It’s fascinating to watch all of the financial scrambling that the government is engaged in slowly dissolve into a Marx Brothers movie. Here are some connections between a few dots that illustrate the point.

The WSJ has a rather good editorial today that points out Treasury seems to be trying to rig the game so that only a few very big players can participate as asset managers in the PPIP. The criteria to participate as a manager require that the entity have at least $10 billion in toxic assets already under management. Not only is the dollar amount high but the requirements for the types of assets that must be managed by the applicant seem designed to winnow out all but a few.

From the Journal:

Treasury rules also say the $10 billion limit must be comprised of commercial and residential mortgage-backed securities that are “secured directly by the actual mortgage loans, leases or other assets and not other securities.” This is another way of saying that they must be “first tier” assets, for instance collateralized debt obligations (CDOs). But what many private players instead deal in are “CDOs squared” or CDOs secured by other CDOs, which would not count toward the requirement. This, too, will make it harder to take part in the program.

While dozens of banks and insurance companies today hold more than $10 billion in toxic securities, the vast majority are trying to get these assets offtheir books — not lining up to buy more. As for asset management firms that hold such a big portfolio — and are also healthy enough to serve as fund managers — there is only a small pool, such as Black Rock, Pimco, Goldman Sachs or Legg Mason, as well as a titan or two of the hedge fund industry, such as Bridgewater.

“This is ugly,” says Joshua Rosner, the managing director of Graham, Fisher & Co., an independent research firm. “As long as they are experienced, there is no rational reason for creating limitations on who becomes a bidder and manager of assets. It doesn’t serve the public good, though it may serve those few large firms that appear to have a privileged relationship with Treasury.”

I have no beef with any of the companies mentioned in the article, in fact I can’t think of one that I don’t admire. But I see no reason why they should occupy a privileged status. More to the point, however, is that at the same time they’re in line for the chance to make billions, they also represent one of the biggest stumbling blocks in terms of resolving GM outside of Chapter ll.

Most of the asset managers also happen to be big holders of GM debt. As such, their cooperation in swapping that debt for equity is crucial if bankruptcy is to be avoided. Yet as we keep seeing again and again things are not that cut and dried. A post at the Market Ticker points out that many of these same players most likely bought credit default swaps to cover their GM debt exposure. If you started thinking that the likely writer of those swaps was AIG you get to go to the head of the class.

This is basically the government telling GM that either they get the bondholders to agree to whatever is necessary, or they’re dead.

They’re dead, and here’s why.

Back on Monday I wrote about the Automakers and said this in closing:

And then there’s the nearly $1 trillion in CDS that will trigger.  There is no accurate way to know what the net exposure is on those, but I’d take the “over” on $100 billion, focused in you-know-where.

Here’s the problem – I’m willing to bet that a huge percentage of those were written by AIG.

The government has provided a history now that says that if you are a holder of CDS written by AIG, you will get 100 cents on the dollar, even if the notes don’t default.  In addition that 100 cents is above what you would normally get even if there IS a default, because normally you have to tender the defaulted bond or the payout is limited by the recovery, and recovery on a defaulted bond is almost never zero.

If you read the article you will note the author assumes that debt holders will be able to collect in excess of the face amount of their bonds. I think he has overlooked some things there and I don’t believe that will happen. But his main point about AIG being the likely writer of the CDS on GM debt and most of the big players being covered is spot on.

So, large asset managers have no incentive to tender their debt for an equity position in GM, in fact the best outcome may be Chapter ll from their perspective. Of course, we now have the taxpayer making some of the GM creditors whole via AIG at the same time that they are going to have to come up with a boat load of DIP financing in order to protect their existing investment in GM.

Is this getting fun. The same guys that stand to make a fortune off of the PPIP may be the players that force GM into bankruptcy because their exposure is backstopped by credit default swaps that the U.S. government is standing behind.

Now there is a very good chance that a GM bankruptcy never happens even if the creditors don’t play ball. Both Holman Jenkins in the WSJ and David Brooks in the NYT have excellent opinion pieces that predict there is now way Obama can risk turning over control of the situation to a bankruptcy trustee. If that’s the case where will that leave us?

Frankly, I have no idea simply because this is all becoming quite surreal. Theoretically, the creditors would continue to be paid in some sort of taxpayer rescue. So instead of the money coming to them via AIG it comes directly from the government. Of course, there’s always the chance that the government rewrites all of the rules to their detriment.

At some point in time, I hope, someone is going to suggest that some of those who placed themselves in jeopardy have to suffer some pain. Right now a select few are being protected by the many. It may be time to just let AIG go. Those that were relying on CDS purchased from them will pay a penalty for not having assessed their counter party risk better. GM will have to go down and the management and employees of that firm can look in the mirror and admit that they both looted the firm. PPIP is seen for the shell game that it is and gets put on the shelf before billions are transferred from the fisc to the chosen.

Yes, there will be a cost to make sure the system survives the shock that these moves would impose. But asking the taxpayer to continue to absorb all of the pain for private risk gone bad is not a solution. It’s just digging a deeper hole. 

Update: 9:15 PM – At the risk of making an overly long post longer let me add some conspiracy fodder to this story.

The PPIP is rigged to favor the big asset managers. The big asset managers own lots of GM debt. They bought plenty of protection from AIG so a default makes them whole. The government says we need you to cooperate on GM and swap your bonds for equity. In exchange we’ll set up the PPIP so you recoup your losses and then some. Net result: they make the swap and take a loss; GM stays out of bankruptcy; AIG doesn’t have to pay out and the asset managers cash in big time via PPIP. Who pays for all of this? Take a guess.

You need to understand that I’m not generally a conspiracy kind of guy, but …