Too many hot button financial news stories tonight, generally not a good sign for the short-term market outlook.
GM is twisting in the breeze, saying it won’t make it through year end without help, but the Bush administration, which has been liberal with aid to anyone who can pretend to be remotely connected to the financial system, has been consistently tightfisted about helping anyone who probably didn’t vote Republican, such as auto-workers and people who lost their homes (recall various Republican initiatives to scrub people who had lost their homes from voter rolls).
Despite the fact that most voters would find GM workers more deserving than investment bankers (at a minimum, they could not be deemed to have created the mess they are in, or have brought down the entire economy along with them), there is an important issue not getting enough attention: the problems with bankruptcy laws.
I don’t pretend to have an answer, but the lack of attention to this issue assures that we won’t get one. For GM, bankruptcy may be a better solution than a bailout. The New York Times explains:
Momentum is building in Washington for a rescue package for the auto industry to head off a possible bankruptcy filing by General Motors, which is rapidly running low on cash.
But not everyone agrees that a Chapter 11 filing by G.M. would be the disaster that many fear. Some experts note that while bankruptcy would be painful, it may be preferable to a government bailout that may only delay, at considerable cost, the wrenching but necessary steps G.M. needs to take to become a stronger, leaner company….
“Just let market forces play out,” said Matthew J. Slaughter, associate dean at the Tuck School of Business at Dartmouth. “And if G.M. or one of the other companies files for bankruptcy, support the workers and the communities that would affected by a bankruptcy filing.”
William Ackman, a prominent activist investor who runs Pershing Square Capital, said Tuesday that G.M. should consider bankruptcy. “The way to solve that problem is not to lend more money to G.M.,”…
Instead, G.M. should submit a prepackaged bankruptcy, laying out steps it plans to enact once in Chapter 11 protection, said Mr. Ackman, who is not a major holder of G.M. shares.
“I’d rather the government’s money be used to train people for other jobs,” Mr. Ackman said. “The bankruptcy word scares people. It’s simply a system.”
Now why can’t we do that for financial firms? In some cases, you get the run on the institution syndrome, which is what happened to Bear Stearns. But that fwas triggered in large part by fear of getting snarled in a Bear bankruptcy.
A Fortune Legal Pad post at the time of the Lehman bankruptcy provided a partial explanation:
In essence,[Ed] Morrison [a professor and bankruptcy expert at Columbia Law School.] explains, bankruptcy laws have evolved since 1978 in ways that actually leave investment banks like Lehman Brothers less protected than most debtors would be from hordes of creditors “descending on [it] and tearing it apart,” as Morrison puts it.
But those laws have been written specifically for the purpose of limiting systemic harm from a collapse like Lehman’s, and averting financial meltdown….
An ordinary bankruptcy petitioner, like an airline or a steel mill, gets immediate protection from its biggest creditors by the operation of law: as soon as it files for bankruptcy, an “automatic stay” takes effect which prevents those creditors from going forward with lawsuits and seizing the debtor’s assets. Metaphorical runs on the bank are prevented, and management gets time to organize its affairs in a way that will, theoretically, maximize value for all creditors, and maybe even allow the company to reemerge in sound health.
With a financial institution, however, the automatic stay offers no protection against many of its most important creditors. In a trend that began in 1978 and was greatly expanded in amendments passed in 2005, most financial contracts — including securities contracts, swaps, repurchase agreements, commodities contracts, and forward trades — are unaffected by automatic stays.
Worse still, as soon as Lehman’s parent corporation goes into bankruptcy, that event (under the contractual language governing most of these) triggers default, allowing the counterparty — the bank or other institution that entered into the deal with Lehman — to immediately accelerate or cancel the contract and seize whatever collateral may cover it.
Why? The thinking, Morrison explains, was that if an investment bank like Lehman ever failed, all its counterparties (like, say, a Bank of America) could extricate themselves immediately from Lehman’s troubles rather than getting mired in a bankruptcy proceeding….
Now comes the downside potential. The risk is that lots of these commercial counterparties will choose to terminate their financial contracts with Lehman — say, for instance, credit default swaps — all at once, and then try to rehedge themselves all at once, causing the market to seize up.
Now the Lehman bankruptcy did reveal a far more fundamental problem: most observers thought the firm was perhaps $10 billion in the hole, but likely to incur even more losses if it attempted to soldier on, when in fact the true negative net worth appears to be an order of magnitude higher.
However, an opportunity was missed: to what extent was the run on Bear and later Lehman the result of bankruptcy law procedures that increased the odds of a run, or otherwise made the process more perilous to creditors? I am wondering whether some changes in rules might have made it possible for financial firm bailouts to be more contained, for instance, for one entity to be bailed out and other carved off and liquidated (ie, could you figure out a way to do a prepack “good bank-bad bank” deal?). It was obvious at the time of the Bear failure that other investment banks were at risk. yet this avenue of investigation appears to have been overlooked.
Ignoring the fact that bankruptcy laws are not as good a vehicle for financial firms as for industrial companies has also skewed the focus of other rescue operations. The reason I liked the AIG bailout version 1.0 was that it put taxpayer interests first but also allowed for an orderly liquidation of the company. If (as many people contended) the firm really did have a lot of valuable businesses, management had time to sell them and if they fetched good enough prices, there would be a rump AIG left for them to operate. But as we have discussed at length, the revisions to that deal have clearly been to benefit AIG incumbents to the detriment of the public at large.