Sunday, June 10, 2012

The strange story of ResCap bankruptcy that may pit Goldman against the US government

Here are some facts (in Q&A format) surrounding ResCap's recent bankruptcy, a story that has become somewhat of an enigma even to many in the financial services industry. This story involves some of the biggest players in the distressed and CDS markets, namely Citi, Goldman, Berkshire, Barclays, and of course the US government.

1. What is ResCap?
Wikipedia: - GMAC ResCap (Residential Capital) is a financial service company that focuses on residential estate loans. It was part of GMAC which was then taken over by Ally Financial. Its corporate headquarters are in Minneapolis, Minnesota. Its subsidiaries include GMAC Mortgage and online home lender Ditech.
2. Who owns Ally Bank (Ally Financial)?

Ally used to be called GMAC - the finance subsidiary of General Motors (many who bought or leased a GM vehicle a few years back got their financing from GMAC). Since late 2008, Ally Financial has been majority-owned (74%) by the United States government. The owners have been trying to build the Ally brand with a fairly aggressive TV campaign (see video at the bottom).

3. Why did ResCap file for bankruptcy?

Basically the US government wants to sell Ally - as it should. But the highly leveraged ResCap subsidiary had made Ally an unattractive asset because of the fears that the bank may become responsible for ResCap's debt. The US government decided to purge Ally of this perceived risk by putting ResCap into bankruptcy and walking away.
Wikipedia: - On May 15, 2012, Ally put the company into bankruptcy. ResCap posted a $402 million loss in 2011 and had missed a $20 million payment on unsecured debt on April 17, 2012. ResCap listed $10.9 billion in mortgages on December 31, 2012, after wiping $22 billion in mortgages off its books in 2009, 2010 and 2011. The company had booked a substantial number of subprime mortgages. The bankruptcy was seen as a step by Ally to exit the mortgage business to focus on its profitable auto loan and direct banking business.
4. Who owns ResCap debt?

ResCap bonds are widely held by numerous investors including many hedge funds. However Berkshire Hathaway (who said Berkshire is not a hedge fund?) until recently owned $500mm of the unsecured junior debt and $900mm of the 9.625% third-lien (secured) notes (40% of outstanding). Holding enough secured notes would allow Berkshire to prevent what's called a "cram-down" on the unsecured notes. In a cram-down the unsecured holders would have to live with (often) harsh restructuring terms pushed through by the secured creditors. By holding enough secured notes, Berkshire would in effect "protect" their unsecured claim by blocking a harsh cram-down. At least that was the theory.

5. What did Ally contribute to the ResCap bankruptcy in order to try to walk away (what did Ally think it needs to do to pacify the ResCap creditors)?
Bloomberg: - Ally agreed to pay ResCap $750 million to settle any claims against the parent, buy as much as $1.6 billion of securities if others don’t, and provide $150 million to help finance ResCap’s operations during bankruptcy, according to a company statement.
6. Is Ally done? After this large commitment can the government-owned bank just walk away?

It's not going to be as easy as the US government had hoped.
LCD: - In its own motion for discovery, the creditors’ committee identified at least 20 different transactions with Ally and its affiliates involving the purchase of assets and businesses from ResCap, or the extension of credit secured by ResCap’s assets. These transactions involved billions of dollars and sizable ongoing businesses, the most significant of which was Ally’s 2009 acquisition of ResCap’s ownership stake in IB Finance Holding Company, the direct holding company of Ally Bank. 
7. What's Berkshire's involvement in this claim?

Apparently Berkshire was going to fight Ally (and the US Government) on this.
Bloomberg: - Ted Weschler, a Berkshire investment manager, ... asked the judge overseeing ResCap’s bankruptcy in Manhattan to approve an examiner to investigate deals made before the company sought court protection, including transactions with its parent, Ally Financial Inc.
LCD: - This and other transactions may give rise to various potential claims that Ally harvested assets from ResCap before seeking a “quick and easy divorce through bankruptcy,” Berkshire said.  
What is evident – abundantly so – is that the debtors’ plan fits neatly into Ally’s publicly stated goal of separating itself, once and for all, from ResCap,” Berkshire said. “Whether Ally’s agenda also happens to be in the best interest of ResCap and its creditors is another question, one that should be a focus of a searching inquiry.”
The claim here is that Ally stripped ResCap of some juicy assets at below-market prices via "affiliate transactions" prior to filing. That would be the equivalent of someone selling a piece of bank funded property to their uncle before walking away from the mortgage. The bank would surely go after the uncle.

7. Does such action indicate that Berkshire is going to hang in there and fight for a higher recovery on their unsecured notes?

Surprisingly Berkshire's commitment to this fight that would potentially recover more on the unsecured notes was not as solid as people thought. The news came out last week that Berkshire dumped their $500mm of their unsecured notes. Some in the market wonder if the Obama administration gave Berkshire a call and asked them to walk away.
LCD: - Berkshire Hathaway dumped more than $500 million in unsecured bonds of Residential Capital, starting just hours after it filed a court motion seeking the appointment of an independent examiner in ResCap’s Chapter 11 proceedings, court filings show.
8. Who did Berkshire sell the notes to?

The exact details of the sale are unknown, but the market talk is that Berkshire sold at least a large part of their holdings to Citi.

9. What was Citi going to do with these notes?

This is where things become even more strange. Apparently Citi decided to deliver these notes into the ResCap CDS settlement auction. Remember the Greek bonds delivered into the Greek restructuring CDS auction? Welcome to the same type of auction but corporate credit style (a fairly common occurrence). Some speculate that Citi was long ResCap CDS protection. Dumping a big block of bonds would make the recovery lower and the payment on the CDS higher.

10. Who bought the ResCap bonds at the CDS auction?

It turns out that Goldman was on the other side of the trade. Being short the ResCap CDS (as many suspect it was), Goldman was interested in raising the recovery price because that would mean the bank didn't have to pay as much on the CDS settlement. The reason Goldman believed the recovery was going to be higher had to do with Berkshire's court filing (discussed above), complaining that Ally was stripping ResCap of good assets. Also Berkshire's holding of the secured (3d lien) notes to protect the unsecured gave Goldman comfort that Berkshire will fight for higher recovery in the unsecured bonds. And that likely got the firm involved in the short CDS trade. If Berkshire is indeed expected to recover more on the unsecured, the CDS will have to pay out less.  But when Berkshire dumped their bonds, Goldman got caught on the wrong side of the trade and had to bid on the bonds to defend their CDS position.
LCD: - But during the auction, there was a faceoff between two of the dealers, one delivering bonds and one that had a long thesis, according to sources. Those dealers were Goldman Sachs and Citi, sources said.

Goldman and Citi faced off during the CDS auction about the recovery of these unsecured bonds, because Citi came to market with a big block of the bonds – presumably Berkshire's – while Goldman had a long thesis that gave them more recovery, using Berkshire's own call for an examiner as support for the possibility that this allocation could somehow be renegotiated to get more recovery. At the CDS auction, Citi offered $520 million of the bonds &or sale, and Goldman bid on $345 million of those...
11. What happened to the bonds?
Bloomberg: - Yesterday and today, those same bonds fell. The 6.5 percent bonds that matured on June 1 dropped more than 7 percent. The 6.5 percent bonds maturing next year fell 16 percent. And the 6.875 percent bonds fell almost 12 percent. All were selling for 17.6 cents on the dollar...
12. What was the auction recovery on the CDS?
LCD: - Heavy trading of ResCap 8.5% notes due 2013 began June 5, continuing through today, at between 17 and 21.5, according to trade data. The level is not surprising given that the credit-event auction held on Wednesday to settle CDS contracts referencing Residential Capital set a final price of 17.625 cents on the dollar...
13. Who benefited from this mess?

Why Berkshire decided to sell the bonds remains unclear (a call from the government to Buffett would certainly explain it), but the firm is obviously not interested in a prolonged fight for the unsecureds' recovery. Berkshire may have taken a hit on its position. It is possible the firm hopes for a better recovery on their secured bond holdings. The cram-down is now far more likely as Berkshire no longer has the unsecured notes to defend.

It is also unclear if Citi made money on this transaction, although it looks like the bank (which coincidentally is also partially US government owned) was more in the loop than Goldman. GS is now stuck with the unsecured bonds (which it bought in the CDS auction) as part of the game of ResCap musical chairs.

14. How will ResCap operate in the mean time?

Barclays has arranged a DIP loan to the tune of $1.45 billion, which was well received in the market.
Reuters: - Barclays cut pricing on Residential Capital's $1.45 billion debtor in possession (DIP) facilities amidst strong investor demand.

The DIP facility will be modified to consist of a $175-200 million revolver, a $1.05-1.075 billion term loan A-1, and a $200 million term loan A-2. The DIP facility previously pegged the revolver at $200 million and the term loan A-1 at $1.05 billion.

The revolver upfront fee has been raised to 200bp from 100bp. The proposed pricing on the revolver loan is now 375bp over Libor, down from 400bp over Libor, with a 75bp unused line fee unchanged.
15. What will happen to the unsecured claims?

The new bond holders, with Goldman being the largest, will try to prove in court that Ally (effectively the US government) needs to cough more money because of the bank's affiliate transactions with ResCap. It certainly would be politically easier for the US government to fight Goldman in court than to take on Berkshire. Goldman vs. the US government will make for an interesting court case to say the least. Whatever the outcome, this story is far from over.

Ally has become known in the last couple of years for its aggressive marketing campaign as the US government tries to build the Ally brand.
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