GMAC, the Fed, and Moral Hazard

The GMAC announcement on December 10 was quite unambiguous. The headline alone told you everything you needed to know:

GMAC Announces That the Results of Its Exchange Offers Are Insufficient To Meet Regulatory Capital Requirements To Become a Bank Holding Company

GMAC went on to explain:

The Federal Reserve has required GMAC to, among other things, achieve a minimum amount of total regulatory capital of $30 billion in connection with its application. In order for such condition to be satisfied, among other things, the estimated overall participation in the offers would be required to be approximately 75% on a pro rata basis. The Federal Reserve has informed GMAC that if GMAC is unable to meet these capital requirements, it will not approve GMAC's application to become a bank holding company.

As a result, GMAC extended its offer to bondholders until December 26, in what I thought at the time was a game of chicken between GMAC's bondholders and its majority shareholder.

On December 24, with the tender offer over in all but name, the Fed announced that it was going to allowe GMAC to become a bank holding company after all. It was clearly in close contact with GMAC: did it have inside knowledge that the 75% acceptance level had been reached? Or was the Fed's decision contingent on that happening?

Actually, it turns out that the Fed was happy to let GMAC become a bank regardless of whether or not the tender offer succeeded. In the game of chicken, neither the bondholders nor Cerberus needed to blink, since the Fed simply climbed down from its previous stance. Bloomberg reports today:

The Federal Reserve last week approved GMAC's application to become a bank holding company. GMAC said yesterday that the Fed's approval didn't hinge on the debt swap.

Yep, a 180-degree about-face from its stance a couple of weeks ago. Back then, it was crucial that the debt swap go through in order to get Fed approval; now, it really doesn't matter either way.

It's actually worse than that, though. The Fed clearly spent a large amount of time approving GMAC's application to become a bank holding company: the order announcing the fact is 15 pages long, and densely-argued. But it looks very much as though the Fed delayed making the announcement until the bond exchange was all but over: it essentially conspired with GMAC to keep the decision secret so that GMAC could continue to threaten bondholders with the Fed's earlier statement and thereby get them to tender into the exchange.

Now the Fed is actually quite good at keeping secrets. But it's also very close to Pimco, which was the largest of the bondholders refusing to tender into the exchange as of December 10. Did Pimco stay out of the tender offer to the end? Did they know or strongly suspect that GMAC would be allowed to become a bank holding company even if the exchange offer failed? Are they now essentially free-riding on all the bondholders who took the Fed's earlier statement at face value, and tendered into the exchange believing that the only other option was bankruptcy?

These are important questions, because this is not the last time that bondholders are going to be asked to give up money they're owed in order to save a company. In fact, a much bigger bond exchange is looming: one from GM itself. And nowhere are moral hazard considerations more important than when it comes to the tactics of distressed-debt exchanges. If a bailout is coming anyway, then a smart bondholder will always stay out of any exchange. And if most bondholders are smart, then no distressed company can effect a significant debt reduction without declaring bankruptcy.

The Fed has set a nasty precedent here -- one which will make it much harder for GM to negotiate effectively with its bondholders. The government is now so deeply invested in both GM and GMAC that it's hard to see how it won't blink a second time if and when bondholders refuse to go along with their debtor company's restructuring plans. Which raises the specter of the worst kind of bailout of all: one in which the primary beneficiaries aren't GM's workers and dealers, but rather its bondholders, who have been paid very well in recent years to take GM default risk.

There's one other option. GM is still current on its debt payments, which means it is allowed to buy up its debt at distressed levels in the secondary market. Since GMAC now has access to Fed liquidity, there might be some way in which it can start buying up those bonds and cancelling them. But even that would consitute a rescue of holdouts who don't sell at these levels and just hold on to their bonds.

This whole tale is really rather sordid -- as Henry Blodget says this morning, it even approaches the level of an illegal check-kiting scheme. I do hope that come January 20 we'll see no more deals like this one. But I'm not holding my breath, especially given that Tim Geithner must have signed off on this decision.