Bankruptcy or bailouts?

• Author: Ayotte, Kenneth

1. INTRODUCTION II. THEORIES OF FINANCIAL DISTRESS: FIRM-SPECIFIC COSTS A. Debt Overhang B. Creditor Runs III. BANKRUPTCY LAW AND FIRM-SPECIFIC SOLUTIONS TO FINANCIAL DISTRESS IV. FINANCIAL INSTITUTION BANKRUPTCY: DREXEL AND LEHMAN A. The Drexel Burnham Bankruptcy B. Lehman Brothers V. FIRM-SPECIFIC COSTS OF GOVERNMENT AD-HOC RESCUE A. The Case for Rescue Loans: Illiquidity vs. Insolvency B. Direct Costs to Taxpayers C. Moral Hazard (of Equity and Debt) D. Corporate Governance Distortions E. A Comparison to Bankruptcy Resolution VI. SYSTEMIC RISK CONSIDERATIONS: IS BANKRUPTCY APPROPRIATE? VII. SYSTEMIC CONCERNS WITHIN BANKRUPTCY VIII. NEW RULES FOR SYSTEMICALLY IMPORTANT FIRMS? IX. CONCLUSION I. INTRODUCTION

   The onset of the current financial crisis brought with it an unprecedented intervention in financial markets by the Federal Reserve and the United States Treasury. Starting with the bailout of Bear Stearns in early 2008, these governmental bodies and their leaders were prominently involved in the negotiations and the ultimate resolution of each major non-bank financial institution that encountered financial distress. The government arranged outcomes on an ad-hoc basis, with varying degrees of taxpayer support. In the Bear Stearns case, taxpayer funds facilitated a merger. In the AIG case, the Federal Reserve made a substantial direct loan to the company. With Lehman Brothers, the government declined to offer any money, and the company ultimately filed for Chapter 11 bankruptcy.

   Although it was hard to distill a consistent policy rule from the government's rescue efforts, one guiding principle was its preference to avoid all possible bankruptcy filings because of the supposedly severe consequences that would follow. Federal Reserve Chairman Ben Bernanke acknowledged this policy in a rare public interview on 60 Minutes:

   There were many people who said, "Let 'em fail." You know, "It's not a problem. The markets will take care of it." And I think I knew better than that. And Lehman proved that you cannot let a large internationally active firm fail in the middle of a financial crisis. (1) Treasury Secretary Timothy Geithner echoed these sentiments in defending the rescue loan to AIG:

   We were caught between these terrible choices of letting Lehman fail--and you saw the catastrophic damage that caused to the financial system--or coming in and putting huge amounts of taxpayer dollars at risk, like we did at AIG, to keep the thing going, unwind it slowly at less damage to the ultimate economy and taxpayer. (2) This point of view has become the conventional wisdom, which now points to the Lehman bankruptcy as the singular, defining moment of the financial crisis. The government's decision to allow Lehman to file for bankruptcy, instead of providing a government rescue, was, in the standard account, the primary cause of the severe economic and financial contraction that followed. (3)

   Critics emphasize two different shortcomings of bankruptcy, often without distinguishing between them. The first focuses on the effect of bankruptcy on the value of the distressed firm itself. Bankruptcy, the reasoning goes, would severely dissipate the value of the firm's assets. We will refer to this first set of concerns as the firm-specific risks of a bankruptcy filing. The other rationale highlights the negative repercussions of a bankruptcy filing outside the firm. A bankruptcy filing directly affects the firm's contractual counterparties, some of whom (such as lenders and derivatives counterparties) have direct claims on the firm, while others hold contracts whose value is tied to the distressed firm. (4) A bankruptcy filing also may have broader spillover effects, such as a general effect on confidence. We will call these direct and indirect spillover effects systemic risks. (5) This Article will seek to explore the widespread perception that firm-specific and systemic risks make bankruptcy untenable for financial institutions.

   Our first goal is simply to assess the trade-offs between bankruptcy and the discretionary, government-orchestrated rescue system that was used instead as the financial system tottered, and which is reflected in the Obama administration's financial reform proposals. The merits and demerits of the two approaches are too often simply asserted without any serious comparison of the benefits and costs of the strategies. In this Article, we will take a much closer look. Drawing on the tools of corporate finance and applying them to key institutional features of bankruptcy, we will consider whether bankruptcy can effectively resolve the financial distress of a large nonbank financial institution. We then will subject the bailout alternative to a similarly careful stress test. (6)

   Our conclusion can be simply stated: we believe that allowing the bankruptcy process to work is preferable to an ad-hoc approach of preventing bankruptcy with last-minute rescue efforts. The rescue loan approach favored in the financial crisis increased uncertainty, increased the costs of moral hazard, and dampened the incentive of private actors to resolve distress before a desperate "day of reckoning" arose. These forces created substantial costs, over and above the direct and substantial cost to the taxpayer of rescue funding. While there is also a downside to allowing distress to be resolved through Chapter 11, we believe the firm-specific risks of Chapter 11 are overstated, and are not sufficient to justify recent policy. On the firm-specific dimension, the law gives distressed firms several advantages in bankruptcy that are unavailable outside of bankruptcy. These advantages help preserve firm value, allocate control rights to residual claimants, and do a more effective job of handling moral hazard concerns than taxpayer funded rescue loans on the eve of bankruptcy.

   Concerns about the systemic consequences of financial distress, by contrast, are a more serious, and more viable, objection to Chapter 11. Some of these systemic costs, however, would arise in any procedure that forces counterparties to bear losses when there are not enough assets to satisfy all counterparty claims. The costs could perhaps be reduced through the use of a "prompt corrective action" regime designed to shut down institutions before they become truly insolvent, as with commercial banks. But this approach brings important costs of its own, and it does not eliminate systemic risk. (7)

   More importantly, recent examples suggest that bank regulators often are unable or unwilling to identify distressed institutions and trigger a resolution procedure before the institution becomes deeply insolvent. As a result, prompt resolution can only be guaranteed with the promise of taxpayer assistance behind it. The distress of financial firms thus poses an inescapable choice: regulators must either allow counterparties to take losses, and thus confront the possibility of systemic effects, or they must use taxpayer money to prevent the losses from being realized. (8) Bankruptcy has proven to be an adequate mechanism for handling the former choice, and it is flexible enough to accommodate the latter.

   The general "crisis of confidence" effects that follow from the bankruptcy filing of a major financial institution that is greatly interconnected with the financial system (like Lehman Brothers or AIG) cannot be discounted entirely, even if they flow purely from a self-fulfilling prophecy rather than from fundamentals. It is entirely possible, for instance, that Lehman's bankruptcy had severe effects on the financial system simply because people believed that it would. Yet there is reason to believe that any blame for the effects of the Lehman crisis should not be laid on the doorstep of the bankruptcy laws. Other major events took place during the same time period: for example, the distressed acquisition of Merrill Lynch by Bank of America occurred the same weekend, and the announcement of the AIG rescue followed several days later. As we shall see, the AIG rescue announcement produced immediate negative reactions that were as severe as the reaction to Lehman. (9) This suggests that the "Lehman effect" on the markets stemmed from the news that two major investment banks were financially distressed, rather than from the news that Lehman had filed for bankruptcy to resolve its distress. It is far from obvious that a rescue loan to Lehman would have prevented the general disruption and crisis of confidence in financial markets that followed.

   Given the inherent challenges that these issues present to policymakers, we do not mean to suggest that government should not intervene in financial markets generally. In particular, we do not address the efficacy of the numerous broad-based infusions of capital into financial markets, some of which seem to have had stabilizing effects.10 Nevertheless, we hope that this Article will provide a useful framework for understanding the complicated issues involved in the interaction among financial firms, systemic risk, and Chapter 11. We also hope to challenge the common view that Chapter 11 bankruptcy is an inappropriate vehicle for resolving distress in financial firms. In particular, the common phrases used to describe Chapter 11 filings in these circumstances (such as "failing," "collapsing," or "going under") provide a very misleading view of the bankruptcy process and its actual consequences, compared to the taxpayer-funded non-bankruptcy alternative.

   Although we still cannot be certain that the recent wave of financial institution failures is over, attention has now shifted to regulatory reform. Congress has been debating financial reforms that would give bank regulators new powers to resolve the financial distress of the largest nonbank financial institutions--those deemed "systemically important." (11) Although expanded powers could counteract a few of the perverse effects of the recent rescue loans, they also would...