The Day the Capital Structure Died | WHAT REALLY HAPPENED

The Day the Capital Structure Died

I'm stunned, I tell 'ya, stunned!We got word on the restrictions for paying back TARP:
Banks that want to return Troubled Asset Relief Program funds will have to demonstrate their ability to wean themselves off another major federal program, according to senior government officials, making it less attractive for some banks to return the money.
The other program, a guarantee of debt issuance offered by the Federal Deposit Insurance Corp., allows firms to borrow money relatively inexpensively. Banks have $332.5 billion of debt outstanding under this program, which began last fall.

Ok, that seems fair, right?

There's one small problem: The Government took a pole-axe to the debt market Tuesday afternoon with their second attempted complete invalidation of corporate capital structures in as many days; the first was Chrysler, the second GM.

Now this seems like a rather ignoble thing, and the Chrysler non-TARP bondholders are suing, as one might expect when priority is tossed in the trash can like a couple of wet rags.

But last year I was warning that if we were not careful these bailouts had the potential to destroy the debt markets in The United States. The reason was simple: once priority gets tampered with all bets are off because the essential purpose in the purchase of super-senior (or senior unsubordinated) debt is that you are protected by all the subordinated classes under you!

Let's take a hypothetical company "The Widget Co" (TWC) that has $100 billion in outstanding debt. $20 billion of it is senior unsubordinated (the top class for this particular firm) and then there are an assortment of subordinated issues under it containing the other $80 billion.

If TWC goes bankrupt (liabilities > assets), whether Chapter 11 or 7, the senior unsubordinated debt class should get all of their money back so long as the liabilites do not exceed assets by more than $80 billion dollars!

Since a debtholder can force a bankruptcy filing when there is a missed payment or other breach it is extremely unlikely that the firm will get 80 billion underwater before someone notices and nails them with an involuntary bankruptcy filing.

As a direct consequence of this senior debt is considered extraordinarily safe and due to that it is very cheap in terms of interest payments over the reference rate (e.g. 10y swaps if it's a 10 year non-callable bond, etc)

Well, now it isn't so safe any more! In fact there may be no differentiation between debt classes at all, and if the Treasury gets involved, you may find yourself staring at a 90% loss with absolutely nothing you can do about it.

The question is no longer hypothetical as it was when I first wrote about it when these bailouts started: If you hold debt in any firm that has received taxpayer assistance, thinking you're safe, exactly how well did you sleep last night? How well will you sleep tonight?

Bottom line: If you hold in any company that the government has interfered in beyond reading this Ticker, you're nuts. For proof of "how nuts" I direct you to those who thought they had priority in both Chrysler and GM, both of whom are now getting the pole-axe to the cranium.

Think it won't happen again?

Are you willing to bet 90% of your money on it?

The bottom line is that JP Morgan (JPM) and Goldman (GS), who have both recently issued debt "without government guarantees" have probably met that test and will be able to repay TARP.

Will anyone else be dumb enough to buy any other TARP'd banks' debt issues, given what just happened to holders of GM and Chrysler paper?

I'm not and you shouldn't be either.

Disclosure: No positions related to the subject matte