American Thinker: Obama's Pinstripe Revolution

At the end of April the Obama administration tested its ability to take direct control of the US financial system. The test was a success. There is a revolution underway which would impress Chavez or Castro. If you were like most people, you did not realize it happened.

As the details of the GM restructuring plan emerged, on Monday, April 27^th, Lawrence Kudlow was one of the first to sound the alarm as secured lenders and bond holders were being given a fraction of the amount owed to them under long established bankruptcy law.

What is going on in this country? The government is about to take over GM in a plan that completely screws private bondholders and favors the unions. Get this: The GM bondholders own $27 billion and they're getting 10 percent of the common stock in an expected exchange. And the UAW owns $10 billion of the bonds and they're getting 40 percent of the stock. Huh? Did I miss something here? And Uncle Sam will have a controlling share of the stock with something close to 50 percent ownership. And no bankruptcy judge. So this is a political restructuring run by the White House, not a rule-of-law bankruptcy-court reorganization.

Some might have dismissed Kudlow's comments as partisan hysterics. Kudlow is a radical free marketer with ties to the Reagan administration. On Tuesday, April 28^th as details of the Chrysler reorganization began to leak other experts in the financial industry began to speak out.

"To say it's unusual is an understatement -- it's unprecedented," said Norman Kinel, a New York-based partner at law firm Duval & Stachenfeld. "The government doesn't ever get involved in this way."

Dan Seiver, a finance professor at San Diego State University, said that as some of the automakers' creditors have received bailout money from the government they may be forced to "ride herd over other lenders" to get a deal done.

"We're in a new era where the government is calling a bunch of shots," Seiver added.

Intervening in the auto industry is also seen creating a conflict of interest for the government, where its role as a shareholder collides with its desire to protect jobs and benefits.

There is also concern about what Syd Finkelstein, a professor at Dartmouth's Tuck School of Business, called the "implied consequences" of disobeying the government.

Finkelstein referred to the case of Bank of America Corp Chief Executive Ken Lewis who, according to testimony released by New York Attorney General Andrew Cuomo, said he had been pressured by the government to complete a merger with Merrill Lynch & Co.

"This is a very active, hands-on Treasury Department that is not afraid to flex its muscles," Finkelstein said.

The government sponsored reorganization plan for GM calls for the UAW and government to control the restructured companies leaving only 10% to all other current creditors combined. A few months ago had any financial pundit publically predicted this outcome they risked being dismissed as a kook.

Since this story lacked stunning visuals like troop columns or burning buildings most people did not notice. By May 3^rd 2009, the first cycle of Sunday talk shows since both reorganization plans were announced, more time was spent discussing the Swine Flu pandemic than the auto industry deals. On the few occasions the reorganization plans were discussed it was in terms of the administration's political victory.

While many Americans were worrying about going to the mall or getting on an airplane, people who understand the byzantine world of corporate finance and bankruptcy were wondering how the executive branch nationalized two giant companies and no one seemed to notice.

To understand the gravity of the events you need a basic understanding of bankruptcy laws. The pecking order of bankruptcy claims is supposed to be:

1. Debtor in Possession (DIP) financing which is loaned to the restructuring company
2. Secured Lenders - creditors whose loans are backed by assets such as real estate or equipment
3. Unsecured Lenders - creditors such as bond holders, vendors and the UAW
4. Equity Owners - shareholders

When a company files for bankruptcy the claims that are superior (represented by a lower number) in the pecking order are paid first. Claims with equal status are treated equally; those claims are almost always paid on the same pro rata basis. It is an explicit goal of our bankruptcy system is to treat all creditors equally. This is how Lawrence Kudlow's rule-of-law bankruptcy-reorganization should work.

In the case of GM, the UAW and bond holders are both unsecured creditors with equal rights under bankruptcy law. As The Cleveland Plain Dealer reported Monday April 27^th, interim GM CEO Fritz Henderson contends a 2007 deal between GM and the UAW gives preference to unsecured claims of the UAW. The bond holders never explicitly agreed to have their claims subordinated to the union so that contention is certainly open to debate in bankruptcy court.

Considering GM owes the UAW $20 billion (Henderson says the figure is closer to $30 billion) and bond holders $27 billion, they should receive a similar ratio of shares in the restructured GM. The deal announced by Henderson gives roughly 40% of the stock in a reorganized GM to the UAW, 50% to the government and 10% to the bond holders. The math does not make sense even if you accept Henderson's contention that the UAW is owed $30 billion.

Henderson took the helm of GM when CEO Rick Wagoner was fired by President Obama a few weeks ago. It is reasonable to assume Henderson would acquiesce to the pressure of the administration after witnessing Wagoner's fate. But that does not explain the silence of major bond holders and secured creditors.

The Chrysler reorganization details are more bizarre. At Chrysler the institutions owed $6.9 billion by Chrysler are secured creditors. As a matter of law, the secured claims would be superior to those of the UAW in bankruptcy court.

Putting the Chrysler deal in terms of household finances, the secured creditors would be the banks holding the mortgage and car note. Instead of the car and house going back to the bank in bankruptcy, the Chrysler deal calls for the car and house to be shared with unsecured creditors like credit card companies and the cable company. That is not how the system is supposed to work.

These bedrock principles are codified in our bankruptcy laws. They are why mortgages and car loan interest rates are in the mid single digits; why most credit card rates start in the mid teens and reach as high as the low thirties. Unsecured debt is supposed to be riskier than secured debt.

So who are these bond holders and secured creditors who would just walk away from tens of billions? The GM bonds are distributed among hundreds of institutions and thousands of individual investors, so it is difficult to see a pattern without extra information.

As the Chrysler talks broke down Wednesday April 29^th more clues appeared as to who was taking the loss. The Washington Post reported the next morning some of Chrysler's secured creditors were balking.

Indeed most of the friction in the Chrysler deal making has revolved around efforts to get the company's secured lenders -- to whom Chrysler owes $6.9 billion -- to accept a small fraction of that amount.

The Treasury Department is pressing them to write that down to $2.25 billion, and officials spent much of yesterday in last-minute negotiations with the lenders.

While four of Chrysler's major creditors -- J.P. Morgan Chase, Citigroup, Goldman Sachs and Morgan Stanley [emphasis added] -- have agreed to the Treasury's plan, other lenders, mainly hedge funds, had held out. The holdouts included Oppenheimer Funds, Perella Weinberg Partners and Stairway Capital, two sources said. The last two have funds that invest in "distressed" companies. It is not known what companies ultimately failed to reach agreement with the government.

Thursday April 29^th at noon, President Obama announced a deal with most of the stakeholders at Chrysler had been reached. But he had harsh words for a small group of secured lenders -- whom he referred to as "speculators" -- who were forcing Chrysler into bankruptcy:

While many stakeholders made sacrifices and worked constructively, I have to tell you some did not. In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. They were hoping that everybody else would make sacrifices, and they would have to make none [emphasis added]. Some demanded twice the return that other lenders were getting. I don't stand with them.

[snip]

I know that there are some who will insist that bankruptcy, even for these limited purposes, is a step that should not have been taken. But it was unsustainable to let enormous liabilities remain on Chrysler's books, and it was unacceptable to let a small group of speculators endanger Chrysler's future by refusing to sacrifice like everyone else [emphasis added]. So I recognize that the path we're taking is hard. But as is often the case, the hard path is the right one.

Among people who understand bankruptcy rules these comments raised eyebrows. Does President Obama mean to say secured loans like mortgages are speculative investments? Is a bank which insists on repossessing a car secured by a note seeking something unjustified? These comments were certainly not comforting to credit markets in the US and abroad.

Obama's comments were followed on May 2^nd by Jake Tapper's report that a lawyer for one of Chrysler's secured lenders who opposed the administration was threatened. Threats consisted of an organized media campaign to destroy any company opposing the deal.

By May 4^th, The Detroit News was reporting death threats as well. Thomas Lauria, the lawyer for the objecting secured creditors said one client dropped their objections to the reorganization plan after the threats.

Several major Chrysler creditors avoided Obama's criticism by agreeing to take a fraction of what they were owed. These creditors (J.P. Morgan Chase, Citigroup, Goldman Sachs and Morgan Stanley) also have received billions in TARP funds. They are also among the 19 largest financial institutions which recently undergone a special stress test administered by the Fed, US Treasury and various regulatory agencies.

These stress tests were completed weeks ago but the banks had until May 4^th to appeal. The methodology and results have been kept secret. Shortly after President Obama's statement on the Chrysler, Reuters reported the stress test results will be announced publically Thursday May 7^th, 2009. It is widely speculated some banks may fail the tests and will need to raise additional capital to satisfy regulators. This will likely include some or all of the banks who agreed to forgive debt and let control of Chrysler pass to the UAW instead of the banks.

Among the regulators determining the fate of these banks are representatives of the US Treasury, the same agency whose officials brokered the Chrysler plan. In short, the government "asked" lenders to write off assets while at the same time holding a regulatory sword of Damocles over their heads.

The auto company restructuring deals make the legendary financial "Masters of the Universe", who once made billions by facilitating and structuring deals, look like rank amateurs. Saul Alinsky and the partners at Goldman Sachs would both be impressed with Obama's team.

A condition of TARP loans to GM and Chrysler granted the government the right to convert loans to Debtor-in Possession (DIP) financing. Since DIP financing is the most protected in bankruptcy, the US Treasury has the power to trump stakeholders at will. Obama used this leverage to take power from the investors and creditors and give it to the government and union as the restructuring was being negotiated.

Although both GM and Chrysler are likely to be forced into bankruptcy court by some objecting creditors, the reorganization details are not likely to change significantly. When the deals are consummated, Obama will have established control directly (US Treasury at GM) and by proxy (UAW at Chrysler) of two of the largest companies in the US. He will have erased the previously unmanageable corporate debt and amassed a huge cache of personal political capital.

Obama will have funded the juggernaut with taxpayer money and his ability to strong arm creditors. This would be the pinnacle of almost any Wall Street Titan's -- or community organizer's -- career. Obama is just getting started.

The Chrysler and GM reorganizations are certainly astounding in themselves. Leveraging existing bank regulations, TARP loan conditions and the bully pulpit, the administration was able to muscle creditors in an extraordinary way. These two reorganizations also show how Obama can nationalize all the major banks.

The bullied banks which walked away from billions in cash and stock will be forced to recognize the losses on their balance sheets. In order to maintain the proper asset ratio (i.e. asset value to loan value) these losses need to be replaced with new assets. Since the government is running the stress tests and setting the required asset ratio, the amount of capital needed by the banks will be determined solely the Obama administration.

The banks can object and comment, but they have little or no recourse in the courts. A long line of cases gives deference to the rulings of executive branch agencies when it comes to regulatory affairs. As long as the agencies are acting within the scope of their enabling legislation and are not "arbitrary and capricious" the regulators have free rein.

Given the state of the credit markets and the administration's shabby treatment of private investors in the Chrysler and GM deals, it is unlikely private sources of capital will be available to banks which have taken large amounts of TARP funding. Banks can sell off profitable units to raise cash, but this makes banks weaker in the long run.

For example, the US government already owned 36% of Citigroup at the end of February, 2009. This figure does not include additional stock the government might acquire after the GM deal, the Chrysler deal and stress test hits Citigroup's balance sheet. The Wall Street Journal on Saturday, May 2^rd suggested Citigroup would need an additional $10 billion following the stress tests. The government's stake in other major financial institutions is growing as well.

If the federal government is the only source of capital to the banks, the US Treasury or Fed will be able to set the terms without negotiation. There are no significant roadblocks to acquiring more power over the bank's internal affairs.

Obama has made it clear he is willing to use his political muscle on the banks as well. Politico reported on this meeting between bank CEOs and the Obama administration during the AIG bonus imbroglio:

Arrayed around a long mahogany table in the White House state dining room last week, the CEOs of the most powerful financial institutions in the world offered several explanations for paying high salaries to their employees - and, by extension, to themselves.

"These are complicated companies," one CEO said. Offered another: "We're competing for talent on an international market."

But President Barack Obama wasn't in a mood to hear them out. He stopped the conversation and offered a blunt reminder of the public's reaction to such explanations. "Be careful how you make those statements, gentlemen. The public isn't buying that."

"My administration," the president added, "is the only thing between you and the pitchforks."

When one Wall Street CEO raised the issue of paying back TARP funds to avoid public and government scrutiny Obama pushed back.

[JP Morgan CEO] Dimon also insisted that he'd like to give the government's TARP money back as soon as practical, and asked the president to "streamline" that process.

But Obama didn't like that idea -- arguing that the system still needs government capital.

The president offered an analogy: "This is like a patient who's on antibiotics," he said. "Maybe the patient starts feeling better after a couple of days, but you don't stop taking the medicine until you've finished the bottle." Returning the money too early, the president argued could send a bad signal.

Several CEOs disagreed, arguing instead that returning TARP money was their patriotic duty, that they didn't need it anymore, and that publicity surrounding the return would send a positive signal of confidence to the markets.

Regardless of the President's motives, the more money lent to the banks, the more stock under the control of the US Treasury and Federal Reserve. Anything that causes banks to take more government money moves them closer to direct government control. The administration has already announced a program which will do just that.

A significant player in the GM reorganization is company named Pimco. Pimco, either directly or through the funds it manages, is one of the largest bond holders on the planet. Pimco was also a significant GM bond holder until January of 2009 when it decided to leave the creditors committee and begin selling GM bonds. Pimco may have foreseen the government sponsored cramdown or they may have been tipped off. Whatever the case, Pimco has not been frightened enough to stop doing business with the administration.

Pimco has applied to participate in the US Treasury's toxic asset auction program. In this program, participants like Pimco will purchase assets from banks for a fraction of the value banks currently list them on their balance sheets. Pimco will manage and resell those assets and split the profit with the government.

Although the government will take half the profit, Pimco stands to make billions. Participants in the program like Pimco get a leverage of 12-1 with government backing. For every $1 of Pimco capital -- or more likely capital from investors -- they will be able to purchase $13 dollars of highly discounted bank assets.

Say Citigroup sells $20 billion dollars of troubled mortgages to Pimco for $13 billion. Pimco only needs $1 billion to purchase the assets because of leverage provided by the government. If Pimco sells the asset a few years later for $15 billion, Pimco and the government will each make a $1 billion dollars in profit. This is a 100% return on the $1 billion of Pimco capital leveraged to purchase $13 billion.

Many commentators including Paul Krugman (New York Times columnist, Nobel laureate and arguably the top progressive economist in the country) criticized the program for requiring too little private capital and too much government capital. So after seeing how savvy the Obama administration was in structuring the GM and Chrysler bailouts, why would they allow Pimco the ability to make billions? Why not keep the money to pay down the national debt?

The answer is Pimco's profit is coming at the expense of the banks. In the example above, Citigroup would be forced to take a $7 billion dollar loss on their balance sheet when Pimco purchases the troubled mortgages. As losses like these mount the regulators will force Citigroup and other banks to raise additional capital. As private investors become leery of investing in companies susceptible to government muscle the only source of additional capital to the banks will be the government.

Another benefit of Pimco's involvement to the administration is purely political. Pimco's activities could arguably be described as healthy "creative destruction" in a functioning capital market. If the Obama administration needs to provide the banks more financing it can be framed as a response to the excesses of capitalism. Of course, by pure coincidence the government acquires more control of the banking system as it responds to this excess.

The Obama administration will be able to make a plausible argument that nationalization of the banks was forced upon the administration by capitalism run amok. Given the type of patently absurd statements made by politicians of all stripes, this rather nuanced position will pass without a second thought.

In summary, the mechanism to nationalize the US financial system is now in place. All the levers are controlled by the executive branch. Here how it works:

1. The government determines various loses have eroded a particular bank's balance sheet and regulatory intervention is necessary.
2. The bank is ordered to raise additional capital to maintain the proper asset ratio.
3. Increasing government activism causes private capital to avoid investing in banks.
4. The government is "forced" to loan more money to the bank in exchange for more stock and control via loan conditions like those found in earlier TARP loans and legislation.
5. As government acquires more power they force the bank to accept loses to benefit key constituencies of the administration (like the UAW) or the sale of toxic assets to firms like Pimco.
6. If the government does not own the majority of the bank's stock return to step 1and repeat.

On May 5^th, Fox reported as many as 10 of the top 19 banks in the country will need to raise additional capital following the stress tests. The troubled asset auction program is expected to start within a few weeks. If the administration chooses to do so the largest banks in the country can be nationalized by the end of summer.

There is no additional legislative action required to allow the executive branch to continue on this path. The regulatory framework was reviewed and approved by the judicial branch decades ago. The public at large may not even notice what is happening. Anyone looking for strutting fascists will be disappointed; this revolutionary change will be brought about by clean cut men and women in pinstripes.

Tom Suhadolnik is a serial entrepreneur and management consultant living in Kent, Ohio. Tom can be reached at tom - at - suhadolnik.com

Obama's Pinstripe Revolution

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