On a Crash Course With the Rule of Law

As noted in my post on the invariable failure of the Treasury’s PPIP initiative, it is impossible to coax liquidity from the sidelines if asset owners are unwilling to trade at a price approximating market value. In this case, banks perceive themselves to own a valuation call option, one where they hope time will boost asset values such that underwater (at least on a mark-to-market basis) securities have time to recover. While this is a negative approach supported by weak and ineffectual accounting rules, banks are not violating the rule of law.

Consider, however, the looming time bomb that is the Commercial Mortgage-Backed Securities (CMBS) market. With the hundreds of billions of 5 year paper originated between 2005-07, there is a huge refinancing requirement just over the the horizon. Many, if not most, of these projects are not readily financiable in today’s market environment. Further, the complexity of their capital structures has given rise to an array of misaligned motives that will invariably find their way into court. Think about the unrated, junior most layer of the capital structure. These investors, with expected IRRs at inception of 20%+, are looking at a zero payout at this point However, many also hold the servicing rights to the structures, and are charged with the responsibility of acting in the best interests of all debt holders. With the scepter of refinancing just 1-3 years out, all is not looking good. But with the hammer of their contractual rights and historically low interest rates, they are currently able to service the debt without the pressure of necessarily selling out, which is exactly what the AAA senior tranche would like them to do. So you have the AAAs who felt very secure in a liquidation scenario not controlling the timing or manner of liquidation, while the unrated z-bond holders are bust on a mark-to-market basis but holding most of the cards. At the end of the day the magic of securitization didn’t disseminate risk, it spread responsibility. And in the absence of a need to mark-to-market, the vehicles can continue to exist as members of the walking dead. Now that the day of reckoning is rapidly approaching, their legal construct will necessarily be tested. The General Growth Properties bankruptcy will be our first mega-scale test of whether these Special Purpose Entity (SPE) structures hold up. This is a clear indictment of the way these vehicles were established, and the blame lies squarely at the feet of the structurers (convoluted and conflicted, no?), the rating agencies (AAA-rated super senior? Really?) and the investors (were these documents ever read?). When all is said and done, the rule of law will show us the way. But if the courts determine that the legal underpinnings of the CMBS market were somehow flawed and that the contractual terms between the junior and senior creditors are abrogated, then what is an already complex and fractured market will only get worse with a seemingly endless stream of litigation and confusion.

Another train wreck is the auto companies. Chrysler is currently staring into the abyss, soon to become part of the Fiat family. In the meantime, Chrysler’s bondholders are in a game of chicken with the US Government, which would like to portray them as “obstructionist” and “putting their interests in front of preserving the company.” Well, duh. What else did the the Government expect them to do, donate their holdings to the Chrysler pension plan? The kind of coercion and stiff-arming going on here, if not amicably settled, will land the Obama Administration and recalcitrant Chrysler creditors in a pitched court battle, which could have ramifications for not just the auto industry but any sector where the Government seeks to get “enthusiastically” involved. Is restructuring under the Administration’s watch somehow more beneficial to all constituencies than under the experienced eye of the bankruptcy court? While the Administration has been pulling strings from the sidelines and tacitly engineering the bailout of the financial sector, it has steadfastly refused to force troubled institutions to face into their problems, whether through bankruptcy or radical restructurings of their businesses. The inconsistencies between the treatment of the autos and the banks is blinding, likely leading to suboptimal outcomes in both cases. Pussyfooting around with the banks. Wielding the hammer with Chrysler and GM. It just doesn’t make sense.

One thing is certain: while many transactional lawyers have found their business drying up, bankruptcy lawyers will be in strong demand for years to come. May heaven help us all…

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