Dismantling the foundations of capitalism: the Chrysler haircut

Over centuries the US has built the greatest capitalist system in the world. Though capitalists make lots of mistakes, but they have strong incentives to fix these mistakes, and will do so as long as the underlying structure remains sound.

But over recent weeks, the Obama administration has been dismantling this structure out of short-term political expedience: let’s get nice headlines, cover that pig with lipstick, and damn the long-term consequences. It’s the kind of short-term thinking that hedge funds have been accused of. But even if hedge funds were inclined in this direction, they don't have the powers the federal government can wield.

More specifically, what business needs is a clear idea of what the rules are when investors put their money at risk, and full disclosure of these risks. Government’s job in our capital markets is to follow and enforce the rules, including those on disclosure. If these conditions aren’t met, risks and the costs of capital rise and investment declines. Worse, resources are allocated to the bribers, favor-seekers and cheaters rather than the builders and suppliers of productive assets.

I’m going to consider examples of what’s been happening over the last few weeks, beginning here with the Chrysler haircut. 

First some background. Firms raise money by promising certain terms to their creditors. Equity holders take more risk and get more reward. Secured lenders take the least risk because they have rights to specific company assets. But these rules are inconvenient for a government that has different priorities about who should get what in a high-profile US company like Chrysler. The UAW wants some of what the secured lenders are contractually entitled to. The Obama administration, in addition to having been elected with key labor support, finds it politically expedient to get union support for the deal by extracting benefits from secured lenders. Specifically, the government wanted the lenders to settle for a third of what they were owed while labor got half. The lenders can agree to modify their rights, but they don’t particularly want to.

Against that background, the President calls the lenders “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

These words distort reality. It’s the banks that are getting the bailouts. The hedge funds just wanted what they had paid for. They have not gotten bailed out. Moreover, the “sacrifice” Obama is calling for is, by another name, a breach of fiduciary duty by the managers to their investors.

At one level these are just words. But keep in mind that Congress is as we speak considering regulating hedge funds, that tax changes are in the air, and that executive branch lately has been wielding some awesome powers.

The President’s remarks elicited an angry, and perhaps courageous, response from Clifford S. Asness, managing partner of AQR Capital Management, which is not involved in Chrysler. Asness pointed out in an open letter that when “hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back.” Bankruptcy law has certain procedures and protections, set forth in “rules of the game lenders know before they lend. . . . [W]ithout this recovery process nobody would lend to risky borrowers. Asness points out that investment managers are not allowed to “give away their clients’ money to share in the “sacrifice”.” When they do this, “they are stealing” – including from pension funds. “Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power."

Maybe you don’t feel sorry for the hedge funds and their investors. But consider what else Asness has to say:

Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won’t work because of this irresponsible hectoring.

The bottom line is that the rapidly increasing power of government over recent months entails a rapidly increasing opportunity for abuse, a toxic entanglement of government with business, and an accelerating loss of confidence in markets just when we most need this confidence.

Comments

[Matt Bodie]

I don't see how this is the dismantling of capitalism when Fiat is just as much of a winner as the healthcare VEBA. The bondholders are just pushing for a better deal, but there is no chance that another bidder is going to come in with more money. (Who else would buy Chrysler?) The main narrative here is that the Obama Administration is pushing through a deal with Fiat in order to save the company. Maybe it shouldn't be saved. But is there any indication here that the bankruptcy laws aren't being followed? The judge has to approve all of this, after all.

[save_the_rustbelt]

Lest anyone think the UAW is getting some great deal, the union is getting stock of dubious value to cover a VEBA-ized health care liability that may be in the range of $15B.

Obama is just kicking the can down the road, probably past the 2010 elections. The UAW members think they got something of value - hmmmm.

About the hedge funds:

1. Why did they do this insane deal in the first place? Was there no due diligence? Was the boom euphoria blinding? Did they just want to suck up to Cerebus?

2. If Chrylser went into Chapter 11 without being Obama-ized, what would the hedgies get? Hard to say.

[Brad Boericke]

Without a doubt, the creditors are entitled to the deal they bargained for but that principle (and the foundation of capitalism) really doesn't seem at stake here. Without government funds being put in the mix (which I view as outside of what the creditors bargained for) it seems like what the creditors hold is very much a pig. The government has it's reasons for wanting to put some lipstick on it, and they don't include increasing the return to the creditors beyond a level the government finds politically expedient - the reasons the government cares what happens to Chrysler has much more to do with jobs (at Chrysler, at suppliers to Chrysler, etc), which seems perfectly sensible from a political and policy perspective. Each needs the other (bondholders would certainly be worse off if the government turned away completely - no one else is going to step up for that DIP; and the government has to deal with the legal rights of the bondholders in order to achieve its ends) so it is a game of chicken, but one being played squarely within the rule of law and the foundations of capitalism.

[Larry Ribstein]

Brad
Fair comment, but you're overlooking a critical paragraph in my post: "At one level these are just words. But keep in mind that Congress is as we speak considering regulating hedge funds, that tax changes are in the air, and that executive branch lately has been wielding some awesome powers." Bankruptcy law is intended to deal with the coordination problem you allude to. I'm concerned about the government's ability in the current context to go further and apply pressure for a political expedient deal.