There seems two kinds of important ignorance about bankruptcy in the current discussion of the housing crisis.
First, on the regulator side, Secretary Paulson and Chairman Bernanke’s discussions suggest that they believe somehow assets disappear if Lehman or some other institution fails. This is simply not the case; in their capacity as brokers, investment banks and hedge funds still possess the earmarked stocks or bonds or other portfolios of investors. It’s the equity holders (and limited partners in funds), the holders of Lehman or Bear Sterns denominated securities and bonds, who risk losing everything in a meltdown. But this is the same regime in place with banks, ordinary companys, and average joes. There is already an orderly means for failed banks and investment houses to distribute their assets, pay the debts they can repay, and then disappear: it’s called Chapter 11 and Chapter 7 Bankruptcy. (My strong preference is for the latter, not least because Chapter 11s tie down resources and eat up fees while the real economy would make better use of the assets, entitlements, real estate, choses in action, and any number of other transferable items available at auction.)
The other ignorance relates to short sales of stock. Short sales are just a futures contract for stock: the stock is taken as an asset, promised for sale at some future price, and if the stock drops the spread between tomorrow’s market price and the future lower price represents the profit for the shorter. (There are other variations, but basically it’s a hedge on the price dropping.) Naked shorting means that the stock in question is not owned. If the price goes up, the shorter must cover the spread from the future hoped-for lower price and the new higher market price from some other source. Any institution or individual caught significant upside down on such an investment can be completely judgment proof, owing many millions or billions more than the institution or individual has. While shorting by people who can and do put their money on the line likely adds important information to the market, it makes good sense to regulate or limit investment schemes that create significant risk of judgment proof obligations on the tail end. It’s no different than mandatory collateral requirements to get a bank loan, limitations on contracts as violative of public policy, or, in the private economy, net worth requirements to have a seat on the NYSE.
Leveraged transactions where the scale or risk is unknown but potentially limitless and the risk of bankruptcy undisclosed or impossible to evaluate are perfectly legitimate objects of regulation to avoid schemes where the investor has all the upside and a far more limited share of the downside through the protections of bankruptcy.
Bankruptcy is a necessary and important means of sorting out failed ventures. But when important secondary and tertiary effects on the public are felt, such transactions should be limited to prevent bankruptcy-tempting speculative ventures. After all, bankruptcy is supposed to be an emergency escape hatch, not a routine avenue for risk-laden investment funds dealing in debt obligations.
Subscribe To This Feed
While I don’t believe there’s a prohibition against it, banks rarely actually declare bankruptcy. The usual path is for the Comptroller to appoint a receiver, who generally acts quickly to find a buyer for the bank’s holding assets and some reduced number of liabilities.
Your objections to Chapter 11 are exactly why the DIP has become so popular, though it seems to be that the DIP process often puts the rat in charge of the cheese shop.
Amen on that last point. That said, it’s not like all the assets disappear in a bankruptcy, which appears to be the de facto operating assumption of the Fed and the Treasury.