The bankruptcy canard with conservatives.

Put me with Felix Salmon here, commenting on John Taylor’s WSJ editorial on financial reform. Felix:

But I expect that the FCIC will show convincingly that the Fed did not feel empowered to take such drastic action before the crisis, and in fact was run on the basis that it was best to leave such decisions to the market. The Dodd-Frank bill is necessary in that it gives the Fed the explicit mandate it needs to grow some teeth and to use them. Powers are useless if you have no mandate to use them.

Meanwhile, your own proposed solution to the problem of how to prevent further crises is simply impossible: “reform of the bankruptcy code to allow large complex financial firms to go through a predictable, rules-based Chapter 11 process without financial disruption and without bailouts”. Well yes, that would be lovely, and it would be great if we could all get a pony, too. But there are very good reasons why banks can’t file for Chapter 11 bankruptcy, all of which you know better than I do: basically, banks can’t operate unless their creditors are confident they’re going to be repaid everything they’re owed, in full.

This reminds me of Eugene Fama’s argument that if we let all the major banks go into bankruptcy court everything could have been figured out “in a week or two.” Now that guy is a financial economist.  What about asking a bankruptcy judge?  Say Lehman’s bankruptcy judge, who declared: “This is the most momentous bankruptcy hearing I’ve ever sat through. It can never be deemed precedent for future cases. It’s hard for me to imagine a similar emergency.”   And Lehman wasn’t even that big.

Taylor also didn’t mention that this bill is a bankruptcy bill as a default, with several waves of checks that need to be hurdled to put FDIC’s “resolution authority” into motion. This was specifically put in to address conservative critics, and some like Kudlow appreciate it. The Federal Reserve, the Treasury Department and a panel of bankruptcy judges all need to sign off in order for resolution authority to be invoked. It’s very likely we’ll go into the next crisis with a strong presumption of bankruptcy.

Now I love our country’s bankruptcy courts; I love them so much I wish they could also get to work on second liens and first lien stripping for underwater homeowners. But it’s important to understand the limitations of our institutions. FDIC put out a fair and accurate critique of this bankruptcy court fetish:

Op-ed assertion: Bankruptcy courts do have the experience and expertise to handle a large-scale financial failure. This was demonstrated most recently by the Lehman Brothers bankruptcy.

The facts:

  • Bankruptcy has been rarely used for large firms.
  • Lehman Brothers was the largest bankruptcy filing in U.S. history. Second to Lehman was Worldcom at $103 billion — $500 billion less than Lehman, and $200 billion less than WaMu. Third, was Enron with $63.4 billion; fourth, Conseco with $61.4 billion; and fifth, was Texaco with $35.9 billion in 1987.
  • In 22 years, the bankruptcy courts have only resolved five major corporate entities — one of which was a financial company.
  • The Lehman failure would have been much more destructive had the Federal Reserve Bank of New York not lent into the illiquid Lehman broker dealer after the failure of Lehman Holdings – in effect providing liquidity so that trades could settle outside of bankruptcy.
  • The bankruptcy process did not respond rapidly to ongoing transactions. For example, about 100 hedge funds used Lehman as their prime broker and relied largely on the firm for financing. Despite the availability of collateral, those positions were not transferred to other parties and the prime broker positions were frozen.
  • The bankruptcy process has shown that it creates:
    • Significant market disruptions;
    • Huge fees and expenses. As of January 2010, fees paid to debtor’s counsel and experts in the Lehman bankruptcy exceeded $588 million without a plan of reorganization having been proposed by that date;
    • Drawn out resolution (WAMU was resolved in 24 hours on a Thursday). Lehman has offered a “blueprint” for its reorganization 18 months after filing Chapter 11.

Bankruptcy is a great procedure for many different types of institutions; I have not seen a credible argument saying it is a good procedure for firms that act like banks. Taylor: “[a new bankruptcy law is] a far better alternative than the highly discretionary resolution authority in the bill. Without this orderly bankruptcy alternative, the too-big-to-fail problem will not go away.” I love this conservative meme that judges and the bankruptcy court are somehow more “above the fray” than FDIC. I especially like the idea I’ve heard from others that bankruptcy courts are different than government or ‘politics’, as if our system of administrating disputes among property right holders isn’t entirely a political creation.

But I hate to say, we have bankruptcy right now, and the market doesn’t believe we will use it. I don’t know many people who believe giving ourselves a “bankruptcy+1+’we really mean it this time'” law will prevent too-big-to-fail either.

More Conservative Critique

Felix also argues that “And once it has done so, with any luck Republicans will turn from John Taylor’s politicized rhetoric, designed to find fault in anything the Democrats agree with, and will instead embark on a good-faith effort to shore up whatever weaknesses remain in the US regulatory architecture.”

I hope so too. I was really hoping to see better from conservatives in the financial reform debate, and with a few exceptions (Audit the Fed, ratings agencies) I didn’t see much that was productive. (My suspicion is that there is a brain-drain problem: if you can argue about this stuff, and have strong conservative values, you likely work on Wall Street already instead of a DC think tank.)

This is representative of conservative critiques of the bill. Here’s a recent bloggingheads where Heritage’s Conn Carroll tells The American Prospect’s Monica Potts that the bill allows the Federal Reserve to bail out any firm whenever they want to. I not sure which exaggerated critique he is invoking, as he never actually clarifies the mechanism in which this is done. One guess is that he’s using the talking points against section 210(b)(4)(B) of the Dodd language in regards to resolution, talking points which we debunk here. If he’s referring to the 13-3 lending it’s a massive improvement over the status quo, and has several new safeguards put into place. If he wants to get rid of 13-3 lending all together, that’s fine. But he should clarify that, as the rhetoric of “bailouts” in that public context isn’t helpful.

(I also remember him in a previous bloggingheads quoting bad GSE numbers; a particularly nails-on-chalkboard quoting for those who watch the numbers closely, bad numbers Arpit Gupta takes apart here.)

There are a lot of problems with this bill, and with this course of financial reform. But the problem has to do with preventing the next crisis, not repeating it again but this time really mean it when it comes to being tough.

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3 Responses to The bankruptcy canard with conservatives.

  1. csissoko says:

    You should at least be aware that there are law professors (whom I don’t believe are conservative) who have argued that reforming the bankruptcy code so that financial institutions can go through Chapter 11 is likely to be a more equitable solution than a “resolution authority”.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1265070
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1569627

    Personally I support the resolution authority because that law is written and ready to pass, whereas amending the safe harbor provisions of the bankruptcy code is a pipe-dream right now. But amending the bankruptcy code so that financial institutions can go through it is not necessarily a completely crazy idea.

  2. Adam Levitin says:

    Mike,

    I can’t stand the way this debate gets framed. The issue isn’t bankruptcy vs. bailouts. No matter how we upgrade the bankruptcy system, it’s basic nature is that it is a collection of pre-set distributional rules for situations when there isn’t enough money to pay everyone in full and on time. Bankruptcy says who has to take their lumps first, second, third, etc. We can tinker with that all we like, but the problem in a crisis stems from our fear of those distributional impacts. If AIG fails and ends up in bankruptcy, Goldman or Societe General will be impaired, etc.

    FDIC-style resolution doesn’t really help with this problem. (And it’s worth recalling that the FDIC has never done a real resolution of a major bank. For Wachovia, it did a quicky sale with some guarantees. Otherwise, FDIC is mainly doing doo-hickey local banks.) FDIC differs from bankruptcy primarily in procedure (no debtor-in-possession option, e.g.), not in flexibility of the distributional scheme. The only way the FDIC can really deviate from the distributional scheme is to sell assets backed by guarantees or loss-sharing. And that’s a bailout in the end, even if the FDIC is a mutual insurance fund, because it is ultimately backed by full faith and credit.

    So bottom line is that if we get scared enough, we bail. Sometimes via FDIC, sometimes via the Fed, and historically sometimes via Treasury directly. Laws against bailouts won’t do any good (see the EU). So if we just accept that we’re going to have bailouts when things get hairy enough, all we can try to do is regularize the bailout procedure to add some transparency and fairness. What this means is that Dodd-Frank really doesn’t change much of anything. Can anyone truly claim that things would have been handled differently in fall of 2008 if Dodd-Frank had been in place?

    Adam

  3. Knute Rife says:

    It seems that we are overlooking a bankruptcy alternative for financial institutions that is already on the books. Insurance companies don’t go bankrupt; insurance commissioners put them in receiverships in state courts (This can lead to all sorts of cross-border issues, but that’s for another day.). The Federal courts have a well-established receivership procedure for financial cases as well; there is a receivership created in the bulk of Federal fraud cases (SEC, CFTC, FTC, etc.). The Federal courts also have procedures for multi-district cases. It would appear that this system could be applied with minimal modification.

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