Rule 1: Wall Street always wins.
This one is a bit complicated but is indicative of the complexity of the financial mess we face.
Here is the short version: GM is in talks with unions and bondholders to try to get an agreement to restructure the firm short of bankruptcy. They are trying to get bondholders to convert their debt into shares (to make GM more viable going forward). You would think that it is in the best interest of the bondholders to do something, or else they could get wiped out in a bankruptcy....OR...
It is never that simple in the financial world. You see a lot of the folks that hold GM bonds would also be holding credit default swaps, or in simpler terms, insurance that pays out if GM goes bankrupt.
So if the bondholders do not "play ball" with GM, their bonds may get wiped out, but they could also end up collecting the full amount of the bond from their insurance. So what you say!
Well guess who writes most of the CDSs - you got it - our friend and now government owned insurance company - AIG.
So how is AIG going to pay out on the insurance you ask ------ well thank you Mr. and Mrs. taxpayer for your generous donations to AIG's cause.
That's right, if you follow the money, taxpayers are bailing out AIG so AIG can bail out GM bondholders who are better off not helping GM because that way they get all their money back.
So everything is not as it seems:
The Obama administration believes it would be irresponsible to use taxpayer money for principal payments to bondholders, according to a person familiar with the thinking of the task force who declined to be named because the deliberations are private.
As part of its restructuring, GM must shrink $27.5 billion in debt by getting bondholders to swap their claims for equity. The carmaker must also reduce $20.4 billion in obligations to a union-run health-care fund.
So even though Obama does not want to bail out the bondholders, a good percentage of them may very well end up being bailed out INDIRECTLY.
You can read more about this little quirk - HERE
The government has provided a history now that says that if you are a holder of CDS written by AIG, you will get 100 cents on the dollar, even if the notes don't default. In addition that 100 cents is above what you would normally get even if there IS a default, because normally you have to tender the defaulted bond or the payout is limited by the recovery, and recovery on a defaulted bond is almost never zero.
So in this case the winning play, if you're a big bondholder, is to tell GM to suck eggs; you'll get paid 100 cents on your CDS even though AIG has no money, because the taxpayer will make you whole on those CDS, even if the bonds have a recovery in bankruptcy.
In other words you could conceivably get more than 100 cents if you hold those bonds - so long as you also hold a CDS as a hedge.
It must be nice to be able to screw the taxpayer for more than a 100% payout, right?
This is not the end of the mess....I will try to put a diary together for tomorrow on how the Geithner public/private plan is already being gamed by Wall Street so that guess who wins...