You've got to know when to hold 'em, know when to fold 'em...

The cardinal sin in poker, worse than playing dud cards, worse even than failing to figure your odds correctly, is (apparently) becoming emotionally involved in the game. Emotions such as charity, greed, hope and fear all get in the way of deciding correctly whether to hold or fold. All too often in the current financial crisis the hands that governments around the world have been dealt, have looked pretty awful on the face of it - broken banks, rising unemployment, increasing budget deficits and the like. In many cases, however bad these hands have been, governments have tended to underplay their cards for emotional reasons - fear often, but understandably, being the main emotional roadblock to an efficient playing strategy.

Often this emotive instinct has played into the hands of the notoriously hard-nosed - Goldman Sachs and others in the AIG shambles for example (see previous blog - http://aidan.neills.net/2009/03/real-aig-scandal.html). To take the poker analogy further - it should be far easier to be aggressive with a hand when you have most of the chips, no matter how bad the hand is. In most cases, as the lender of last resort, governments have been holding virtually all of the remaining chips in the casino that is financial markets, but have rarely used their position to the full benefit of their taxpayers who are funding their entertainment.

The poker game that has been played out over the Chrysler bankruptcy in the US, seen from a taxpayers eyes, should be quite heart-warming, as it appears to be one of the first occasions where the taxpayer’s hand has been reasonably played by their elected players. The Federal government holds virtually all of the available chips, or available capital in this case, and has exploited the situation to it's benefit, in a quite fantastic way. Most of the time it's the investment banks or hedge funds putting the government or other interested parties over the barrel. Not this time.

The struggle between the US government and its stakeholders began last year when Chrysler and GM faced a potential meltdown, unable to sell enough cars to justify creditors refinancing past loans via the capital markets. Chrysler went to the lenders that held 70% of its debt - JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley. It wanted to know whether they would lend more and if they would provide financing in case Chrysler filed for bankruptcy.

When each of these banks, in turn, said a resounding "no", Chrysler was forced to look to Washington for some Federal assistance. Last December, the Bush administration in its final desperate days, agreed to lend Chrysler $4bn as well as $13.4bn to GM. The Treasury gave Chrysler three months to reduce its debt and forge a cost-cutting agreement with the United Auto Workers Union (UAW).

In its first attempt to reduce its outstanding liabilities Chrysler went back to its lenders, and instead of asking for more money, asked them to agree to not get paid in full for their old loans. It wanted to cut the $6.9bn debt to $5bn, on the grounds that if it’s liabilities weren’t cut it would likely spiral towards a bankruptcy where the lenders would get much less than $5bn back.
This polite request was roundly given the two-fingered salute by the banks in question. With the government now involved in supporting Chrysler, the banks held out for more constructive talks with federal officials. The sense from the banks was that they could “game the government” in the process, as they sensed that the government wanted a liquidation of Chrysler even less than they did. This was similar to the situation with AIG, where the banks who had big exposures to AIG claimed that they would collapse if the government did not step in assume AIG’s liabilities. In the AIG case this brinkmanship cultivated government emotions (fear), which ultimately served those banks, but not the taxpayer, very well.

On the Obama side, the auto task force held minimal hope that all of Chrysler's 46 different lenders would agree to a compromise. Many of these interested parties were small hedge funds and distressed debt funds, most of whom had bought their holdings at a discount (i.e. less than 100% or "par value") in the secondary debt markets. With no consumer operations, these institutions had less reputation on the line that the big banks did so did not have to worry about being seen as the ‘bad guys’ who forced Chrysler into liquidation.

The view that the big banks could game the government (again) started to change when Obama very publicly talked about the possibility of Chrysler going into bankruptcy or even liquidation. The credibility of his words was increased by the more aggressive approach it was talking towards GM who’s chief executive, Rick Wagoner had just been pushed aside by the government. Acting like a bank that is a troubled firm's last hope, which the government effectively was, Obama sketched out what Chrysler would have to do to get more federal money.

On April 2nd, the head of the auto task-force, Steven Rattner, hosted a meeting of senior bank officers, where they heard presentations from Chrysler's CEO Robert Nardelli and Fiat’s CEO Sergio Marchionne. Fiat had been brought into the discussions as a potential operating partner for a restructured Chrysler. The 25 listeners were told that deals with Fiat and the UAW had almost been agreed – the ownership of Chrysler after the negotiations would be between Fiat, a trust fund run by the UAW and the American and Canadian governments. The deal, which could give Fiat up to 51% of Chrysler, was designed to increase Chrysler’s overseas sales and get Fiat to develop fuel-efficient vehicles in the US by 2013, an area where they had developed considerable expertise.

That fact that such progress had already be made in itself may have scared the room’s participants, but when the issue of the repayment of the $6.9bn in debt came up, the nausea would have truly set in. Steven Rattner looked at the lending group and said, "We have in mind for you a much lower number than the $6.9bn that is outstanding….$1 billion."

The $1bn figure wasn't the real maximum that the auto task-force was willing to pay - the figure they had in mind as their cut-off point was the amount the lenders would get in a liquidation of Chrysler assets - which was estimated by Chrysler earlier in the year at $2bn. Which given that the book value of Chryslers assets in their audited accounts had been given as $39.3bn shows both how illiquid the market for these assets is and also how daft some accounting measures are.

The bankers gathered in the room asked the government for projections of what a combined Chrysler-Fiat alliance would look like. In the following days, the lenders began to realize the strength of their negotiating position was weak and getting weaker. Only the government had the ability or willingness to finance a bankruptcy reorganisation of Chrysler, while also supporting its warranties and suppliers. None of the lenders had any desire to take over and liquidate the company, or to recapitalize it.

The lenders spent a week haggling over how to respond to the auto task-force position. The big banks at first proposed that the group offer to cut the debt in half and get no equity stake. That outraged some hedge funds and distressed-debt firms that didn't face the banks' broader concerns about reputation and that were accustomed to "street fighting" for their interests. The reply, sent April 20, reflected the hardening position of the hedge funds: The lenders would cut just $2.4 billion in debt, in exchange for 40% of Chrysler's equity.

The offer was duly and rightly rejected as the lenders were seeking much more than market value for their debt, which would have amounted to an unnecessary taxpayer subsidy. It was just 10 days until the government's deadline to reach agreements with the UAW, Fiat and lenders if Chrysler was to get more government money.
After receiving one more bank counteroffer, the Treasury on April 28 offered what it had planned all along, to buy out the lenders for $2 billion.

The big banks quickly agreed to the deal -- equal to 29 cents on the dollar. News that the big banks were accepting the offer leaked before they had told the smaller lenders. JP Morgan as lead negotiator for the creditors was intent on winning the required 100% approval from debtholders, to ensure that the deal went ahead and therefore the government had the option of avoiding a Chrysler bankruptcy filing. After a flurry of phone calls from JP Morgan, about 20 firms, mostly small hedge funds, voted no.

The following day, Barack Obama said Chrysler would file for bankruptcy. He blamed "speculators" who had turned down the $2 billion offer for their $6.9 billion of debt. “They were hoping that everybody else would make sacrifices, and they would have to make none. I don’t stand with them”, he said.

A few days later, the battle-weary holdout firms abandoned the fight as too costly, financially and politically, and agreed to the $2bn deal.

The government had won, after rounds of brinkmanship that could have induced poor decisions through the fear of ugly consequences. They had effectively played the banks and the hedge funds at their own game – a game that in the past has falsely resulted in taxpayer’s bailout money being used to compensate risk takers for the past mistakes that they have made. The banks and hedge funds made loans to a car company that was not well run, and did not perform - if the reverse had been true then they would have benefited. It’s fitting that they should bare risk and reward in equal measure.

This was a bad hand well-played.