Forgot to get this up earlier this week. There was an editorial in the NYT proposing changes to the bankruptcy code that would allow for a controlled resolution of financial institutions.
Since the collapse of Bear Stearns just over a year ago, the government has bailed out financial institutions whose failures threatened the broader financial system (with the exception of Lehman Brothers). In explaining this approach, federal regulators have said that they lack the tools to prevent disorderly failures of such institutions. Bailouts have been the only alternative to bankruptcy filings that can have dangerous effects on the rest of the economy.
But why not adopt an approach that would, where necessary, allow the controlled failure of a major financial institution?
To limit the disruption such an event might cause in the broader market, the government could announce that it would support the institution — for example, by guaranteeing its trading obligations — for, say, 60 to 90 days. During this period, the institution’s creditors and counterparties would not be permitted to cancel their contracts and demand immediate repayment, or force the institution to pony up additional collateral...
In return, the institution requesting government assistance would be required to ask its creditors and counterparties to reduce or defer their claims in order to restore the institution to solvency. It would also be required to commence plans for a possible bankruptcy at the end of the support period; make all material information about itself available to prospective buyers; and cooperate with counterparties that wish to enter into arrangements among themselves that would smooth an eventual bankruptcy, if one cannot be avoided.
If at the end of the support period enough creditors and counterparties have agreed to reduce or defer their claims so that the institution can stay afloat, or a third party has agreed to acquire it, then it would resume normal business.
I'm not a bankruptcy expert, in fact, I know only the barest minimum about bankruptcy law. What I do know is that our current bankruptcy regime seems ridiculously unfit for handling the problems in our financial industry, which is why we keep avoiding the subject.
Especially egregious is the fact that due to what I suspect must be serious lobbying efforts on behalf of the financial industry, certain derivatives are not actually subject to the "automatic stay" (or freeze) that all other claimants of the bankrupt entity are subject to (this was part of the 2005 bankruptcy "reform", arguably one of the most corrupt piece of legislation ever put into place). I believe (though again, would love correction if otherwise) that this is why having a large financial institution going directly into bankruptcy is considered generally undesirable. From Lehman's example, once a financial entity is pushed into bankruptcy, the counterparties to derivatives with the bankrupt entity have a huge incentive to pull out as fast and recklessly as possible, leaving other stakeholders in the financial institution holding nothing.
This has never been the intention of bankruptcy law, which was always meant to allow the orderly unraveling of insolvent institutions, with due attention to certain fairness considerations (the priority issues we've heard so much about w/r Chrysler, and don't get me started on how insane it is that the Obama administration decided to simply ignore these considerations when negotiating the Chrysler bankruptcy).
Srsly, sometimes I wonder if the American government isn't acting like the poor schlub who thinks that if he puts his overdue bills in a drawer, they cease to exist.
Given that we currently have one of the country's foremost expert on bankruptcy knee deep in this crisis (Elizabeth Warren, chair of the Congressional Oversight Panel overseeing TARP), I don't understand why this isn't on the agenda.