Bankruptcy v. Bailouts

This post comes to us from David Skeel of the University of Pennsylvania Law School and Ken Ayotte of Northwestern University School of Law.

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.

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One Comment

  1. Posted Sunday, April 19, 2009 at 7:14 pm | Permalink

    There’s no question that deciding whether or not to declare bankruptcy is a difficult, agonizing choice. A bankruptcy will affect your future credit, your relationships and your self-image. But it can also improve your short-term quality of life and possibly keep you from losing your home, car and other essentials.

    Personal bankruptcy is generally considered the debt management tool of last resort because the results are long-lasting and far-reaching. It’s the financial equivalent of major surgery — not something you should undergo unless it’s absolutely necessary. You need to study the pros and cons carefully before making a decision. Then, if you decide bankruptcy is the way to go, it’s important to do it right. The following pages will help you do just that.



    • You will lose all your credit cards (unless you pay them off before filing.) You may also have to give up some luxury possessions.

    • When you file bankruptcy, it stops all collection actions by creditors, including foreclosures, repossessions, and garnishments. If you have filed with an attorney, she or he shields you by handling all inquiries from creditors.

    • A recent bankruptcy makes it nearly impossible to get a mortgage (although you should be able to do so within about five years).

    • Most states allow you to exempt your home, car and other essentials, so you will not wind up homeless and unable to get around.

    • A bankruptcy stays on your credit report for 10 years, making it difficult to acquire credit, buy a home or car, get life insurance, or sometimes get a job.

    • Declaring bankruptcy now can get you started sooner on rebuilding your credit and your life. If there is another disaster, you may be able to amend your existing Chapter 13 plan to accommodate it.

    • Not all debts may be “discharged” in a bankruptcy. Student loans and back taxes (within 3 years) are prime examples.

    • While nothing will get rid of student loan debt, at least bankruptcy will prevent your lenders from aggressive collection action.

    • Bankruptcy is an admission of defeat, an embarrassment.

    • So is being sued for bad debts, having your car repossessed or your home foreclosed on.

    • If I declare bankruptcy, my name will be in court records and may appear in the newspaper.

    • If your creditors sue you, your name will be in court records and may appear in the newspaper.

    • You will have to explain to a judge or trustee how you got into a financial mess.

    • Both judges and trustees have heard far worse stories than yours.

    • It will be a long time before you are able to get credit cards again.

    • Good. Credit cards helped you get into this mess. They can get you into another one just as quickly.

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