Guest Post: Moral Hazard Now Biting GM

Submitted by Lune

This blog and many other authors have pointed to the large moral hazards that the federal government’s actions have created so far. It was typically expected that these moral hazards would play out in the next cycle of boom/bust, with financial players taking bigger risks for their own gain while expecting public bailout when the inevitable bust began.

Unfortunately, it appears that moral hazard is making its appearance rather early, and for GM, not in a good way, either.

As has been reported, GM is on the verge of declaring bankruptcy. As part of the conditions for their initial Federal infusion, GM is required to prove its viability as a going concern to the federal government’s auto task force by March 31st.

Part of that viability is restructuring its debt, lowering payments to its bondholders, and reducing outstanding principle as well.

Yet GM’s bondholders have so far been unwilling to go along. According to the Financial Times, in February:

General Motors and its bondholders failed to reach a deal on a debt restructuring even as the carmaker requested additional federal aid as part of a viability plan submitted to the US government late Tuesday.

Agreement from bondholders to cut GM’s debt is part of the US government’s terms for a $13.4bn loan granted to the carmaker last year.
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In the run-up to the deadline, bondholders had been pushing for what they feel is more equitable treatment with other parties in the restructuring.

The original loan terms dictate that GM must reduce $27.5bn in unsecured bonds by two-thirds, which would be the equivalent of cutting the face value of the bonds to just more than 30 cents on the dollar.

Some of GM’s long-term bonds are trading about 15 cents on the dollar.

Still, bondholders have bristled because they feel their concessions are not balanced with those of other groups.

I suspect what has GM’s bondholders bristling is not necessarily their position vis-a-vis the UAW or GM’s other stakeholders, but rather the treatment received by GMAC’s bondholders when GMAC was bailed out.

As detailed by the Detroit Free Press:

As part of its drive for government aid, GMAC needed to convince bondholders to swap 75% of some $38 billion in debt for equity. Bondholders held out for better terms, eventually turning in only 59% of the bonds sought. Federal officials stepped in anyway, injecting $6 billion into GMAC and allowed it to become a bank to prevent its collapse.

The rescue drove up the value of GMAC’s debt – essentially rewarding the bondholders who said no, and setting a tough precedent for GM.
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[Rod Lache, automotive analyst at Deutsche Bank] says given the results from the GMAC swap, GM probably won’t be able to get all of the bondholders to agree to the concessions its needs…

While GM can force bondholders to accept a restructuring in bankruptcy, the point of the federal bailout of GM was to allow it time to come to a voluntary agreement with all its stakeholders and avoid the supposed disruption and chaos of a reorganization done under bankruptcy. Yet by being lenient with GMAC’s bondholders during its bailout, the federal government has made it more difficult for GM to satisfy the terms of its own bailout package.

GM bondholders (probably correctly) perceive that a federal government that didn’t allow GMAC to go bankrupt even when its own rather generous criteria weren’t met will be highly unlikely to allow GM to go bankrupt regardless of the costs. And indeed, GM bondholders are probably wondering why they need to take a haircut on their bonds when the counterparties of Bear Sterns, Lehman, and AIG are being made whole at par after investing in far riskier securities.

Discussions are apparently continuing between GM and its bondholders, and barring last minute extensions from the government, GM needs to present a final plan by the end of this month. But in this game of chicken, the vast moral hazard the federal government has created has already strengthened the bondholder’s resolve, much to the detriment of GM’s negotiating position and the success of the government’s original bailout plan.