Buffett's Berkshire Thinks This Bankruptcy Deal Stinks

Residential Capital is moving rapidly toward exiting bankruptcy -- and Warren Buffett is not pleased.

Residential Capital ("ResCap" to its friends) filed for Chapter 11 bankruptcy protection a year ago, laid low by a balance sheet stuffed to the gills with poor-quality mortgage loans. But Buffett's Berkshire Hathaway subsidiary didn't think the loans were all that bad and anted up $1.5 billion to buy a bunch of them at the bankruptcy auction -- and then bought a bunch more just this past February.

The plan: to patiently collect the payments, or unload them at a profit once things settle down.

Buffett's also bought a significant stake in loans to ResCap -- unsecured bonds -- and owns at least $900 million worth of those. (At face value. It's hard to say what he paid for them, but at one point, the bonds were selling for as little as $0.24 on the dollar.)

An interested party
This stake in ResCap's debt makes Buffett a major player in ResCap's bankruptcy proceedings. It gives Buffett a voice in agreeing to (or refusing) settlement negotiations to resolve creditor claims against ResCap, and it could result in an equity stake in the company if it exits bankruptcy -- and that's where things get complicated.

You see, a key reason ResCap went into Chapter 11 in the first place was as a favor to its parent company, Ally Financial. Ally wants to pay back the $17.2 billion TARP bailout it got from the U.S. government and gain independence from the U.S. Treasury, which currently owns 74% of its equity.

To do that, however, Ally must first convince the feds that it can survive as a going concern without the bailout money. And to do that, Ally had to convince everybody concerned that it was not liable for ResCap's debts. By pushing ResCap into bankruptcy court, Ally hoped to resolve this worry.

One step forward, one step back
That's proving easier to say than to do, however. ResCap's creditors (Buffett included) would prefer to keep Ally on the hook for ResCap's $25 billion in debts. To escape this responsibility, ResCap recently conceded that it would be willing to contribute $2.1 billion to ResCap's bankruptcy estate, for distribution to creditors in the proceedings. That's more than Ally's previous $750 million payout proposal.

Many creditors seem to like the idea, with AIG, MBIA, Allstate, and hedge fund Paulson & Co. reportedly all on board. The way they see it, the settlement, plus cash already raised by ResCap from asset sales, should provide enough cash to pay them $0.35 on the dollar of the face value of their ResCap bonds. For anyone who managed to buy at the $0.24 low price or even a bit higher than that, this should mean a tidy profit.

A fly at the buffet (or "Buffett takes a flyer")
Buffett and Berkshire aren't so sure they like the deal, though. For one thing, a condition of Ally's agreement to "pay $2.1 billion" to ResCap's estate is that ResCap then immediately turns around and pays Ally back its $1.1 billion in secured claims against its old subsidiary. That hardly seems a plus for ResCap's unrelated creditors.

For another, these creditors have long alleged that Ally and ResCap regularly moved money back and forth between them before the bankruptcy -- a fact that, if true, would strengthen the case for tying the companies together, "piercing the corporate veil," and holding Ally responsible for ResCap's debts -- or at least extracting a bigger payment from it.

Pardon me. Have we met?
How close were these dealings between Ally and ResCap? It's hard to say. The bankruptcy court asked an independent bank examiner to look into this question recently, and that report has now been handed in -- but not yet made public. Buffett's demanding that it be madepublic before Berkshire decides whether to vote in favor of accepting Ally's offered $2.1 billion contribution, and releasing Ally from further liability for ResCap's debts.

That seems only fair. Even if the other creditors are happy with Ally's offer, knowing that it will give them a small, quick profit on their bond holdings -- that may not be the best deal for their shareholders. Depending on what's in the report, it's conceivable the creditors are "leaving money on the table."

Buffett and Berkshire are right to push for full transparency in these bankruptcy proceedings, so that all interested players know what they're being asked to give up -- not just what Ally is offering to give them.

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The article Buffett's Berkshire Thinks This Bankruptcy Deal Stinks originally appeared on Fool.com.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends and owns shares of AIG and Berkshire Hathaway and has long January 2014 $25 calls on AIG. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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