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from Breakingviews:

Ally’s mortgage misery needs a clean ending

By Agnes T. Crane and Antony Currie The authors are Reuters Breakingviews columnists. The opinions epxressed are their own.

Ally Financial finally seems to have woken up to the need to get rid of ResCap, its ailing mortgage unit. Once the jewel in the former GM finance unit’s crown, the home lending and servicing operation has been a prime candidate for the bankruptcy court for years. ResCap has been on U.S. taxpayer-funded life support since 2008 - sucking up most of the $17.2 billion in aid the U.S. Treasury funneled to Ally. Now a Chapter 11 restructuring may finally be on the cards. But Ally needs to ensure its mortgage misery comes to a clean ending.

Bankruptcy ought to allow that. Back in 2005, Ally - or GMAC, as it was then called - revamped ResCap’s corporate structure so that it became a fully independent subsidiary with its own board and funding strategy. The purpose was to insulate the mortgage lender from any problems at GM and the auto finance arm. At the time, ResCap’s bondholders seemed perfectly satisfied they were protected.

Now, though, activist hedge fund Elliott Capital Management, which owns 2.3 percent of Ally, is questioning how watertight that arrangement is. It’s concerned a bankrupt ResCap could still drag its arms-length parent into another protracted mess. If that happened, Elliott argues, Ally would be embroiled in a flood of mortgage-related claims the hedge fund reckons could swamp the court. What’s more, Ally would have to duke it out with other creditors - its home-lending arm relies on its parent for $1 billion of secured loans and a $1.6 billion credit line.

Ally appears to think that’s less of a risk. According to Reuters it is considering whether to sell ResCap to another hedge fund, Fortress, through the bankruptcy process. If successful, that would remove most of the problem assets that caused it to fail the recent Federal Reserve stress test and may even put its mooted common stock offering back on track.

Taxpayers should cheer that: the unencumbered core auto business may be worth as much as $23 billion, more than enough to repay the $14 billion still owed Uncle Sam. But Ally Chief Executive Michael Carpenter needs to show that the risk of Ally being laid low by a ResCap bankruptcy is minimal. The last thing the firm, and taxpayers, need is for a bad decision to prolong its own pain.

from Breakingviews:

Hedge funds show banks how to recoup loans to Gulf

By Una Galani

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Hedge funds are showing banks how to get their money back from Gulf borrowers. Privately-owned Bahraini investment house Arcapita is following in the footsteps of General Motors and Chrysler by filing for U.S. Chapter 11 bankruptcy protection after non-bank creditors opposed extending a $1.1 billion loan facility due in March.

That’s an important first in a region grown accustomed to “extend and pretend” debt deals. In the three years since its debt crisis began, there has been no high-profile haircuts or debt-for-equity swaps – staple features in mature markets.

Dubai World, the region’s largest restructuring, benefitted from a massive government cash injection. Bank lenders only took an effective haircut after agreeing to be repaid their principal in full over a five-to-eight year period. Optimistic assumptions have already run Kuwait’s Global Investment House back into trouble on its original $1.7 billion debt deal agreed in 2009.

Arcapita isn’t a willing trail blazer. It wanted to delay repayment for three years. Most of the investment firm’s 50-odd creditors agreed, presumably keen to preserve local relationships. But hedge funds, thought to hold around 18 percent of the maturing security, were ready to take a tougher line. The threat of a forced liquidation prompted Arcapita, which owns assets around the world, to seek refuge.

Hedge funds may have wanted a quick pay off for loans that recently traded around 40 cents on the dollar through a capital injection. They might now need to wait longer. But at least all creditors should walk away with some certainty for full or partial repayment. Chapter 11 is designed to help firms rebuild a sustainable balance sheet. A solution based on Arcapita’s current liabilities, worth $2.6 billion, is likely to mean more upfront pain.

from MacroScope:

CDS and the self-fulfilling default

Wall Street-made financial instruments purportedly created to protect investors against default actually hasten corporate bankruptcies, according to a new study. And it’s not Occupy protesters bashing these credit default swaps (CDS) –  the report comes from none other than the New York Society of Security Analysts. Its findings are as follows:

We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. […]

Lenders who insure themselves by buying CDS protection help push borrowers into bankruptcy, even though restructuring may be a better choice for the firm from the conventional (without CDS protection) lenders’ perspective.

The problem, say the authors, comes down to a basic conflict of interest – creditors holding the securities suddenly hold an actual stake in the firm’s failure.

CDS could affect bankruptcy risk through two channels associated with the empty creditor problem. The first and direct channel is the effect on the willingness to restructure the debt, whereby creditors (over)insured with CDS break the link between cash flow rights and control rights. Empty creditors are unwilling to restructure the firm even if doing so is efficient for debt value as they can profit significantly from their CDS positions. Several theoretical papers model the empty creditor issue.  […]

The second and indirect channel of the empty creditor mechanism is reduced monitoring by creditors who are insured by CDS, and hence, less concerned about the credit risk of the borrower. Absent monitoring activity by creditors, managers can shift risk from shareholders to creditors, since this improves shareholder value, and thereby increases the probability of bankruptcy.

from Breakingviews:

Lehman is back! Is the financial crisis over?

By Antony Currie The author is a Reuters Breakingviews columnist. The opinions expressed are his own. If only 42 really was the answer to life, the universe and everything. That’s how many months Lehman Brothers languished in Chapter 11 protection. The Wall Street firm’s failure in September 2008 triggered a global financial meltdown. Sadly, the emergence of its ghost from bankruptcy three-and-a-half years later scarcely offers even symbolic hope that the crisis is truly over.

Lehman’s was neither a typical bankruptcy of the kind seen, say, at American Airlines nor a quickie reboot like the ones the government funded at Chrysler and General Motors. Instead, the firm offloaded its major businesses just days after going under - the asset management unit to its partners, the U.S. brokerage to Barclays, and the European and Asian operations to Nomura.

Since then, Lehman has been a humongous exercise in asset liquidation for debt holders to fight over. Creditors submitted more than $300 billion in claims and will probably recover around $65 billion over time. The process has been a steady source of bounty for lawyers and other advisers, who between them charged the defunct bank’s estate $1.5 billion in fees.

In the meantime, the worst of the crisis, in the United States at least, has become history. But the effects are lingering. Other failures from September 2008 are still struggling. Taxpayers have so far committed $180 billion to keep Fannie Mae and Freddie Mac afloat, with no sign of any meaningful reform. American International Group has at least paid back some of the aid it received, but managed only a 2.3 percent return on equity last year.

A mix of unresolved new regulations, a slow U.S. recovery and Europe’s sovereign debt crisis make profit hard to come by for banks and other insurers, too. It’s also unclear whether the financial system is now any better placed to cope with another Lehman-like collapse, despite the hopes attached to reforms in the United States and elsewhere.

Perhaps most tellingly, Western governments and taxpayers’ funds are now far more enmeshed in keeping financial markets functioning than for decades - and are likely to stay that way for some time. Lehman’s emergence from bankruptcy is a landmark of sorts. But for the future of the financial system, it’s irrelevant.

from Breakingviews:

Apax finds French twist on bankruptcy tourism

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Restructuring specialists have a lot to thank the UK for. The country’s creditor-friendly legal framework has drawn companies from across Europe to restructure in London. European Union law states that companies should use the insolvency regime relevant to their centre of main interest, or “comi” for short. But the concept is elastic; a Greek mobile telecoms company, Wind Hellas, was able to restructure in London by relocating one of its companies from Luxembourg to the UK.

Disgruntled creditors say the UK has become a bankruptcy brothel. Restructuring experts prefer to extol the advantages of UK law, which allows for smooth restructurings by disenfranchising stakeholders who are out of the money, such as shareholders or junior creditors.

Apax has found a new twist on this theme. When Marken, a logistics company it bought in 2009 for 975 million pounds, breached covenants at the end of December, it moved a unit of the group to France. Unlike the UK, French bankruptcy law and its restructuring framework, called sauvegarde, is considered borrower-friendly. Courts give greater credence to shareholders and employees, and it is harder to disenfranchise creditors whose loans are out of the money. Take Eurotunnel, where shareholders were left with value even though creditors took losses.

In practice, a so-called “comi shift” to France could be harder and less predictable than it sounds. Bondholders may threaten legal action. French courts could look askance at highly leveraged arrivistes, while documents drafted under UK law could create complications.

However, the move may give Apax, and other buyout houses in similar situations, a subtle edge in negotiations with creditors. In Marken’s case, the two sides will probably hammer out a deal without the company having to go through the trauma of sauvegarde. However, a high-profile example of a French comi shift and restructuring would create a precedent for other financial sponsors. With many private equity-owned companies creaking under high debt loads, sponsors may be tempted to explore all ways of stopping creditors from seizing control.

from MuniLand:

A municipal bankruptcy does not ruin a state

Chart source: Bonddesk

State politicians in Alabama, Pennsylvania and Rhode Island have lambasted municipalities within their borders that have either declared, or attempted to declare, bankruptcy. The politicians gripe that when a municipality in their state goes into Chapter 9 bankruptcy, it affects the cost of borrowing for the state and other issuers located there. But this rests on the false assumption that markets do not discriminate between different borrowers. Municipal bond issuers, like public companies, are looked at individually because every entity has its own story. After all, when American Airlines went bankrupt, it was not as if all airlines suffered.

Alabama Governor Robert Bentley explicitly used the increased cost of borrowing for other Alabama towns as a bludgeon against Jefferson County officials who declared bankruptcy last November. The Birmingham News wrote:

He [Governor Robert Bentley] said the county's situation already has affected borrowing throughout the state and he expects the bankruptcy to increase the cost of borrowing even more. "The credit rating of Jefferson County is terrible already so it can't get much worse, but certainly filing bankruptcy does not help," he said. "I know they were frustrated but at some point, you have to step up and have to be a leader and have to be a statesman and you have to do what's right. Bankruptcy is not right."

I remember thinking at the time that the governor seemed to be exaggerating the effect Jefferson County's bankruptcy filing would have on the state. In discussions with Chris Shayne, the senior market strategist at Bonddesk, the leading alternative trading platform, I asked if it would be possible to compare the yields of a bankrupt municipality with those of  its state. Chris and his team were able to pull six years of trade data and construct the chart above. Some amount of Jefferson County bonds and warrants are floating rate, so they have been excluded from the analysis. But you can still see that yields for the bankrupt county spiked way over the state's borrowing cost. In his analysis Bonddesk's Shayne said:

The main reason that the JeffCo bankruptcy was a non-event outside of Alabama is that it was not a surprise. The county has had well-documented financial troubles going back to the Great Recession of 2008. They were afflicted with a combination of serious problems, including heavy exposure to derivatives, fraudulent city officials, and difficulty raising new taxes. By the time they finally filed for bankruptcy protection last month, most observers were expecting the announcement. (It is also worth pointing out that neither JeffCo nor Harrisburg is large enough to roil the markets by themselves.)

The chart [above] shows that JeffCo yields increased substantially as soon as the trouble began to leak into the market. You can also see that prior to the distress in 2008 Jefferson County actually had lower bond yields than both the national median and the statewide median. Following the first sign of trouble, however, yields crossed over and remained elevated till they declared bankruptcy.

from Breakingviews:

Double-dipping Twinkies tarnish bankruptcy process

By Agnes T. Crane

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Wednesday marked a day of mourning for American junk food aficionados - and not for the first time. Hostess Brands, maker of the cream-filled bright yellow Twinkie snack, filed for Chapter 11 bankruptcy just three years after emerging from the court’s protection. That’s not just a kick in the gullet for Ripplewood Holdings, the private equity owner that sank $40 million into the baker last year. The company’s failure leaves a greasy stain on the American bankruptcy process itself.

Filing for Chapter 11 protection is supposed to give debt-laden companies a fresh start. General Motors, Chrysler, major U.S. airlines like United and others have used the courts precisely for this reason. It is easier to renegotiate labor contracts and ax unsustainable debt loads inside the courtroom. Hostess clearly didn’t go far enough in pruning its obligations the first time around. Its largest unsecured creditor isn’t a bondholder or bank; it is a pension fund. The company, in fact, blamed legacy pension and health benefit costs for its current predicament.

To be fair, Hostess isn’t the only repeat filer. Edward Altman, finance professor at New York University, tallies 215 so-called “Chapter 22” filings between 1984 and 2009. The main problem, it seems, is that companies are not emerging from bankruptcy in solid enough shape. One 2006 study found that firms had higher debt ratios compared with the industry standard even after substantially cutting their debt burdens in bankruptcy.

That’s hardly encouraging for firms like General Motors that have returned to the land of the living in recent years. Operating at a disadvantage when times are tough, especially if, like at Hostess, pension costs remain significant, is hardly ideal. Yet if a producer of baked staples like Wonder Bread and Ding Dongs can’t make it, investors should remain skeptical about just how effectively Chapter 11 can scrub away problems.

from MuniLand:

Can revenue bondholders relax now?

Bond markets generally focus on who has rights to specific cash flows and control over assets. That was what Alabama federal bankruptcy court Judge Thomas Bennett was addressing when he issued an opinion Friday afternoon covering the insolvent Jefferson County sewer system.

To recap the situation in Jefferson County, re-read what I wrote in November:

Last year, amid the county’s fiscal and political meltdown, the Russell County Circuit Court appointed a water system professional, John Young, to take over the management and operation of the sewer system. This action came at the request of the bond indenture trustee, the Bank of New York, which wanted the bond payments protected. Now the county is fighting with the receiver and creditors for control of the sewer system in bankruptcy court.

The crux of Judge Bennett's ruling related to whether the sewer receiver, John Young, could keep control of Jefferson County's most important asset, the sewer system, while the county was trying to consolidate its assets in the bankruptcy process. Bank of New York and other bondholders argued that the federal bankruptcy proceeding could not trump judicial actions taken at the local level. In other words BoNY, representing bondholders, wanted to keep the control of the sewer system and its cash flows. Although revenue bondholders have a lien, or right, to the cash flows of the sewer system, they also wanted control of the asset.

Judge Bennett, in his ruling, confirmed the right of bondholders to receive the revenue payments they are due from the sewer system. This will make the municipal markets cheer because it confirms an important plank of the system. On the other hand, the judge also ruled that control of the sewer system must be returned to Jefferson County. Bondholders would have preferred to keep control of this asset, which was collateral for the bonds.

Chapter 9 municipal bankruptcy cases are rare and market players closely watch the outcomes. The judge made a sound ruling today and the case will grind on. Jefferson County is not yet out of the woods but the path is becoming a little clearer.

Kind thanks to the Birmingham News for posting Judge Bennett's order.

from MuniLand:

How Jefferson County trips up national reporters

The New York Times really needs to improve the quality of its reporting on the municipal bond market. Mary Williams Walsh makes such a terrible hash of the situation in Jefferson County, Alabama, that she is bound to set off another muniland hysteria in the mold of Meredith Whitney.

In the opening paragraphs, Walsh contends that general obligation bonds (GO) issued by state and local governments and with the pledge of their "full faith and credit" may not be as creditworthy as always assumed. About half of the $3.7 trillion municipal bond market is general obligation bonds. She dramatically states that investors who own GO bonds might be in for a "surprise:"

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

What goes unmentioned is that the halted debt repayment is happening in the context of an insolvent county in bankruptcy. More importantly, general obligations bonds can be very high-quality from a strong issuer with top credit ratings, or they could be very low-quality from a near-insolvent municipality with the lowest possible credit ratings. The type of the bond is no assurance of ability to repay bondholders.

The point of a municipality seeking bankruptcy court protection is to halt the legal actions of creditors, including GO bondholders. This gives debtors time and a safe space to reorganize their finances. It's not in any way "breaking with convention" to halt paying GO bondholders in bankruptcy.

The U.S. Federal Court system's bankruptcy guide (page 49) describes Chapter 9 municipal bankruptcy:

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

from MuniLand:

Lessons from MF Global

The October bankruptcy of MF Global has been the subject of several Congressional hearings recently. 38,000 MF Global clients lost $1.2 billion in the collapse, and numerous regulators, as well as the Department of Justice, have been trying to unravel hundreds of thousands of transactions to discover how this client money disappeared. Weeks later, it's still unknown whether clients will have their funds returned or whether any laws were broken. What is certain, though, is that even after the passage of Dodd-Frank, our regulatory system has large supervisory gaps.

The derivatives and futures businesses in which MF Global operated are complex, and it's easiest to understand the firm as a large transaction processor that served its futures clients by connecting them to exchanges around the world. MF Global was both a broker-dealer and a futures commission merchant, meaning it was regulated by the SEC as well as the CFTC. In addition, MF Global was overseen by the Financial Industry Regulatory Authority (FINRA) and the CME, two self-regulatory organizations empowered by the SEC.

The big problem with oversight of MF Global within the U.S. is that there were too many regulators with only a small window into the firm's activities and none with the ability to see the full scope of risks and capital of the holding company. How can we fix this?

The U.S. Chamber of Commerce recently put out a report by a long-time SEC official that recommended a number of softball procedural and structural changes for the SEC, like increasing the number of Commissioners from 5 to 7 and appointing a deputy chairman who would be responsible for operations and management. The report also recommended using cost-benefit analysis at the beginning of the rule-making process and after a rule had been implemented. It was thoughtful and well-meaning but wholly overlooked the fact that modern-day financial firms are geographically unbounded and make their profits often by arbitraging the regulations of one country against another. Big financial firms have enormous legal departments to beat back regulators and ride as close to the law as possible.

There are other, harder-edged ideas floating around about what is needed to regulate sophisticated, globe-spanning firms. From the blogger Epicurean Dealmaker:

... I fleshed out my proposal by suggesting regulators get hired from Wall Street banks, big law firms, and elsewhere. An effective wholesale financial regulator should be comprised of forensic accountants, corporate and securities lawyers, investment bankers, derivative structurers, and the like. They should all be paid market rates for their services, which will make their compensation much, much closer to that of the people they regulate. They should be prohibited from accepting positions in private financial industry—and, most especially, at any individual firm they ever directly or indirectly regulated—or firms working for financial firms (law firms, accountancies, etc.) for a minimum of at least three years after they leave government service. Five would be preferable.

While individually expensive, I don't believe you would need to hire many such people to make this kind of regulatory regime work. Given that you really only need high-powered regulators for the very biggest institutions, I am guessing you could get away with fewer than 100 to start. In fact, it might be less, because you really only need these people to direct and train their junior staff, and to interface directly with senior executives of the regulated entities. Fully loaded, I imagine you could fund a financial regulatory SWAT team like this for less than $150 million per year. That's a drop in the bucket compared to the financial losses these supposedly regulated institutions have already inflicted on the American taxpayer, not to mention in comparison with the normal run rate of your average stodgy, inefficient, and ineffective government bureaucracy. Even better, you could fund such an agency with a levy indexed to the size of each financial institution under its jurisdiction. The larger and more complex a bank, the more fire-breathing, table-throwing, nail-spitting investment bankers and lawyers you could afford to throw at it. Talk about an incentive to shrink your balance sheet.