Sunday, April 5, 2009

Are Creditors Sharing the Pain???

Tyler Cowen's NYT's article, titled,  Why Creditors Should Suffer, Too, slides over some fairly common misperceptions.  First, the counterparty issue:
The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.
These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.
First, these are primarily counterparties, not creditors. They bought credit default swaps from AIG on multi sector super senior CDO's.  The counterparties used contracts that provided for collateral to be posted based on both the rating of AIG and the market value of the underlying CDO.  Because of this, they were largely protected from any deterioration in AIG's financial position.  In fact, by the time these were settled, the counterparties held about 50% of the face value of CDO's.
Thanks to an exemption from the Codes automatic stay - which bars all other creditors from terminating contracts with or seizing assets from a firm in bankruptcy - counterparties to derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money.
It isn't clear what the actual losses are on the underlying credits, but the counterparties were very aggressive in demanding collateral, and may have held enough to completely avoid loss, regardless of AIG's future financial status.  So it was not possible to cram down losses to the counter parties on the most problematic AIG CDS's.  In fact, it was the continuing demands for collateral that precipitated AIG's initial cash problem in September.  

One could argue that the entire credit derivatives market should be eliminated or regulated, but at the time, the counterparties were fully collateralized and had no net risk.  

As far as the creditors, they have faced some steep haircuts already.  Citi put together a deal to essentially force holders of convertible preferred stock to swap it for equity.  Right now, Citi exchange traded debt sells for about 25 cents on the dollar, so to say they aren't sharing the pain isn't accurate.  From their press release
As announced on February 27, 2009, Citi is seeking to exchange approximately $27.5 billion in public and private preferred securities with a commitment from the U.S. Treasury to convert up to an additional $25 billion of its preferred securities for common stock. Assuming full participation of public preferred shareholders, Citi will convert into common shares approximately $52.5 billion in aggregate liquidation preference of preferred shares.
Exchange traded debt for Bank of America is currently selling for 50% of par. These shares sold at close to par within the last year, so the markets see the debt as being distressed.  Here are quotes on some BAC issues, which all have a par value of $25:

BAC-W BAC Capital Trust I $13.15
BAC-V BAC Capital Trust II $13.04
BAC-X BAC Capital Trust III $13.44
BAC-U BAC Capital Trust IV $11.11
BAC-Y BAC Capital Trust V $11.47
BAC-Z BAC Capital Trust VIII $11.29
BAC-B BAC Capital Trust X $11.40
BAC-C BAC Capital Trust XII $12.72

The markets are saying that the debt is distressed, and this exchanged traded debt trades frequently and in significant volume. Before encouraging the Treasury to push for some sort of concessions on these issues, don't forget that the original TARP invested public money in BAC preferred, pari passu with the existing preferred issues.  If it is necessary to convert shares similarly to Citi, it should be done by all means.  However, any debt above this level in seniority would require the more junior debt to take the first loss, and the Treasury needs to make sure that this step is essential.  

The equity goes first, then the preferred, and then the senior debt.  This is simply the capital structure of the bank, and losses must be taken in order of seniority.  This is the case, in or out of bankruptcy.  

All debt holders have taken a market loss so far.  The idea that they are being sheltered is exaggerated.  In addition, the senior debt holders aren't necessarily the enemy.  They are pension funds, mutual funds, etc.  Protection of the debt holders is, in some respects, an unintended consequence of a bailout, but it may well be fortuitous rather than unfortunate. 


Thomas Esmond Knox said...

If an insurance company (say, AIG) refuses to pay a valid claim, it won't be an insurance company for long.

Obama and "the 328 braying yahoos in Congress" (Holman Jenkins) urged AIG not to pay valid claims- go figure.

cap vandal said...

It is impossible to know what would have happened if they had just let AIG fail, but it would have made Lehman look like a picnic -- in my opinion.

The counterparties already had most of the money to make themselves whole on the CDS swaps.

People don't seem to want to let details get in the way of a theory or point of view.