Bankruptcy is Always an Option

I’m very sympathetic to Mike Konczal’s argument against bankruptcy as an option for winding down systematically important financial institutions. We tried bankruptcy for Lehman Brothers, and the consequences were pretty bad (no matter what John Cochrane says). I think it’s pretty clear that bankruptcy, as it exists today, is unsuited for large financial institutions, as they exist today.

Still, I’ve slowly come to the conclusion that a prepackaged form of bankruptcy, under FDIC auspices, has a lot of advantages. It would require some tinkering with the Bankruptcy Code and how financial firms work; but has the advantage of moving us to a world in which financial firms can fail, discharge liabilities in an orderly fashion, and open their doors the next day.

We have some precedent for this, by the way. When WaMu failed; the FDIC stepped in; wiped out shareholders, and sold off the bank to JP Morgan without hurting grandma's deposits. And if you look at the canonical treatments of this issue in corporate finance--it's clear what to do. When firms become insolvent, you need to write down debt and give debt-owners equity ownership.

Here’s how this sort of framework would work—I’m working through proposals advanced by Garrett Jones, Wilson Erving, and Paul Calello. When a firm signs up for bankruptcy; regulators would come in and start by immediately writing off all equity and marking down assets. Then, the bank is recapitalized by writing off junior debt, and then as much senior debt as required, and converting these into equity. Basically, we would by fiat say that all bank debt is really convertible capital, triggered by bankruptcy.

To take a concrete example--let's work through Bank of America's latest 10-Q. I suspect they are insolvent now anyway, as are many large banks--more on this later. You'll see ~2.3 trillion in assets. On the liability side, you have ~1 trillion in deposits, ~500 billion in long-term debt, and about 600 billion in other liabilities. The stocks are worth about 230 billion.

Let's say BofA runs into some trouble, and their shareholder equity (stocks) plummets to ~75 billion. For fun, let's say that they have about the same in losses. They enter bankruptcy. All a judge has to do is say--write down that equity! Those stocks are now worthless. Next, we'll wipe down, say, half of that long-term debt and turn it into equity in the new company. If that's not enough, we'll go after the other liabilities or more debt. We can go after subordinated debt harder than we hit senior debt.

That's it. Bank of America opens the next day having written down large portions of their toxic loans, and is recapitalized by their long-term lenders. We can now sell this entity off to whoever wants it, or they can stick around and make new loans. Grandma keeps her savings account as well--though, in a perfect world, I'd take a haircut of that too if grandma has more than, say, $50,000 saved in FDIC institutions overall.

This proposal manages to do everything we want bankruptcy to do, while tailoring the response for financial institutions. In bankruptcy, we recognize that firms have failed, and kick out old management. Lenders take haircuts in order of seniority, but do better in bankruptcy than in liquidation. Meanwhile, these firms—now recapitalized, and without toxic assets—are free to raise further capital and lend.

When opting for a hybrid bankruptcy route, however, it’s also essential to reform the bankruptcy code to end derivative counterparties’ exemption from the automatic stay preventing collateral seizure in bankruptcy. As both Chris Papagianis at e21 and Mike Konczal have noted, this exemption reduces the incentive for the suppliers of short-term capital to shadow banks to monitor their risk-taking.

To draw an analogy; the Asian financial crisis in 1998 was sparked by the flight of short-term foreign capital, much as the Financial Crisis of 2008 was sparked by the flight of short-term repos from Investment Banks. In the Asian crisis, foreign creditors chose a short-term financing structure because that gave them an easy avenue of exit when things went south. Similarly, repo lending and derivatives took off because these contracts would not be subject to the same considerations as other contracts in the bankruptcy process. The best way to curb a risky reliance on short-term lending is to force these contracts to be treated like others in an orderly bankruptcy process.

Finally--spinning off prop trading desks and derivative dealer operations--which should be happening to a degree under the new Financial Reform bill, should probably make this easier as well. We really want our financial firms to focus on underwriting securities offerings and extending loans throughout the financial system. It's easier to work through the bankruptcy of a bank, rather than the bankruptcy of a bank which also owns a casino.

Dealing with financial companies in some manner like this is incredibly important for three reasons:

1. We finally get to make lenders pay. For instance, here is Russ Roberts:

There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks. Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.

Well, those bondholders and lenders made plenty of money on the way up, taking risks. They need to bear those risks on the way down, instead of taxpayers. Then, maybe they will do a better job of monitoring the risk going on in financial institutions.

Lenders really are the optimal agent to handle bank monitoring, by the way. Regulators are prone to cognitive biases and regulatory capture when times are good. Owning stock in a highly levered institutions is akin to holding an option, and makes you really want to ramp up risk. Managers of firms are paid in stocks, and so also have a strong risk preferences. It's really the bondholders and depositors--who make money as long as things don't go really bad--who have the strongest incentives to watch what's going on in terms of risk-taking. But this won't happen if they get bailed out, or can handle their contracts through repos and derivatives.

2. Two is the zombie banking problem. As Anil Kashyap and others have shown, the refusal to accept banking sector losses in Japan led to a decade-long problem of “zombie banking” in which fundamentally insolvent banks lingered, without funding new investment. Saddled with liabilities, American banks are not lending. Rogoff and Reinhart, among others, have suggested that this is a large part of why recoveries from financial crises are so anemic. The Administration has argued this as well. Yet, incredibly, no one actually seems to have an idea for dealing with this debt. This was Michele Boldrin's point in his debate with Brad DeLong. It's not at all obvious that Keynesian stimulus is a valid substitute for a serious push to deal with bad debts.

2. Third is the problem of soft budget constraints. This is a concept invented by Janos Kornai initially to examine the sources of inefficiency in Communist governments. Kornai had the insight that when firms expect to be bailed out after taking large losses, they alter their behavior.
However, this logic also holds in capitalist economies for all entities—be they hospitals, government-backed mortgage giants, or large banks (or car companies, large insurance companies, airlines, money-markets, sub-national states, European countries, etc.)—that expect fiscal assistance after chronic failure. Financial institutions armed with a Too-Big-to-Fail guarantee are virtually certain to make risky investments that generate current income, with long-term costs borne by the taxpayer.

To a certain extent, the last two problems balance each other out the way our system works now. Banks may be more reluctant to lend if they retain toxic assets on their books, but may be more willing to lend if they expect to be bailed out. This is perhaps the intention of policymakers, who are eager to find ways to increase lending without forcing banks to recognize the true nature of their losses.

This is perhaps why the American response represents a substantial improvement relative to Japan. But as long as these problems remain intact, lending will remain at a knives edge caught between two politically mandated and unpleasant alternatives. It’s clear that the bailout route is a very second-best way to address problems within the banking sector, and It’s important to develop techniques for the unwinding of systemically important financial institutions that avoid creating banks that behave like those in Japan or the Soviet Union.

I don't want to exaggerate the differences between this framework and the newly-created resolution authority. As I understand it; under resolution authority, banks enter federal receivership and their books are sorted out by regulators. The process, then, resembles bankruptcy in certain respects. The big change I'd make here is simply a mandatory haircut of debt before taxpayers contribute a dime, or else mandatory convertible capital requirements triggered when resolution kicks in.

I'm sure this solution has lots of problems as well. But it's not obvious that these problems are worse than the ones we already have. And you only need to write a few pages of legislation to get here.