Bankruptcy v. Bailouts

Almost the only thing CEO’s, politicians and most commentators have agreed on during the current financial crisis is that bankruptcy cannot possibly be used to resolve the financial distress of a troubled financial institution. Indeed, the Chapter 11 filing by Lehman Brothers has been singled out by many as the primary cause of the severe economic and financial contraction that followed, and as proof that bankruptcy is disorderly and ineffective. Ad hoc rescue lending is widely viewed as a superior response.

In our article entitled “Bankruptcy or Bailouts?“, we provide a detailed analysis of the costs and benefits of the two approaches, and conclude that the preference for bailouts is not easily justified. We begin by showing that the bankruptcy laws address many of the most pressing concerns with troubled financial firms, such as the need for financing and the danger that creditors will race to grab the firm’s assets. We illustrate the effectiveness of bankruptcy both with historical case studies and with an analysis of the recent crisis. The most important historical precedent is Drexel Burnham, which filed for bankruptcy in 1990. Drexel’s bankruptcy shows that Chapter 11 can be used both for quick sales of time sensitive assets and for a more leisurely disposition of other assets. We also argue that the conventional wisdom about Lehman is deeply mistaken. The negative effects of Lehman’s financial distress were caused not by bankruptcy, but by the government’s last minute decision not to provide financial support and by the revelation that Lehman was in financial distress.

We do not claim that bankruptcy is always the best option. If a firm is suffering from a liquidity crisis and default will have serious spillover effects (such as harm to the market as a whole), a rescue loan may sometimes be preferable to bankruptcy. But rescue loans have several significant downside costs. The most obvious is that the prospect of rescue loans creates moral hazard—the incentive to engage in risky behavior is magnified if the consequences of the risktaking will be borne by the government. Although the government counteracted shareholder moral hazard by forcing the shareholders of Bear Stearns and AIG to take significant losses in connection with those bailouts, creditors were made whole in both cases– which magnified creditor moral hazard. In addition to creating moral hazard, bailouts also distort the corporate governance of the affected firms. Governance decisions are made not by the firm and its stakeholders, but by regulators, who often are influenced principally by public opinion. Bankruptcy avoids many of these distortions. Moreover, even in cases where government intervention is justified—as perhaps to guarantee the warranty obligations of General Motors—this often can be done in bankruptcy.

In the final section of the Article, we consider the treatment of derivatives in bankruptcy, which has played an important role in the recent crisis. Under current law, derivatives are exempt from many of the core provisions of bankruptcy, such as the stay on enforcement of contractual rights. Although these provisions were justified as a way to reduce the systemic consequences of a bankruptcy filing, we argue that they can sometimes have precisely the opposite effect. Bankruptcy might prove even more effective if these rules will altered by Congress.

Overall, our Article suggests that bankruptcy is a far more effective mechanism for resolving the financial distress than has been recognized.

The full paper is available for download here.