Renouncing the Debt

There are three ways to get out of a debt crisis. First, you can work off the debt, but this takes a long time. An impatient public and an impatient government will not have the stomach the wait that would be necessary for individuals, families, and businesses to get their balance sheets in order so that a recovery can get started.

The second method is to inflate or reflate yourself out of the nominal debt burden you have created. The Federal Reserve is doing its best to create an inflationary environment so that the real value of the debt will be reduced and individuals, families, and businesses will feel comfortable enough to begin borrowing and spending once again.

The third way to reduce the burden of your debt is to repudiate the debt. That is, declare that you will not pay the debt and that those that issued the credit to you will have to take only a partial payment on the amount of funds that they advanced to you. The partial payment, of course, can be zero.

The latter two methods have an “honorable” history that goes back centuries. (Read almost anything by Niall Ferguson.) Usually, it is the government that can get away with either or both of these efforts, but in the 20th century, the private sector got much better in following the lead established by governments, especially repudiating the debt. Individuals, families, and businesses learned the ropes of debt repudiation and are now taking this knowledge to new extremes.

The case that is before everyone’s eyes these days is that of the automobile industry. Both General Motors and Chrysler argue that bondholders must take a huge cut in the amount of money they are owed by these companies so that the companies can survive and thousands and thousands of jobs can be saved. The bondholders, remarkably, have some reluctance to consent to this offer. As of this date, the aimed for restructuring of these two companies depend upon what is worked out between the companies and the bondholders.

Best guess is that the bondholders will lose. And, who will own the auto companies? Not the existing shareholders. The figure I have heard for General Motors is that existing shareholders will end up with about 1% of the ownership of the company after the restructuring takes place. And, not the existing bondholders. The biggest shareholders? The federal government and the labor unions.

The important thing, however, is that the debt problem being experienced by these automobile companies will be resolved. That is, the companies can move forward, leaner and meaner, without the terrible burden of having to honor the debts they had contracted for.

Furthermore, this is what has been proposed for the banking industry. In the plan to sell off bad assets, aren’t the banks being asked to repudiate a large portion of the debt they have on their balance sheets? The assets will be sold to investors and private equity firms to “manage” and this will get the banks out from under the burden of the “toxic assets” they have accumulated.

And, who will bear the risk of this buyout? The federal government, with the real possibility that it may, depending upon the way things work out, end up owning large portions of some of the larger banks. (An important critique of this program is presented by the economist Joseph Stiglitz in “Obama’s Ersatz Capitalism,” http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?scp=8&sq=jospeh%20stiglitz&st=cse.)

Might this plan work? Well, the people that the federal government wanted to get interested in the plan seemingly smell blood. We read this morning that Wilbur Ross and his firm’s parent company, Invesco, are leading a consortium that is going to bid on some of the assets in the government’s P-PIP. He is joining some other prominent money, like BlackRock, Pimco and Bank of New York Mellon, interested in getting involved in the program.

Do these people think that they might make some money out of this program? Do they believe that the risk-reward tradeoff is skewed in their direction? Damn betcha’.

Here is another case of “watch where the big money players put their money.” My guess for the future is that the evolving banking system is going to be somehow connected with the hedge funds and the private equity funds and will not have the same old “bank on the corner” feel to it that we experience now. And, somehow, this new banking system will be even harder to regulate than the current one. Otherwise, this money will not flow there. (Something to think about for the future.)

With these funds flowing into the P-PIP, one of the things the federal government is going to have to face is the huge profits that these companies will make out of the program. On the one hand, if P-PIP is successful in this way and these funds make huge profits, the banks will be freed up of their “toxic assets” and the tax payer will not be burdened with more taxes. On the other hand, the federal government will have to explain how it catered to all these “Wall Street Interests” and left the poor Main Streeter in his or her poverty.

The essence of the plan, getting back to the story here, is that the banks will have to take the “haircut”, the write down on the value of their assets. This is just another way of repudiating the debt, with the federal government standing behind the banks. Is it fair? Of course not!

A fund that made the wrong bet was Cerberus Capital Management. In a real sense, it hoped to do with Chrysler Corp. what Invesco, BlackRock, Pimco, and others, are hoping to do with the bank assets. It just got in too early when Chrysler was not in bad enough shape for the federal government to attach a “put” to the investment Cerberus made in the company. Too bad for Cerberus.

But, what about all the other debt out there? Mortgages on homes, debt on commercial real estate, consumer credit and credit cards, and small business loans? Why shouldn’t the people that accumulated all this debt get some relief as well? This is, of course, the big question and the big issue in terms of fairness. The basic answer to this is, as usual, size. The banks and the auto companies and others are big, their failures could case systemic problems for the system, and they have expensive lawyers and lobbyists working for them. Is it fair? Of course not!

The fundamental problem that is being faced around the world is a debt problem. There is just too much debt outstanding. And, actually, the amount of debt outstanding in the world is really not shrinking. Especially, as governments increase their debt to cover the debt that has been built up in the private sector. The debt problem is going to be with us for a while and will continue to get in the way, one way or another, of any kind of a robust recovery. How we get through it is going to set the stage for the type of world we have to deal with in the future.

Auto Bailouts and Other Things

I have tried to stay out of the auto-bailout thing but I find that I need to add my two cents to the issue. I have done three successful turnarounds in my professional career and have consulted on quite a few more. It is from this perspective that I am making my comments. So hear goes.

First, Ford says that it can make it through the near-term without any assistance from the Federal Government. Good. Let them go for it!

Second, Chrysler…is owned by Cerberus Capital Management, LP…a private investment firm who boasts, “strong corporate governance is the cornerstone of our business.” This is a private investment firm that recently took a risk, made a big investment, has access to billions of dollars of capital…and is coming, hat-in-hand, to the Federal Government asking for money to carry Chrysler through this mess.

Come on…

Sounds like we have a new model for private equity investment!

Third, General Motors…”What’s good for General Motors is good for the United States,” as a former CEO of General Motors put it.

We bailout General Motors and then we bailout the United States? Hmmmmmmmmmmm…I don’t think that is what was meant.

General Motors is a turnaround situation!!!

In a turnaround situation you get rid of the existing management and you bring in new management!!!

Robert (Bob) Lutz says GM should stick with “Rick” Wagoner, Chairman and Chief Executive Officer, because he knows the business and knows what the current situation is and doesn’t have to be brought “up-to-speed” with the situation at GM.

I remember taking a thrift institution public during “the S & L crises” and going to numerous “dog-and-pony” shows of other companies taking their institutions public. I was especially taken aback by managements that would say…”Sure we were the management of this institution for the last 10 years in which the performance of this company got worse and worse…BUT, we have learned our lessons…we can make this bank work going forward!!!” And then they raised quite a few million dollars from people who were willing to bet on this story.

Guess what? Most of them didn’t make it!

We have also heard that the top engineers and other top management want Wagoner to stay. “He can do it!” they say.

Sure these employees want Wagoner to stay! He is the safest thing for them and their positions. A turnaround specialist would take a long, hard look at these people and what they have done and are doing and that is exactly what the top engineers and other top management don’t want!

General Motors is a turnaround situation! If anyone (the Government) is going to invest money in this organization they need to demand the appropriate leadership…and the existing CEO and his top management IS NOT the leadership that is needed.

The bailout of the auto industry is not just about thousands or millions of workers being employed. I, personally, hope that these workers do not have to experience a great deal of suffering.

The question is about whether or not any effort made by the government will have a fair probability of success. Thinking of these efforts as a bailout is not helpful when the situation calls for a turnaround. The issue, in my mind, is not being framed correctly.

OTHER THINGS

Information is starting to come out concerning the efforts to restructure mortgage debt…and the results are not encouraging.

Let me just say one thing about restructuring mortgages…or, for that matter, any debt in the present environment.

Generally, when the restructuring of debt takes place, the situation of the borrower and the situation in the economy are relatively stable. That is, any restructuring that takes place can count on income, employment, prices, sales, and so forth to remain relatively constant in the future. That way, the debt can be restructured in a way that presents the borrower with some likelihood that he or she will be able to pay off the debt.

In an environment that is not stable the situation of the borrower and the situation within the economy is constantly ‘going South.’ And, there is no certainty about ‘how far South’ these things will go. Consequently, any debt restructured in this environment has a relatively low probability of being paid off. Those restructuring the debt are just postponing the day of reckoning and continuing to put these borrowers in a position of almost assured failure.

In essence, within the current environment, those that have been foreclosed upon have gone from borrowing using a sub-prime loan to borrowing using a sub-sub-prime loan.

As I have said in many other posts…once discipline is lost…there are no good solutions to the problems created by the loss of discipline.