Wednesday, 6 February 2008

Bankruptcy as Strategy and Tactic

In an article about the recent credit squeeze, Financial Times (February 5, p. 20) reminded us:
Several years ago, Hicks Muse and Kohlberg Kravis & Roberts each wrote cheques to acquire Regal Cinemas. They then loaded an additional $1.8bn in debt on to the company. The movie chain could not service all that debt and filed for bankruptcy protection.

Distressed debt funds paid 60 cents on the dollar for the debt, acquired control of Regal from the two private equity firms and eventually reaped windfall profits on the investment.
These few sentences make the modus operandi of buy-out firms clear as day light. Take control of a company and saddle it with a large debt that it cannot service. That is the tactic. The strategy? To drive the said firm into bankruptcy. The aim is "to reap windfall profits," for all concerned, including the lenders. All is calculated, methodical and systematic.

On this subject, the liberal columnist of the Times, Paul Krugman, has not one word to throw at a dog. Yet, he was all too willing to lecture Argentina in the 90's in the evils of default. He wrote:
Advanced countries – the status to which Argentina aspires – regard default on debt as a moral sin.
I criticized this empty sentimentality in the Enigma of Options:
The “moral aspects” of default about which columnists and scholars of law are in the habit of sounding off are the indignation of the owners of capital at the loss of their money.
It is not that feelings must be dismissed or belittled. One could sympathize with the European who consider the buy-out firms "locusts." But the subject of finance is not people. It is capital in circulation. To understand the developments in finance, we must adopt the level-headed detachment of finance capital, i.e., we must understand the dialectics of finance – in theory and in practice. Here is what I wrote in the Enigma on the subject of default.
Default is an incident in finance … As financial markets grow in size and sophistication, they take on the subject of default, peel its social shell and turn it into a tradable commodity … The next logical stage in this process is the commoditization of default, a development that is behind the creation and growth of the credit default swaps. At this stage, default is consciously embraced as a revenue source, so the pretence of morality is cast aside. Large banks that sell billions of dollars worth of credit default swaps do not consider default a moral failing on the part of the borrowers any more than insurance companies consider traffic accidents a character flaw in the part of the drivers. Such “failings,” on the contrary, are the very reason for the existence of the credit derivatives and insurance markets.
Buy-out firms play a particularly extreme and nasty version of the default game where, unlike the insurance and credit default swaps market, the event is intentionally engineered. But that, too, is in the realm of the expected. I will have more to say on this topic.