Will Bondholder Haircuts Lead to More Market Disruptions?

A: No, I dont think so! For those that missed Charlie Rose Sunday night, he had a great panel including Bill Ackman, Professor Joseph Stiglitz, & Andrew Ross Sorkin. One topic of discussion talked about a possible unintended consequence in the corporate bond world should bondholders take the haircuts that everybody seems to want them to take in a restructuring effort. Add that to GM's offer this morning to bondholders asking them to exchange $27Bln in a debt for equity swap, and that negative consequence becomes eerily closer. But I don't think it would adversely affect the corporate bond market because the 'debt for equity' swap concept is in fact a very viable road to recovery here, and the upside seems to far outweigh any future dilution to common stock or other consequence of being a common shareholder in a better positioned corporation. Right now it's only talks and no actions, so time will tell what happens.

Ackman & Stiglitz were their usual selves discussing the issues we are facing and explaining optionsour system offers to do what needs to be done; restructure, reorganize, bring down debt via a swap for equity. And then Andrew Ross Sorkin brings up a very important point.

As everyone (including myself) calls for corporate reorganization / haircuts / debt restructuring, Sorkin sticks in a prescient point regarding the corporate bond market as a whole and a possible unintended consequence. Lets discuss that.

I enjoy discussions like this because you must ask the right questions based on the information you have at the time, and play devils advocate every once in a while to discuss what nobody wants to discuss. At least Sorkin is asking the right questions. For a moment, lets take the stainless steel constructed Delorean and go back in time & place to spring/summer 2007. Knowing what we know now, we should all agree that the alarm bells were ringing from a seizing up of the secondary mortgage markets (mainly for subprime RMBS), as subprime borrowers started to default. However, at that time many dismissed the problem as being minor and contained. Remember? If not, allow me to refresh your memory:

MARCH 2007 - Lehman Calls Subprime Mortgage Risks 'Well-Contained' : Lehman Brothers Holdings Inc., the second-biggest U.S. underwriter of mortgage-backed bonds, said risks posed by rising home-loan delinquencies are "well contained'' and will have little effect on the firm's earnings.

MAY 2007 - Bernanke Believes Housing Mess Contained: “Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market; troubled lenders, for the most part, have not been institutions with federally insured deposits,” Bernanke said.

JUNE 2007 - Freddie Mac Says Subprime Rout 'Severe But Contained': Freddie Mac Treasurer Timothy Bitsberger said the subprime mortgage slump is "severe but contained." The owners of bonds made up of subprime mortgages are mainly "large institutional players who can withstand the loss,'' he said.

The point of bringing up these headlines is to prove to you the lack of vision and creativity to put the pieces of the puzzle together at THAT TIME, in an effort to see what might happen down the road!

Back to Andrew Ross Sorkin's comment (6:22 min into video) as he tries to do just this, put the pieces of the puzzle together, in an attempt to see what may happen if a GM fails and bondholders take a beating:

"Its funny, you say Bill the bondholder, I should say Bill Gross the bondholder from PIMCO, and he is someone who has a lot of influence, as have other bondholders, who have suggested that the moment that you effectively force these bondholder to take a haircut or take a swap out into equity, you are going to undermine the entire bond market and you are going to see some kind of cataclysmic disaster. Now I'm not sure thats the case and as you have seen in some other bankruptcies, we have gotten through that. So at the end of the day, yes this would instill more confidence (referring to Stiglitz' comment to restructure and reorganize the distressed company) but there are people on the other side that say this will kill confidence."

So, Sorkin's point is that doing the right thing may have an unintended consequence to it that causes distress to the entire corporate bond market now that this type of capital really is AT RISK. He may be right and at least he is bringing up possible outcomes that not many are discussing now. I just dont agree with it.

GM bonds are already priced for a bankruptcy/reorganization. Ackman breaks down how converting more debt to equity for the largest 19 banks, should be utilized to over-capitalize the banks on a case by case basis. The whole video is worth watching.

ZeroHedge, who is on fire lately, discusses how bondholders are getting the shaft in this latest offer now that GM is in DeFacto Default:

It is odd that the administration is set on continuing its course of antagonizing creditors at the expense of bloated pension plans and workers. While Zero Hedge does not have any particular insight, bondholders are likely not going to be too happy to get the shaft, especially after the UAW (at least optically) receives yet another sweetheart deal, and, as always, bondholders have not been consulted on this development. A 90% tender acceptance ratio is likely a pipe dream but at least Obama can tell his Detroit and rust belt voters he did what he could, and it was Wall Street yet again that derailed the plan and was responsible for the massive job losses about to ensue. Scapegoat the creditors: nothing but politics.

Is an unintended war coming to the corporate bond market? Perhaps, but the prospect of longer term recovery now that the proper road is being taken seems to me to outweigh the negative side effects that come with added risk to what is already risk capital. I don't think it would 'undermine the entire corporate bond market'. But at least Sorkin is discussing one disaster in advance, with the hope of avoiding another major market dislocation in the future.