Bankruptcy

In Case You Didn't Feel Like Showing Up

By Stephen Lubben

I'm on a panel tomorrow at the Dow Jones Restructuring and Turnaround Summit about how the government should address "too big to fail" and the collapse of systemically important firms. For those of you who won't find yourself in lower Manhattan tomorrow, my current thinking on the subject is thus:

• We need a common forum. Be it insurance company, broker-dealer, hedge fund, or bank the entire enterprise needs to be addressed in one place, at one time. Ideally this forum would encompass all the major financial jurisdictions (New York, London, Zurich, etc.) but for now I'd be willing to settle for a single forum for the U.S. part of the problem.
• The mechanism needs to provide liquidity to the failed firm until resolution. And it needs to accommodate the possibility that the liquidity provider might be the government (either the Treasury or the Federal Reserve) or some quasi-governmental thing like the IMF. I note that chapter 11 already has such provision, including provisions for subordinating preexisting liens.
• Regulators need to be able to institute proceedings, because if the failing firm is big enough sometimes nobody else will have the incentives to face the inevitable (see, General Motors, Lehman, etc.).
• Moreover, we need to institute proceedings while the firm still has some working capital, instead of allowing management to drive until the tank is dry (see, Lehman, AIG, Morgan Stanley (almost), etc.).
• Modeling the resolution system on the FDIC approach only makes sense if we think there should be similar goals -- namely, protecting customers of the failing firm from losses and reducing the costs to the government. The second one might be applicable, but I'm not sure about the first -- that sounds a lot like destroying incentives to monitor counterparty risk (or that "Moral Hazard" thing everyone was talking about in August 2008.).
• I don't think it makes a lot of sense to "reinvent the wheel" and create an entirely distinct resolution authority that (hopefully) will only be used once or twice every twenty years.
• Instead, why not use a modified chapter 11, that gives the failed firm a brief period (90 days at most) to reorganize, recapitalize, or sell the debtor? Locate the court in New York, but cherry pick the best judges from around the country to staff it. Or at least look to the SIPC proceedings, which bring in Bankruptcy Code provisions except where there is an express need to do it differently.
• I keep hearing that the Bankruptcy Code won't work because the judge has to consider everyone's interests -- I'm not sure that the lack of transparency and due process has helped in the current situation -- shall we ask the WaMu shareholders and bondholders what they think? -- and the GM, Chrysler, and Lehman sale hearings show that speed, respect for the collateral effects of a case, and due process are not inconsistent.
• Talking about too big to fail or derivatives markets reform without addressing the safe harbors, and their effect on systemic risk, leaves the job half-done, unless we really think no big financial firm will every fail again. In which case, why are we worrying about a resolution authority?
• Overall, the traditional separation between bankruptcy and banking law collapses in a financial crisis. The financial system would be better off if these two disciplines talked more often, and definitely before the petition date.

Full post as published by Credit Slips on March 09, 2010 (boomark / email).