Shared Sacrifice

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.



The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.


Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.