures (the end justifies the means, if you like).

In other words, with Chrysler employing more than 50,000 people in the US and Canada, it was paramount to avoid a long bankruptcy that would have destroyed the company.

If that meant giving junior creditors such as the unions favourable treatment at the expense of senior debt-holders, so be it. As for those hedge funds that rejected the plan, they are nothing but “speculators” according to Mr Obama.

As a fellow basketball fan, the president will not mind if I call a time out. There are several problems with the logic of the Chrysler “rescue”.

First of all, it did not stave off bankruptcy. Chrysler duly filed for Chapter 11 on Thursday.

Mr Obama said it would be a “surgical”, quick in-and-out, process but that will be up to the court, not him.

More importantly, the Chrysler saga sets a dangerous precedent for US capital markets. For once, the law is unambiguous: senior secured creditors should be paid before junior unsecured creditors and employees (the words “senior” and “junior” are a bit of a give-away on this point). By turning legal wisdom on its head – and vilifying investors that opposed the move – the administration is signalling the principle is no longer sacred.

While that, in itself, will not cause a massive capital flight away from the US, it will have some serious repercussions.

Fund managers and hedge funds are already reluctant to participate in the authorities’ plans to rid banks of toxic assets for fear of government retribution on pay. The Chrysler “cram-down” of lenders is hardly going to fill them with confidence.

After this week’s completion of “stress tests”, holders of preferred securities in some banks will be asked to exchange them into equity to recapitalise those cash-strapped institutions. How can they be sure the terms will be fair?

And how safe will senior debt holders in, say, Citigroup or Bank of America, feel after what happened to their Chrysler counterparts?

The government has a real problem here. Call it the “paradox of the official bailer-outer”: the authorities’ position as rescuer-in-chief forces them to take an active role in the private sector, yet their goals (saving jobs, getting re-elected etc) conflict with the smooth running of the very markets they are trying to preserve.

Mr Obama’s task has been complicated by the pre-crisis growth of the “shadow banking system”: hedge funds and other lenders whose aims and strategies are opaque and often conflict with those of larger banks.

But the rulers of the world’s largest economy ought to avoid short-term fixes that undermine the long-term strength of its capital markets.

No end justifies the end of the rule of financial law."

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