Lending to a Company

In order to finance operations, companies need to obtain cash by either borrowing money (debt) or issuing equity (stock). When most people think of the financial markets, the stock market immediately comes to mind, yet the credit market is much larger. In the stock market, if you purchase five Apple shares at $500/share, you pay $2,500 to own 0.0000005% of the company's market value of $500 billion, hoping the market value will increase over time.

A company's equity represents what is left over after paying all other obligations, and is driven by earnings (profits). Earnings fluctuate, and a struggling company may experience a decline in its stock price. A firm can struggle to the point where its liabilities exceed its assets, such as GM and Chrysler, and the value of its stock becomes worthless ($0/share). Investors in the stock market demand a higher rate of return than investors in the bond market, because it is a riskier investment and they need to be compensated for taking that extra risk.

While this prioritization holds true between debt and equity, debt itself can be divided into different tranches that vary according to risk and return. This diagram depicts different investments that can be made in a given company, and ranks the investment types from lowest risk to highest risk.

Source:  https://www.fiig.com.au/learn/educational-articles/2009/07/10/capital-structure---a-detailed-assessment

Before the Equity investors can be paid $1 in dividends, the company is legally obligated to pay all other investors. The Senior Secured Debt investors may demand a 4% annual return, 5% for Senior (Unsecured) Debt investors, 8% for Subordinated Debt investors, and Equity investors receive whatever is left over. Debt investors receive their principal back with interest, but don't receive any upside – a lender to Apple ten years ago would receive the same amount of money whether Apple's stock was $10/share or $500/share.

Without going into great detail here, the GM and Chrysler bailouts deviated from what always happens when a company files for bankruptcy. The Senior Secured Debt investors consisted of banks, mutual funds, and pension funds. Many of you have investments in corporate debt through mutual funds (401k and brokerage accounts), and you have family members who receive private or public pensions. Many such funds lent money to GM and Chrysler, either directly or in the secondary market, knowing that by law, they would receive top priority on any money that could be recovered from the companies in the event of bankruptcy.

In the 2009 bailout, this fundamental principle was completely revamped. Politically favored groups (i.e., United Auto Workers union) had claims in the Senior Unsecured Debt tranche, which was below the Senior Secured Debt group consisting of the banks and investment funds. Despite having legal priority, the Senior Secured group was substantially pressured and felt, shall we say, obligated to accept far worse terms than what the Senior Unsecured group received. Tens of billions of U.S. taxpayer dollars were also used to indirectly prop up the Senior Unsecured group, and you will be financing the principal and interest on that loss for decades to come.

The managed bankruptcy process provided an opportunity to make Detroit sustainably competitive with other automakers (many of whom have significant operations in the U.S.). Instead, very little was done about its burdensome cost structure. Moreover, arbitrarily overhauling bankruptcy law increases the risk premium required by lenders, so automakers and other industries with similar issues will incur more interest expense in the years ahead. Increased expenses leads to fewer profits, which leads to lower stock prices, which leads to less money for investors and pensioners, and results in fewer jobs in those industries. Time will tell if these issues will (yet again) cause financial hardship for GM and Chrysler.