The United Auto Workers gave organized labor a beachhead in the American economy with the great sit down strikes of 1937. Some seven decades later organized capital is looking to expel what remains of the UAW from GM and at the same time complete the isolation of the trade union to low wage immigrant labor based segments of the economy and the public sector. A labor movement that does not have leverage in the most productive center of an economy cannot hope to influence national social policy or progressive politics.
Unlike the bloody Battle of the Overpass pictured above, however, today’s attack on labor is being wielded with complex financial instruments, instruments of fictitious capital. At GM, bond holders who hold credit default swaps have disrupted the ordinary incentive structure in a corporation entering the so-called “zone of bankruptcy”.
Traditionally, holders of bonds were deserving of protection as the company approached bankruptcy because insiders could be tempted to use their control over corporate resources to loot the firm and leave less for those who had a higher priority for repayment in bankruptcy. Thus, courts have held recently that as a company like GM looked more likely to need the protection of bankruptcy its board of directors would have a legal obligation to shift its ordinary fiduciary duty to protect shareholders to the bond holders.
But the emergence of derivative instruments like credit default swaps (CDS) has twisted our ordinary understanding of incentives in corporate governance. Credit default swaps are speculative instruments created to offer a way for investors to bet on the value of bonds that ordinarily would not be open for speculation. The purchaser of credit default swap “protection” pays an annual premium that amounts to several percentage points of the value of the underlying bond (perhaps 2% on a $10 million investment which translates into $200,000 in annual premiums to the “seller” of the protection). If a “default” event were to occur on the bond – such as the failure by the issuer of the bond to make an interest payment or in extreme circumstances outright default on the bond – then the seller of the CDS protection must pay the buyer of the protection a certain amount (typically the difference between the par value and the current (depressed) market value of the bond).
Hence, the term CDS: the credit is the original bond, the default is the event that triggers payoff, and the swap refers to the fact that by putting a CDS in place, the risk of owning the bond has shifted from the bondholder to the seller of protection. One huge seller of protection on bonds was AIG and it sold a huge amount of CDS protection on sub prime mortgage bonds that have now turned out to be worthless. That has obligated AIG to make good on its promises – which they are doing with taxpayer money.
At GM, it turns out that one default event that will trigger repayment to bondholders is the filing of bankruptcy itself. So investors who bought GM bonds at par, e.g., valued at 100 cents on the dollar now hold bonds that are valued at far less, perhaps 20 cents on the dollar. If GM files for bankruptcy then the seller of CDS protection to a GM bondholder would owe the bondholder at least 80 cents on the dollar, if not more as the bond fell in price. So on $10 mn of GM bonds the payoff would be $8 mn plus the $2 mn that the bondholder could get by selling the bonds. If the bonds fell to zero in price, the holders could get the full $10 mn.
That is just a simple example and there are lots of complexities in this situation. In fact, for example, GM bonds are trading at a different price points – somewhere between 6 and 12 cents on the dollar. There is a net exposure for sellers of CDS protection of about 2.4 billion dollars on a total of 34 billion dollars of outstanding CDS positions (sellers of CDS protection sometimes buy CDS protection themselves to hedge against events such as this, but unlike regulated insurers they do not have to have any actual cash reserves to use to pay off in case of such a catastrophic event.) CDS protection also requires an upfront payment that increases as the bond falls in value, so at GM it costs $5 mn a year to protect $10 mn in bonds today (4.5 mn upfront and then a payment of 5% a year or $500,000). Of course, that makes the bonds illiquid today or at least uninsurable.
But here is the key point: GM under US government pressure has offered current bond holders the “opportunity” to exchange their current bonds for common stock in a restructured GM. The bond holders would end up with 10 percent of the equity with the government owning 50% and the UAW’s VEBA owning 39%. Current shareholders would end up with one percent. Apparently, though, bond holders with CDS protection believe that their CDS payoff if GM files for bankruptcy is worth more than the eventual value of the 10 percent common stock position.
Now look at this deal from the viewpoint of current GM managers. If the bond holders turn down the exchange offer, GM files for bankruptcy which leaves the managers in control (they become in bankruptcy parlance a “debtor in possession”) and they get several months to put together a plan of reorganization. That may lead to the wipe out of the bond holders anyway but they won’t care because they will have received their CDS payout! But here is the magic: the payout to bond holders is not made by GM or GM managers – it will be made by the sellers of the CDS protection, perhaps AIG or JPMorgan, and perhaps with taxpayer dollars! Thus, GM is freed of its bond obligations paid off with “other people’s money” and they remain in control of the company now free to use the power of a federal judge to tear up the UAW contract and their remaining obligations to pay billions into the healthcare VEBA.
And once they have cleared their books of the bonds, the VEBA and the UAW, they are free to ramp up offshore production to India and China, as they have been planning for several years.
By the way, GM bondholders were warned of bankruptcy risk at GM when they bought their bonds. They got the benefits of mandatory disclosure of risk factors affecting GM when the bonds were first issued. But the rank and file members of the UAW who “bought” the proposed multi-billion dollar VEBA to manage their health care plan were told by UAW President Ron Gettelfinger that their health care would be safe from GM bankuptcy “for 80 years.” So no CDS protection was purchased by the UAW to protect its payment obligations from GM.
The Financial Times has more on this issue here. There is some interesting discussion of the issue on the blog Naked Capitalism here. And here is a video of an investor explaining how CDS protection is wreaking havoc in another bankrupt company.