Chrysler Battle has Important Implications

Good Evening: Last Thursday evening, U.S. stock market bulls were fretting an aborted attempt to launch the S&P 500 into the green for the year. I speculated then that some undaunted bulls might trot out another rocket and try again on Friday. So they did, achieving a decent launch profile at Friday’s closing bell. The booster phase commenced today, and a broad rally lifted most of the major averages into an orbit that leaves them higher than where they finished 2008. Achieving these heights so quickly after Thursday’s disappointment, the bulls are no doubt in receipt of some envious stares by the engineers at NASA. But as the heat and high fives dissipate, there are some forces at work that may some day lead to orbital decay and re-entry for the indexes. The battle for Chrysler has some very large implications.

Amid reports that the swine flu might soon begin a decay of its own that might prevent it from continually hogging the headlines, global stock prices were up overnight. This rally was likely helped along by a positive economic release in China showing stronger export activity. The resulting strength in Asia, coupled with the afterglow surrounding this weekend’s Berkshire Hathaway annual meeting, had U.S. stock futures solidly in plus territory as Monday’s open approached. Prices might have been higher still if not for reports that the Obama administration was seeking to close a variety of corporate loopholes in order to raise approximately $200 billion over the next 10 years (see below).

The major U.S. averages popped 1% at the open and then received additional thrust in the form of friendly economic data (see below). Construction spending, which had been pegged by economists for a 1% drop, unexpectedly rose 0.3%. But the number that really seemed to combust an ardor for equities, especially ones of the financial variety, was a 3.2% jump in pending home sales. Since pending sales lead actual sales, many hoped this data point was just the latest evidence that Jim Cramer’s forecast of a bottom in housing next month would indeed come true. Just what price concessions may have been needed to generate this relatively mild uptick in sales activity weren’t made available, but the release sure lit a fire under the bank stocks. Adding to the tailwind for financial stock was a New York Times article that reminded readers how low the bar has been set for the results of the stress test due out later this week. In response to all this good news, the KBW bank index was up almost 15%.

The averages seemed to pause over the lunch hour and then kept trading mostly sideways as the closing bell approached. During the final 30 minutes, however, the S&P 500 convincingly broke out above resistance at 900 and the Russell 2000 shot above the 500 mark. All the indexes finished smartly ahead for the day, with the NASDAQ (+2.6%) and the Dow Transports (+6.8%) bracketing the results. Internal market measures were also strong, with 10 stocks advancing for every one that declined. Volume wasn’t gaudy, but it was solid. Treasurys had an unspectacular day, as the Fed’s largest purchase yet ($8.5 billion) of government debt kept prices and yields near the unchanged mark. The dollar continued its recent, tail-between-the-legs creep lower, while commodities tried to keep up with stocks. Nice gains in the energy and metals sectors enabled the CRB index to finish with a gain of 1.5%.

When Chrysler first sailed on to the rocks 30 years ago, the Carter administration was excoriated for wading in and proposing to throw Lee Iacocca’s company a life line. Many still think Mr. Carter and the taxpayers bailed out Chrysler back then with risky direct loans and not much in the way of rewards to merit those risks. Sorry, but the foregoing describes the approach crafted by Congress and the Bush administration late last year. The circa 2008 policies make President Carter look like Alexander Hamilton in comparison. The 1980 deal to save Chrysler involved no direct loans — only loan guarantees of just more than $1 billion. And, like good merchant bankers, taxpayers received a hefty slug of warrants which later netted the Treasury almost $350 million. Chrysler survived for almost three more decades until it sank under the weight of an ill-conceived LBO, but President Obama’s rescue attempt shuns the paths laid down by his predecessors. He wants nothing to do with merchant banking, just as he doesn’t want to be perceived as an all-risk, no reward patsy.

Those who thought back then that Mr. Carter’s form of government intervention over Chrysler would mark the end of American capitalism would be astounded by what passes for government policy today. Government holdings now include banks, investment banks, insurance companies, and, of course, the auto makers. Adam Smith’s invisible hand and how it has increasingly been shoved aside by the visible fist of government is one of the main topics on the mind of PIMCO’s Bill Gross (see below). “2 + 2 = 4” is the title of his latest Investment Outlook, a reference in honor of Wall Street Hall of Famer, Bernard Baruch. Always trying to maintain perspective, Mr. Baruch felt that the arithmetic of value always added up, whether booms implied the sum was 5, or busts implied it was 3. Mr. Gross returns to Mr. Baruch’s equation of value during what he calls “demarcation points”. The 15% government bonds of 1981 and the moon-scraping valuations ascribed to 2000 era companies are two such points, and Mr. Gross thinks we are on the threshold of another one right now.

Though he has been and still is a supporter of President Obama’s, the administration’s stand against Chrysler’s senior debt holders should bother Mr. Gross. He says, in effect, that Mr. Obama has just fired the first shot in a war to redistribute power and wealth away from Wall Street and to Main Street (though he should have also mentioned Pennsylvania Avenue). “If the cannons fired at Ft. Sumter marked the beginning of the war against the Union, then clearly these words (Mr. Obama’s statement last week about “standing against” investment firms and hedge funds) marked the beginning of a war against publically perceived financial terror”. Mr. Gross makes no apologies for Mr. Obama and actually supports this form of wealth redistribution, saying, “Capitalism is about taking risk…” His main point seems to be that investors need to be aware that government intervention and various forms of “public-private partnerships” are here to stay. As such, the risks to even senior claims on corporate assets are substantial and thus must be factored into any analysis of future cash flows.

While I agree with Mr. Gross that these interventionist policies should result in rising risk premiums across the entire spectrum of securities, I completely disagree with his notion that we should just accept what Washington wants and invest accordingly. I am especially troubled that Mr. Gross is willing to chalk up the destruction of the corporate capital structure and the abrogation of bankruptcy law as being just another risk a capitalist bears. Ignoring the rule of law for the sake of imposing wealth redistribution harms not just those who lose money in the process; it loosens the bonds of what binds us together as a society.

If Congress wants to pass (and Mr. Obama wishes to sign) a law making all creditors equal, regardless of the seniority of their claims, then at least we will have had due process and an issue to discuss in 2010. But our President had better be ready for the economic consequences of this action. Lending may not cease, but if senior secured lenders stand as equals in line with unsecured junk bond holders, parts suppliers and employees, then all loans to a corporation will reprice as if they were junk. High yield spreads have come in since December, but they still tower over Treasury yields by more than 1200 basis points. The green shoots supposedly popping up this spring will flattened if the cost of capital reaches these sky-high levels. And what will our foreign creditors think when they see Uncle Sam changing the rules for creditors of domestic origin? Will they want to extend us loans for 10 years at 3% if they fear we’ll game them, too?

Since Mr. Gross wants to support this “war against publically perceived financial terror”, I once again appeal to Paul Volcker to have a chat with his boss. I hope he tells President Obama that while closing corporate tax loopholes and raising marginal tax rates are legitimate policies to pursue, blowing up corporate capital structures is as costly to the economy as it is dangerous to the whole concept of contract law. Changing the rules without public debate just doesn’t hurt Wall Street; it hurts everyone. I hope investors start to pay attention to this battle, too. Who knows when NASA might be called upon to send up the Space Shuttle to retrieve the S&P from its new orbit above 900?

— Jack McHugh

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2 + 2 = 4 Investment Outlook — Bill Gross, PIMCO, May 2009

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