Equity is Temporary and Debt is Forever

The current negotiation between the government and bond holders of General Motors has been instructive if for no other reason than to highlight the relative merits of debt and equity in a severely depressed market.

General Motors is in dire straights and is seeking a way to avoid bankruptcy (I have advocated Chapter 11 for several months) by having the U.S. government buy a controlling interest in the company. Part of the restructuring being proposed by GM and the government is to have a very large portion of the existing GM bonds converted to common stock: debt to equity swap. This part isn’t going so well.

Here are a couple definitions to bound the problem:

“A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. It is a formal contract to repay borrowed money with interest at fixed intervals.”[1]

“Common stock (equity) is a form of corporation equity ownership represented in the securities. It is a stock whose dividends are based on market fluctuations.”[2]

Yesterday, CNN online noted that things were not going so well, “The bondholders own $27 billion in corporate notes. GM needed owners of 90% of those bonds to accept stock in return for the debt in order to reduce its interest expenses to a more manageable level.”[3]

As late as October 2007 the common stock of General Motors was trading in the range of $38 - $42 per share. Currently it is mired in alongside the penny-stocks closing at $1.45 per share on the 26th of May.

There are two reasons, in my opinion, that bond holders are highly reluctant to convert debt to equity.

1. Bond holders are first in line to receive proceeds from a liquidated or restructured company. If GM were forced to liquidate the holders of debt are first in line to receive distributions from the proceeds of the company. While they would not get anything near 100% of the face value of their bonds, they would get something. Equity holders are last in line and would be virtually assured of getting nothing from a bankrupt GM. They are assured of getting 0% of their value.

2. The government and the bond holders do not have the same goals. The bond holders seek to maintain the value of their assets (bonds) while the government seeks to minimize economic disruptions and keep union employees employed. I dare say that the government doesn’t care that much about the bond holders’ value.

I continue to believe that bankruptcy proceeds are the only solution for GM in that such proceedings will allow the automotive giant to restructure its expenses in line with its revenues. That GM were to proceed through Chapter 11 is not cataclysm.

Bottom Line: During the darkest days of World War II, British Prime Minister Winston Churchill noted, “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” There is much more to be done at GM to make the company profitable again. Restructuring is necessary and there is no reason to keep putting off the inevitable.


[1] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 197,507.
[2] Ibid, p. 508.
[3] http://money.cnn.com/2009/05/26/news/companies/gm_bond_offer/?postversion=2009052704