woody_zimmerman_118_2007My own modest opinion-sample suggests that much of the public is confused about the Chrysler and GM bankruptcy proceedings. Both companies have filed for Chapter 11 protection. The Obama administration is pushing for a fast track, to get the companies reformed and their debt cleared. Chrysler filed a few weeks ahead of GM, so it is farther along in the process.

The point of confusion, as I divine it, centers largely on the nature of bonds and how they differ from stock. When you buy stock, you own a share of the company. If the company succeeds, that share gains in value. Conversely, if the company does poorly, that share of stock diminishes in value. If the company fails altogether, the stock becomes essentially worthless. Either way, the company does not have to buy back its stock. It is tradable on public markets at a price the markets set.

A bond, on the other hand, represents a loan to a company. A bond has both a "face value" and a market value. If you buy a bond whose face value is $1000, then the company owes you $1000. As on any loan, the company promises to pay specified interest at agreed-upon intervals - e.g., 8%, annually, paid every half-year. This means your $1000-bond will pay you $40 interest every six months on specified dates. A bond also has a "redemption date." The company promises to repay the face value of the bond to its current holder on that date. Bonds are called "secured debt" because they represent debt linked to the tangible assets of the company. Bondholders have a right to those assets - or their equivalent value in cash - if the company fails.

Bonds are also negotiable securities on public markets. They go up or down in market value as economic conditions change or as the company's fortunes wax and wane. If the company is doing well, its bonds increase in value because buyers feel more confident about the company's future. When an investor buys a bond above its face value, he effectively receives less interest than the stated coupon: e.g., if he paid $1100 for a bond of $1000 face value, then his effective interest rate = 8% x (1000/1100) = 7.3%.

But if a company is not doing well, or if the business climate is poor, bonds might sell below their face value. This increases the effective interest rate for the investor, but increases his risk. If he can buy that $1000 bond for $800, his effective interest rate = 8% x (1000/800) = 10%.

None of these market dynamics affects the redemption value of the bond, however. On the redemption date, the current holder receives the full face value of the bond, no matter where its current "market value" stands. If the company fails before the redemption date, bondholders are first in line to receive as much of their investment back as is possible from liquidation of the company's assets. A bankruptcy court handles that disposition. Stockholders might receive something for their stock, but they are farther down in the food chain.

Some citizens might think they don't know much about bonds. In fact, most of us are parties to bond-like transactions because we have mortgages on our homes. A mortgage is much like a bond that the bank buys to furnish an individual the cash to buy a home. It is "secured debt" - attached to the property on which it is lent. Like a bond, a mortgage has a fixed term, a fixed rate of interest, and a specified frequency and amount of payment. The borrower pays interest on the mortgage principal balance still outstanding.

In earlier times, mortgages were due in full, annually. On the maturity date, the debtor was liable for the entire loan principal, plus the accumulated interest. If he could negotiate a new loan, he could retain the property for another year. But banks were not obligated to lend for another year. If the bank declined to refinance, and the debtor could not find new money elsewhere, the bank could foreclose and take the property.

This contentious and disruptive practice ended when the fully amortized mortgage was invented in the 1930s. An amortized mortgage has a fixed monthly payment - a function of principal, interest rate, and loan term - calculated to cover accrued interest, plus payment on principal, each month. The principal is gradually retired over the specified term. Mortgages typically are let for 30 years, during which time the property cannot be repossessed unless the debtor becomes delinquent. This orderly process allows millions of people to buy homes and pay off their mortgages without the disruption of re-borrowing every year. Some economists call the fully amortized mortgage a key element in America's resurgence from the Great Depression. There can be no doubt that it has remade the economic face of the United States.

I mention all this about mortgages because it makes it easier for the average person to understand bonds in the context of the automobile companies' fairly confusing bankruptcy proceedings. (Some of that confusion certainly stems from inadequate reporting by journalists who don't understand the situation themselves.) An example might be instructive.

Suppose you own a home on which the bank holds a mortgage - perhaps a house worth $250,000, with a $200,000 mortgage. You're doing fine until financial reversals make it impossible for you to meet your mortgage payments on time. Instead of letting the bank foreclose and take the property, so it can recover its loan, you make the bank "an offer it can't refuse." First, you strip out all assets from the house - e.g., chandeliers, toilets, appliances, sinks, etc. - and sell them to traders in such items. You have the sod in the yard rolled up, which you sell, as well as various shrubs and plants. You also find someone who will buy the screened porch, which is dismantled and taken away. You keep the proceeds for future expenses. Then you negotiate with the bank to forgive the old loan at a rate of 30¢ on the dollar - i.e., about $60,000, which you ask to be rolled into a new loan. This allows you to keep the house. Will the bank go for this? (Anyone...?)

In Plan B, you sell the house to your son for $5,000. You keep the money but you excuse the buyer from the $200,000 debt. He lets you live in the house, and you enlist government to protect the transaction on grounds that it is good for the economy. The bank sues to protect its rights, but government mounts a demagogic campaign against the bank for its "greed." How about this deal? Will the bank go for it?

Of course, all this is absurd. No bank would conceivably take either offer - unless you had some scary, raspy-voiced guy named Vito show the bank manager the advantages of cooperating, as well as the "unfortunate" things that might happen if he resists. You can't bust up a property and sell it, piecemeal, because mortgage laws prohibit it. Furthermore, you cannot sell a home out from under its secured debt. Any 5th-grader will tell you that things just don't work that way.

A combination of these scenarios, however, in rough approximation, is what the federal government has offered to Chrysler's bondholders, who hold nearly $7 billion of the company's secured debt. Chrysler and its government "bankruptcy team" want to sell the company to the Italian carmaker Fiat, while paying its bondholders off at 29¢ on the dollar. Under government pressure, unsecured debt-holders - primarily the United Auto Workers - will receive nearly 60¢ on the dollar for pension funds the company owes them. Contrary to existing law and long tradition, this puts them ahead of bondholders for repayment.

Essentially, the Obama administration - solicitous of the interests of unionized workers - has rewritten bond contracts by fiat (so to speak). Most of the financial world is watching the spectacle with a kind of fascinated horror - wondering which part of financial contract law will be swept away next, but having no idea what to do. Parties that could be expected to contest this power-grab are mysteriously silent, causing this observer to wonder if "Vito" (from the government) has stopped in to warn them not to interfere.

In recent weeks, the State of Indiana - whose teacher-pension funds hold $42 million in Chrysler bonds - sued to stop the sale to Fiat, claiming that the 29¢-offer is too little. The bankruptcy court ruled against their suit, and an appeal to the U. S. Supreme Court has now been rejected. Thus, the Court has ruled, de facto, that the traditional obligations to bondholders - which have centuries of foundation in English Common Law - can be rearranged by presidential diktat. This makes the Chrysler deal a kind of "test case."

If the rearrangement of these contract laws is allowed to stand, private lending to business, via bonds, will suffer a serious - possibly mortal - blow. State and local government bonds will also be severely damaged as useful instruments of finance. Who will buy a bond after this fiasco? Mr. Obama might think investors are stupid enough to continue lending without a guarantee that bond-contracts will be honored, but he might be unpleasantly surprised to learn otherwise.

Our orderly system of debt, law and responsibility has collapsed - not with a bang, but with a whimper. Who would have imagined it, only a few months ago? Sworn to uphold the laws and Constitution of the United States, our president has broken his vow with this reckless move. Protection of property rights is a pillar of our freedoms. Mr. Obama's actions toward the Chrysler bondholders are a "high crime" within the meaning of the Constitution's impeachment clause. GM bondholders will be next. The Obama administration has already decided that they are only rich, old, bald guys who don't need that money. Other bondholders may be assured that their turn will come soon enough. There is nowhere to hide and no one from which to obtain succor.

These are dangerous times. Citizens inclined to think this is no concern of theirs should pause and reconsider. Who can know when his life savings - like those of many bondholders - will be taken next? Who will sound the alarm? An ignorant citizenry that doesn't know what a bond is? A bedazzled journalistic corps that thinks the Great One can do no wrong? We all need to wake up before it is too late. Business cannot be conducted without trust. And freedom cannot endure without stable, predictable law.