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Thursday, April 30, 2009

"Bankruptcy is Vital to Capitalism" (WSJ column)

I happened to just now come across this column that appeared in the WSJ on April 2: "Bankrputcy is Vital to Capitalism", by David Wessel (who, I just learned (pdf here), is economics editor of the WSJ and writes this "Capital" column weekly).

Wessel opens the piece as follows:

America is relearning an old lesson: Failure and bankruptcy are essential to capitalism.

Bankruptcy is an orderly way to give an overburdened debtor a fresh start and to decide which creditors get paid back and which don't. As Nobel laureate Joseph Stiglitz teaches: Bankruptcy is a way to cope with those times when markets fail to allocate capital wisely and monitor its use.

(Stiglitz is an econ prof at Columbia, and, as the Wikipedia entry nicely summarizes:
He is a recipient of the John Bates Clark Medal (1979) and the Nobel Memorial Prize in Economic Sciences (2001). He is also the former Senior Vice President and Chief Economist of the World Bank. He is known for his critical view of the management of globalization, free-market economists (whom he calls "free market fundamentalists") and some international institutions like the International Monetary Fund and the World Bank.
He's also got quite a personal website: I have been meaning to read his Globalization and its Discontents and/or his followup Making Globalization Work. He has been popping up a lot lately with his thoughts on the financial crisis, e.g. "Stiglitz Says Ties to Wall Street Doom Bank Rescue").

The column continues with some historical context, connecting the railroad industry of the late 19th century to the auto industry of the early 21st century:

At the end of the 19th century, nearly 20% of the railroad track belonged to insolvent railroads, says David Skeel, a University of Pennsylvania law professor who has written a history of bankruptcy. With state governments unable to deal with railroads that stretched beyond their borders, and Congress hamstrung by a narrow interpretation of the Constitution, creditors turned to courts. Judges fashioned an approach to divvy up assets among creditors that was codified in an 1898 law, the spirit of which survives today.

General Motors and Chrysler are 21st century analogs of 19th century railroads. They cannot pay their debts; the only issue now is how, not whether, their creditors take a hit. The only difference between GM today and GM in bankruptcy court is that the president and his appointees are making the decisions, instead of a bankruptcy judge constrained by federal law.

Skeel is a name that seems to come up quite often in discussions about bankruptcy law. Indeed, it seems like he quite literally wrote the book on the topic: "Debt's Dominion: A History of Bankruptcy Law in America" (which I impulsively purchased from Amazon a couple days ago, after reading this WSJ column).

From there Wessel gets into how the Obama Administration has been handling the case of the auto companies. That is where I found it got somewhat confusing:

President Barack Obama's critics say the government has no business picking GM's chief executive and apportioning losses among auto workers, pensioners, suppliers and lenders. They fear "politics" will produce unfair or unwise decisions, such as protecting lenders and workers in the domestic auto industry at taxpayer expense while lenders and workers in less politically salient industries suffer.

But sometimes "politics" is just another word for "democracy." The people are having a hard time understanding why big banks and insurers get bailouts and GM gets bankruptcy. It's hard to convince laid-off auto workers that banks and their credit are the vital circulatory system of the U.S. economy, more important than any one industry, even one as large as domestic auto makers. Mr. Obama knows he almost certainly will need more taxpayer money to resuscitate the nation's banks; that won't be popular. If making a very public effort to avoid bankruptcy fails, he will say: I tried, but it just couldn't be done. That may help him get Congress to approve money for the banks.

I take this to mean that the "politics" the critics decry are a necessary part of the process in this environment. It's democracy at work, in the sense that the whole spectrum of stakeholders--not only equity and bondholders, but also labor, and even the wider community, as represented, say, by Michigan House reps and Senators--have an influence on the outcome, and that the Administration must take into account the political and economic context in approaching restructuring/bankruptcy of the auto companies.

Here are the closing paragraphs, which raise some very interestng points:

What about big financial houses, though? Why can't they go through bankruptcy the way Macy's and Delta Air Lines did? One reason is that a retailer or airline can shed debts and then operate stores and airplanes. Financial institutions have nothing so tangible: They basically have their names, their people and their ability to borrow a lot of money short term. All of that can vanish instantly while a judge ponders the matter. So the U.S. devised a bankruptcy substitute for banks: The Federal Deposit Insurance Corp. does the deed quickly without a judge.

The Treasury and the Federal Reserve want a similar pseudo-bankruptcy process for big financial institutions to avoid the problems of Lehman Brothers (whose bankruptcy coincided with a bad turn in the crisis and some say caused it) and American International Group (which didn't go into bankruptcy, at substantial cost to taxpayers). They want better choices next time, and they don't think conventional bankruptcy is practical.

Not everyone sees it that way. "The usual reaction if one mentions bankruptcy as a mechanism for addressing a financial institution's default is incredulity," Mr. Skeel and Northwestern University's Kenneth Ayotte wrote recently. "Those who favor the rescue of financial institutions...treat bankruptcy as anathema. Everyone seems to argue that nothing good can come from bankruptcy." They disagree, and would tweak bankruptcy laws to deal with the peculiarities of finance so the rules are clear to all -- and the Treasury secretary and Fed chairman have less discretion.

Here is the paper by Skeel and Ayotte cited above: "Bankruptcy or Bailouts? "

It will be interesting to see how the regulatory/legal framework evolves in this direction. As Wessel wrote, the Bankruptcy Act of 1898 was a reaction to the widespread insolvenices of the late 19th century (and was later revamped in the 1978 Bankruptcy Code--Chapters 7 and 11 of which govern, respectively, liquidation and reorganization.