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  • Beam While Bond Holders Burn

    Posted by Carl from Chicago on May 17th, 2009 (All posts by )

    Let’s run a small thought experiment. Assume that I have a business, and I want to borrow $10,000 from Dan as a LOAN to finance the business. The terms are typical – I pay back the principal, plus interest, on a regular schedule. If the business fails, Dan is a creditor and we liquidate the business and he receives a percentage (some amount of cents on the dollar, from 90 cents to 5 cents) depending on what my failed business can be sold for. WHY would Dan loan me money? He may have some cash available and would like a steady stream of income (interest) and a relatively low risk of losing his principal.

    Now let’s say that the business is in trouble. I go to Dan and say… how about I pay you maybe 30 cents on the dollar, and you take these new loans and your investment is now worth only $3000 plus the interest on the $3000 (assuming I pay it out). My old obligation to you is null and void. And, oh yeah, I am going to go talk to all the newspapers and local reporters and tell everyone how great I am at managing the business and put my face on the cover of a major magazine, beaming.

    This is pretty much an analogous scenario to the situation facing Ford motor. While Ford motor has done some things better than its two brethren in dire straits, and has been willing to make tougher choices like sell of brands such as Jaguar and Range Rover (to Tata) and has done other things right, the MAIN reason that Ford is alive while GM and Chrysler are circling the drain is because the prior CFO took out $23 billion in bonds, essentially hocking everything Ford had, when the markets were easy on financing (now Ford would never be able to raise those kinds of funds at those low rates).

    Here is Mulally’s business plan (edited, obviously). Certainly, compared to the management at Chrysler and GM, he is a relative genius, the veritable “one-eyed man” among the blind. I helpfully updated the plan so that we could see the most important reason for his success, which is his shameless cram-down of debt holders and having them exchange debt while Ford HELD THEIR CASH to use on Ford’s cash-burning operations.

    I realize that “theoretically” the fact that he is exchanging debt outside of bankruptcy isn’t that different than exchanging debt through bankruptcy, but the fact that they are doing it without any regret or remorse shows the type of character that they have. I also realize that the people who own the bonds today mainly bought them on the secondary market and figured that there would be some sort of distressed exchange, and were trying to get more from Ford than they paid for the bonds. But the ORIGINAL bond investors were the ones who were holding the bag, so to speak.

    Note that bond investors and equity investors are not the same. Bond investors basically want their money back, along with an interest income. Equity holders want to take a ride on the business, hoping it is profitable or otherwise valuable and that their equity stock price increases. They KNOW that they are taking a major chance, while the bond holders are trying to preserve their capital.

    I do think that at least he should acknowledge that a huge part of their advantage is 1) the fact that they issued debt in huge amounts among historically very favorable terms 2) that they have the chutzpah to use all this cash to run their operations on the short term without considering the long term needs of the bondholders 3) that they have no shame in squeezing out better terms to leverage the fact that this cash will be burned, anyways.

    ANYONE who loans money in the future to these types of entities, or is an investor in a fund that does, is a SUCKER, unless there are very rigorous terms for the use and return of these cash assets. Character does matter, and firms and individuals that without shame squeeze you aren’t people that you should do business with in the future.

    So stop beaming while the bond holders burn…

    Cross posted at LITGM

     

    12 Responses to “Beam While Bond Holders Burn”

    1. Shannon Love Says:

      This type of short-term thinking is even worse than the kind that produces bubbles. Bubbles pop and we recover from the bubble in a few years at most. Altering the standards of how people who loan money can be repaid will have damaging repercussions for decades.

    2. Carl from Chicago Says:

      I think Reagan said it best –

      “Trust but Verify”

      These loan and debt covenants have to be made much stronger. New debt will have to assume that the debt seller will not act honorably and put teeth into their covenants.

      I just can’t stand the guy smiling while doing this. He should at least seem ashamed.

    3. Robert Schwartz Says:

      The Ford deal is not a problem. It is a voluntary exchange. It happens all the time and has for years.

      The Chrysler deal is a problem, the banks were in hock to the Government, which abused its position to get the deal approved involuntarily.

      The GM deal stinks for the same reason. The UAW is receiving about 4 times as much for its unsecured claim as the bond holders.

      As a taxpayer, Ford is my hero.

    4. Carl from Chicago Says:

      I don’t agree that the Ford deal isn’t a problem. The rating agencies categorize the Ford actions as a default, which it essentially is. These actions hurt the bond markets and investor sentiment, as they should.

      In the post I do compare Ford favorably to Chrysler and GM. Sadly that doesn’t count for much.

      The fact that Obama is trying to screw the bondholders even harder than Ford did doesn’t justify anything. The UAW has no claim on those assets and shouldn’t be a party in bankruptcy. That is a separate issue and also sadly in character for the democrats, trying to reward their union faithful.

    5. rjsasko Says:

      THANK YOU for being the only one I have seen who has pointed out that the only real difference between Ford and GM/Chrysler is Ford hocked everything including the silverware before the financial markets seized. Everyone (it seems) has been running around saying how much “better” Ford is relative to the competition when in reality they hit the wall first and that just happened to be lucky. What is sad is Ford is still going down the tubes but maybe a year later. In the mean time Ford’s false (relative) prosperity is resulting in harsher treatment towards GM and Chrysler. Imagine if they all went down simultaneously…Washington might have been forced to come up with a fair deal that would spread the pain equally between management, stockholders, bondholders, suppliers, UAW, and dealers instead of the farce we’re seeing which will result in no Chrsysler, GM, or Ford in a few years.

    6. tomw Says:

      The Ford creditors lent the money with their eyes wide open. What was hidden? What was forced upon them by the government?
      Everyone knew that Ford was in trouble a few years ago, at least everyone that paid a whit of attention. We all watched as they shuttered factories and offered early retirement packages. The writing was on the wall for all to see.
      My question is what legal enforcement power does the Administration have over GM and ChryCo to force them to agree to the distribution of assets as has been reported? What part of the Constitution allows for contracts to be arbitrarily changed by a third party?
      What did I miss?
      tom

    7. kurt9 Says:

      The manner in which the senior bond holders were screwed in the Chrysler bankruptcy will definitely make it more difficult for any company that is even thought to require a government “bailout” to raise money in the bond markets. Any company issuing bonds will now have to include a risk premium to cover the “sovereign risk” of the bond holders being screwed by a left of center government in the case of a government bailout.

    8. Carl from Chicago Says:

      I can’t answer the question on the government and GM and Chrysler and I 100% don’t agree with it.

      To say that the Ford debt repurchase terms were typical is not correct – they are essentially a default, and a unique default, in that Ford still has the cash but is pretty much telling the bondholders that it will squander the money on immediate cash needs rather than use it for reinvestment in their long term capacity which is how it was marketed to bondholders. The bond market is built upon trust – companies have to mention their future intentions – and the credibility of the bond issuer impacts their ratings.

      The fact that major companies are continually lying to debt holders is going to have a big impact on the cost of capital in the future – if bond holders have to build bullet-proof covenants into everything is going to impact the efficiencies of the market. If bond buyers ASSUME that the issuer is 100% unreliable and everything out of their mouth is a lie that will drive up rates. Reputation matters, and it doesn’t help a functioning market.

    9. tomw Says:

      Carl from Toddlin’ town:
      “use it for reinvestment in their long term capacity which is how it was marketed to bondholders”

      Sorry, I don’t believe that, or don’t understand the meaning. It was obvious to anyone observing that there is and has been serious over-capacity in auto production in the US. Plant closures by Ford and GM were announced years ago. Their (both firms) long term capacity needed to be trimmed to match demand. How are they ‘investing in long term capacity’ by closing plants? I don’t understand the terminology as used. My understanding of Ford’s strategy of several years ago was to mortgage everything they owned, and sell off the prizes they could and use the money to weather the multi-year losses expected and re-tool their product mix.
      Did I misunderstand? I am unaware of any cram down taking place re Ford bondholders. But, then again, I don’t follow the bond market…
      Mulally may be smiling on the cover of Forbes, but he has a pretty tough future ahead. He will compete (maybe) with GM and ChryCo un-fettered by debt, perhaps without health benefit costs…?
      tom

    10. Andy Wagner Says:

      As many others have pointed out, Ford’s re-financing was done voluntarily, without the compulsion of the courts or the government.
      To accomplish it, Ford had to come to its creditors with a plan. GM and Chrysler came to the government with plans, but Ford’s plan was reviewed and voluntarily endorsed by people who know something about business, rather than capricious politicians more concerned with jobs in their districts.
      You claim that Ford “would be” just as poorly off as GM and Chrysler, but the evidence is to the contrary. Ford’s financial losses are less than GM and Chrysler in the present crisis, and market share increases, while GM and Chrysler hemorrage. Ford has invested and continues to invest in new product development, while GM and Chrysler cut off their own noses.
      While business magazines praise the early refinance effort, Mulally’s first order of business was to reduce warranty claims by $250M in his first quarter as CEO. This reduces the company’s costs *and* improves owner loyalty and word of mouth advertising.
      He has every right to smile about where he’s leading the company. On every score he’s addressed Ford’s most pressing problems with an approach that gives customers what they want in a way that’s most profitable to the company.

    11. Carl from Chicago Says:

      OK. Now I need to go and read the prospectus for the $23B bond term deal.

      I am telling you that I am not speculating about how raising debt works and how rating agencies work. I understand what I am talking about.

      In general, IF creditors assume that EVERYONE is going to intentionally act in ways contrary to their interests then we will have trouble in the bond market. This isn’t a criminal law issue, and it isn’t the same (or as bad) as Obama screwing creditors with regards to GM and Chrysler, but it is bad and it is a default.

      I still maintain 100% that he shouldn’t be “beaming” while screwing the bondholders. It isn’t honorable. It burns them in the credit market and starts a process that will eventually result in a much less liquid market for all.

    12. Bill Waddell Says:

      All three – Ford, GM, Chrysler – have been taking a very public beating from Toyota and Honda for 25 years. Their long, steady downhill slide – temporarily stalled from time to time with good produst like the Taurus only to resume when the novelty wears off – is plain to see. They clearly have internal, systemic management weaknesses vivs a vis the Japanese companies.

      Of course you are right – they screwed the bondholders; as the Obama gang is screwing the people who loaned money to GM and Chrysler – but c’mon! How much sympathy do people dumb enough to lend money to the Detroit 3 deserve?

      Some great philosopher or another … PT Barnum or WC Fields maybe … said that we have a moral obligation to take money away from fools before they do something to hurt themselves with it. I believe that applies in this case. Ford did them a favor by taking their money away from them before they did something really dangerous with it.