The Bondholder's Gamble

President Obama characterized the withholding of funds to GM as a chance to give them 60 days to submit plans for further restructuring, but clearly he has already decided that he would rather try an accelerated bankruptcy to force haircuts on all the key stakeholders. It looks like that will take the form of a good GM and a bad GM.

The Obama administration's auto task force has pressed General Motors to consider a form of bankruptcy that would split the company in two, with one entity containing the unprofitable units and the other in essence becoming the new GM consisting of the company's more successful brands, people familiar with the matter say.

The company prefers not to ever enter bankruptcy because the mere word would stir fear among consumers and further damage sales. But GM will be forced to do so if it fails to win concessions from its bondholders, union and dealers within 60 days. Then bankruptcy court would compel GM stakeholders to make sacrifices, rehabilitating the company by clearing away billions of dollars of debts from its balance sheet.

"They're all options. They're all being studied," Kent Kresa, GM's new chairman, said in an interview. "The preferred [option] is to do it outside of bankruptcy."

You would think this would be the last outcome sought by the bondholders, as their stakes would be crammed down in a bankruptcy court. However, I wondered earlier whether they think they have a better shot from a judge than from a negotiation. And Autoblog reports on another potential reason - they could cash in their credit default swaps.

The bondholders appear to be the biggest obstacle to restructuring. They're not allowing GM to reach its government-mandated target for debt reduction because they would lose much of their investment in the process. According to Denninger, however, the biggest and most savvy of those bondholders could get 100% of their investment back if GM files for bankruptcy. Those bondholders would have had their bonds backed by credit default swaps (CDS), which Denninger supposes would have been written in large part by insurance giant AIG. If that's the case, then we the taxpayers are on the hook to repay 100% of those bonds because the government has agreed to fulfill AIG's CDS collateral obligations.

Thus, these particular bondholders would have no reason to help GM stay afloat by reducing its debt obligations. If GM goes under, they would just wait for checks from the government to be made whole again. Denninger goes on to say that in such a scenario, these bondholders could make even more than 100% of their investment back because the government backing takes place "even if the bonds have a recovery in bankruptcy." The only way to stop this would be for the government to decline to back any more AIG obligations, which could then bankrupt the "too big to fail" AIG depending on its ultimate exposure, but would save GM. Decisions, decisions...

Wow. Just, wow.