The Hedge Fund Empire Strikes Back

The role of hedge funds in the bankruptcy of Chrysler and GM will probably be discussed and studied for some time.  It’s not often this POTUS singles out a Financial Institution for scorn since they’ve all been major donors to his campaign but POTUS made an exception when announcing the Chrysler bankruptcy.  Evidently, POTUS was not amused that a few of them would not bend to his will on the deal.

The most interesting thing is that the spoilers are now responding.  They are not only responding, they are making it clear that the group the cut the deal were TARP fund babies and they were not.  They are actively referring themselves as the No-Tarp Gang just to make that perfectly clear.

Also, interesting is the tone of the coverage concerning the bankruptcy.   A Motor Trend blog has a headline screaming  Chrysler Bankruptcy “Cruel” Result of Hedge Fund Greediness. Motor Trend obviously has more interest in the Car Makers than the Deal Makers and there in lies the rub.  The government-brokered deal, led by four of the biggest Tarp Babies, puts interests that are usually at the back of the line in corporate bankruptcy at the front.  Basically the union employees could potentially lose it all in the bankruptcy court.

This deal, turns the entire idea of the safety and primacy of bonds in a bankruptcy deal upside down which could argueably further destabilize financial markets. So, before you accuse me of being anti-union here, which I’m not, let me talk about that.   Bonds are usually first in line in any bankruptcy.  It’s why they are considered less risky and yield less than their riskier cousins, the equities.  Folks that buy corporate bonds play an important role in the market.  They provide corporations with huge, long term sources of cash at better terms than any one of them could get from a bank.

If a deal can be cut that undercuts the nature of bonds, what would this mean to other bond holders in other deals that are likely in the bankruptcy pipe?  (This would include GM and other industries.) Could this deal actually destabilize the primacy of bonds in the bankruptcy hierarchy?  Is that what the fuss is about?   Are they being greedy?  Are they looking out for their investors?  Are they posturing?  I don’t think we quite know yet. But, the Hedge Funds spoke up as reported in today’s WAPO.

President Obama’s harsh attack on hedge funds he blamed for forcing Chrysler into bankruptcy yesterday sparked cries of protest from the secretive financial firms that hold about $1 billion of the automaker’s debt.

Hedge funds and investment managers were irate at Obama’s description of them as “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

“Some of the characterizations that were used today to refer to us as speculators or to say we’re looking for a bailout is really unfair,” said one executive who spoke on condition of anonymity because of the sensitivity of the matter. “What we’re looking for is a reasonable payout on the value of the debt . . . more in line with what unions and Fiat were getting.”

George Schultze, the managing member of the hedge fund Schultze Asset Management, a Chrysler bondholder, said, “We are simply seeking to enforce our bargained-for rights under well-settled law.”

“Hopefully, the bankruptcy process will help refocus on this issue rather than on pointing fingers at lenders,” he said.

I supposed that I don’t have to tell you that hedge funds are not charitable organizations but many of them actually invest for charitable organizations, along with unions and state and government workers.  Their clientele can be anything from a small group of rich investors, to  you and me, actually. We’ve heard a lot about them recently but most people, I’d speculate, don’t know a lot about what they are and what they do.  Hedge funds came onto the scene in the 1950s and what mostly defines them is their regulation regime.

Here’s an easy definition from a website at the University of Iowa.

“Hedge fund” is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term “hedge fund” refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.

Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. However, they are regulated in significantly different ways. Up until 2005, hedge funds in the United States often relied on Section 4(2) and Rule 506 of Regulation D of the Securities Act of 1933 to avoid having to register their securities with the Securities and Exchange Commission of the United States (SEC).  Further, to avoid regulation regarding mutual funds (a type of “investment company”), hedge funds relied on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. In short, hedge funds escaped most U.S. regulation directed at other investment vehicles such as mutual funds.

European nations regulate hedge funds by either regulating the type of investor who can invest in a hedge fund or by regulating the minimum subscription level required to invest in a hedge fund. In the years to come, experts are predicting the rise of an alternative regulatory framework that will be tiered yet flexible.

If you follow that link you will see that there are many many types of hedge funds with a variety of goals.   Not all hedge funds are active in derivatives markets or speculative activities.  Some are highly speculative and use a lot of leverage.  Others are very conservative and use no leverage at all.   There are classifications that will indicate the level of risk pursued by the fund manager.  So, these fund managers may just be representing your interests or mine or some other agenda we haven’t found out yet.  POTUS defined them as ” hold outs” that were hoping “for the prospect of an unjustified taxpayer-funded bailout. ”   He said, “They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don’t stand with them.”

What POTUS didn’t mention is that the other lenders are currently being underwritten by the taxpayers.  The deal was basically cut by  4 huge banks that were TARP and TALF recipients.  I believe that I hold a large cap fund in my state retirement plan that is one of the ‘hold-out’s’ although I haven’t had time to check yet.  (Given the state of my retirement plan right now, I’d like to not lose any more to any one at the moment too.)  So here’s a spokesman for the hold-outs as quoted in that WAPO article.

Geffner added that Obama’s remarks made it difficult for the lenders that rejected the offer to speak publicly for fear of appearing “anti-American.”

Indeed, a group of lenders issued a statement yesterday — but did not identify its members. The group said it included approximately “20 relatively small organizations” that represented “the country’s teachers unions, major pension and retirement plans and school endowments who have invested through us in senior secured loans to Chrysler.”

The funds hold about $1 billion in Chrysler bonds and have turned down the government’s terms. The government would have paid just under a third of the value of those bonds. However, many funds bought the bonds at deep discounts from other investors who feared the bonds might ultimately be worthless.

A few firms stepped forward to defend themselves openly. “OppenheimerFunds sought fair treatment for the shareholders of our funds and we were willing to make very significant sacrifices to reach an agreement,” the firm said in a statement. But it said the government “unfairly asked our fund shareholders to make financial sacrifices greater than those being made by” other creditors. The firm said its bonds “are entitled to priority in long-established U.S. bankruptcy law.”

Here’s Steven Perlstein, also of WAPO, denouncing the hedge fund managers response to POTUS.  It is vitriolic, to say the least.  But he does have to admit they have a point, even if it’s not a politically correct one.

The creditors are right when they say that Obama offered a sweetheart deal to Chrysler’s employees and retirees, who as unsecured creditors would have stood in line behind banks and hedge funds in a liquidation and would probably have received nothing. It’s also true, as the unhappy creditors point out, that it was the above-market wages and benefits negotiated by the United Auto Workers that helped to bring Chrysler to the brink of bankruptcy in the first place.

But those arguments are really beside the point. If the U.S. government wants to lend billions of dollars to help save the jobs, pensions and health benefits of hundreds of thousands of workers, that is certainly its prerogative. And it doesn’t have to extend the benefits of that bailout in equal measure to the banks and hedge funds that stupidly lent $6.9 billion to finance a highly leveraged buyout of a long-troubled automaker.

The only “fairness” test that the bankruptcy judge must apply is to determine whether those secured creditors will get as much from the government’s proposed reorganization plan as they would from selling off the company in pieces. It shouldn’t take a judge more than a few weeks to conclude that 30 cents on the dollar is the best they’re going to do.

If there is anyone who can claim to have been treated unfairly in this process, it is us taxpayers.

What is really odd in all of this, is that if the deal was approved by around 70% of the stakeholders, chances are the bankruptcy judge won’t over turn the deal.  If the hedge funds do get more, it’s probably going to amount to pennies.  This makes me wonder if more is at stake here than meets the eye. The WSJ shares some insight:

In speaking specifically about Chrysler, Obama was singling out three institutions – hedge-fund managers Perella Weinberg Partners LP and Stairway Capital Advisors LLC, and mutual-fund operator Oppenheimer Funds – which are publicly known to have been part of the group that rejected the Treasury Department’s $2 billion debt reduction deal.

While Perella Weinberg and Stairway didn’t immediately return calls seeking comment, the group of 20 creditors to which they belong, calling themselves the “non-TARP Chrysler lenders,” told their side of the story in a press release. The group refers to themselves as non-TARP to distinguish themselves from the large banks that have received government bailout funds and agreed to the Chrysler debt restructuring terms.

The group said it offered to take a 40% haircut on its investment, even though some groups down the legal priority chain were “being given recoveries of up to 50% or more and being allowed to take out billions of dollars.” The group said its proposals were rejected or ignored.

“The government has risked overturning the rule of law and practices that have governed our world-leading bankruptcy code for decades,” the statement said. The group says it has a fiduciary obligation to its investors, naming specifically “many of the country’s teachers unions, major pension and retirement plans and school endowments” that invest with those creditors. The group invests in $1 billion worth of Chrysler loans. Oppenheimer put out a statement echoing many of the same things said by the group.

Other hedge-fund companies owning Chrysler loans, including Elliott Management Corp., took the government’s deal.

A person at a hedge-fund firm that owns Chrysler loans, speaking anonymously, told Dow Jones Newswires that the difference between what loanholders would get in bankruptcy and out of bankruptcy wasn’t that much, meaning the non-TARP lenders are making a political statement more than anything.

“Are they taking reputational risk for pennies?” asked the person. “Do the math on the recovery levels. It doesn’t make sense for them to have held out for purely economic value.”

However, the New York Times is still speculating today that the group is just hoping for a better deal in the bankruptcy court.

“There are reasons to hope it will work out that way. In particular, a judge may be unwilling to favor the dissident bondholders when other significant stakeholders have been able to come to agreement outside of court,” The New York Times said.

Bankruptcy always contains some element of unpredictability, and the minority of debtholders who oppose the new arrangement could argue in court that the company is worth more to them in liquidation. Mr. Gapper argued that the holdout creditors may even “have a better chance of getting improved terms from the bankruptcy court than the US administration would have us believe.”

Frankly, I think the WSJ may be on to something.  There has been a good deal of pushback coming from the many firms and banks that don’t need the government money.  Some that took advantage of TALF and TARP funds are now attempting to return them because of after-the-fact changes made by the government, only to find the procedure difficult and costly.  Remember for every loser in a deal, there is a winner.  It may be that some of the funds just want to signal their vitality to investors as well.  This definitely seems like a power play to me which could explain our  petulant Potus.