Are Bankruptcy Laws Too Tough?

I’m late to this good post from Steve Waldman, which has some provocative ideas about how stringent bankruptcy laws should be. He contends that the current regime is too friendly to creditors, which means they can and do make overly optimistic assumptions about recovery, which in turn makes them too ready to take risks.

We’ve seen that phenomenon with credit cards. As we wrote last month:

The irony is rich, even if the consequences to both credit card issuers and borrowers are painful.

Many readers no doubt know that the October 2005 bankruptcy law changes were a long sought, hard lobbied for win for credit card companies. It considerably restricted access to Chapter 7 bankruptcies which allow borrowers discharge the debt once they liquidation of existing assets, save those exempted by the state, and divides the proceeds among creditors, including credit card issuers. Debtors who are above median income in their state are most likely to have to file for a Chapter 13 bankruptcy. In Chapter 13, the borrower has to repay debts over five years. In addition, before 2005, the judge determined, based on information provided by the debtor, what a reasonable repayment plan would be. The new standard is based on IRS living standards, which a cousin who is a bankruptcy attorney described as “draconian” (for instance, the food budget per month for an adult individual is $200).

MBNA estimated that passage of the bill would enable it to collect an additional $100 per month per bankrupt, which would increase its profits $85 million a year.

So what did these credit card issuer do with their new enhanced rights? Emboldened, they went out and lent more to near-deadbeats, confident they could extract blood from turnips.

They are now reaping what they have sown….

Waldman focuses on the same issue as it applies to derivatives

Commenting on Nassim Taleb’s provocative agenda for fixing the world, Felix Salmon notes that

Looking at the rest of the list, how on earth do you stop the financial sector from… creating complex products? Derivatives are, at heart, bilateral contracts: how can you ban two consenting adults from entering in to such a contract?

The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements… Libertarians may have perfect freedom to contract, if their agreements are self-enforcing or voluntarily adhered to. For the rest of us, every contract is a negotiation between three parties, the two who put a signature at the bottom the document, and the state which will be called upon to give force to the arrangement when disputes arise or someone fails to perform….

This has something to do with derivatives, but even more to do with one of Taleb’s broader concerns: debt. At present, the state enforces debt contracts by permitting lenders to force nonperforming borrowers into bankruptcy. That is not a natural or obvious arrangement. Bankruptcy evolved as an improvement over automatic liquidations or men with big necks and brass knuckles. It serves to balance the contractual right of a lender to be timely paid with a broader interest in preserving the overall value of enterprises and preventing extremes of immiseration. To some degree, bankruptcy lets debtors to escape the terms of their own agreements and limits the right of contract (though bankruptcy is onerous enough that debtors don’t seek this sanctuary easily). The fact that creditors’ rights are limited is socially useful: it encourages lenders to discriminate between good borrowers and bad, reducing the frequency with which resources are lent foolishly and then destroyed.

One thing I think that we are learning from the present crisis is that the logic of bankruptcy hasn’t been taken far enough. Creditors’ rights are too strong. Creditors have insufficient incentive to discriminate, especially when lending to “critical” organizations, because the bankruptcy that would attend a failure to pay is too disruptive and destructive to be permitted by the state. We have seen tremendous resources lent to banks thoughtlessly, and then squandered or stolen rather than carefully invested. Similarly, those who entered into derivative contracts often ignored credit risk when a counterparty was seen as too dangerous to bankrupt. If it were possible for borrowers and counterparties to welsh on their agreements without provoking consequences as disruptive as bankruptcy, creditors would have more reason to be careful of whom they do business with, and potential deadbeats (like large financial firms) might not be able to take levered risks cheaply.

I think that, going forward, the state will have to limit the right of debtors to enforce claims by bankruptcy. Creditors and counterparties who go to the courts would run the risk of having their claims converted into something like cumulative (and maybe convertible) preferred equity. This would ensure that no dividends are paid to stockholders until the disgruntled creditors are made whole, but would not otherwise disrupt the operation of firms or affect other claimants. (Such conversions could be combined with tight compensation limits, to prevent shareholders and managers from taking payouts as wages and bonuses while failing to pay creditors forcibly converted to equity.) Judges would weigh the rights of creditors against the costs to other stakeholders in deciding between formal bankruptcy and ad hoc conversions, so that the risk to creditors would increase with the size and interconnectedness of borrowers.

It may be hopeless to try to control what kind of contracts private parties write amongst themselves. But we can control how contracts are enforced. There is nothing natural or neutral about how we currently enforce debt contracts. We made up some procedures that seemed to work reasonably well. The current crisis has exposed some shortcomings. Nothing prevents us from modifying how we enforce contracts in order to improve the incentives of parties to manage their own risk, and to prevent collateral damage when private contracts come undone.:

One change in the 2005 bankruptcy laws that has not gotten much attention in the wider world may have contributed to the dislocations last year, namely, that derivative positions were exempted from the creditor stay of bankruptcy. That per Waldman may have lead to more willingness to enter into derivative exposures. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”

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  1. B. Mull

    This idea that the bankruptcy laws coused the crisis is sort of the handmaiden of the notion that short-selling caused the crisis. Both seem to have a lot of currency on the pro-banker blogs. I’m not convinced, but I do have to agree that, to the extent that these factors contributed, the crisis may in fact be amenable to shoveling money to the banks. Just thinking…

  2. Richard Kline

    One could perhaps make a contrary historical argument regarding the evolution of bankruptcy as an institutional process in countries of the European tradition(s). Once on a time, if you defaulted on your debts, _you_ could be seized in many venues and sold into slavery, since your corpus and/or the atendant labors that could be extracted therefrom were considerably mover valuable than most moveable chattels. Seriously: trade revived in Western Europe entering the Early Middle Ages in significant part due to the the profit-attraction of the slave trade.

    —But as slavery became less available one became increasingly stuck with the _debtor_ whose assets were by definition less than what was owed. So an orderly (read sanctioned under law) process for extracting what of value was to be had became desirable. Debt-slavery was tried, but really it wasn’t worth all that much after administrative costs; it was better selling the schlub into bondage. When forced sale of the _debtor_ became unavailable under law, something like bankruptcy began to look might purty. Creditors don’t take booking a loss kindly, but better go get out and get on.

    The 2005 Bankruptcy revision was perfectly designed for the Bubble Years: most would borrow more, and the few who fell in the hole could have their accounts on-sold for a profit by the lenders with little in the way of ongoing loss. But now said debt-slavers are stuck with the chattels, indeed yoked to ’em. That’s a big *ouchie*.

  3. Anonymous

    Steve Waldmen should wake up and smell the corruption …

    Yes the current regime is too friendly to creditors, of course it is.


    Because the wealthy ruling elite creditors own the regime’s puppet politicians that craft on demand the laws that allow them their continued exploitation of the masses.

    You can tender remedial measures until the cows come home but you will get no where until you crack the non responsive to the people, corrupt government, nut.

    Further — keeping every one engaged in this pointless fantasy of appealing to a gangster government that doesn’t give a fat shit what you think distracts from the necessary effort of resetting that gangster government.

    And … creditor, debtor and profit are three words that need to go in the “Library of Most Co-opted Words and Phrases”. As used in this post they mean; master, slave and exploitation.

    Deception is the strongest political force on the planet.

    i on the ball patriot

  4. run75441

    “If the debtor be insolvent to serve creditors, let his body be cut in pieces on the third market day. It may be cut into more or fewer pieces with impunity. Or, if his creditors consent to it, let him be sold to foreigners beyond the Tiber.” Twelve Tables, Table III, 6 (ca. 450 B.C.)

    Its not quite that bad today, but close enough. Similar to eliminating Glass-Steagall, the financial interests tried for years to change the bankruptcy laws into something financial industry friendly and the result was the: The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Damn glad, I have that act to protect me.

    The Bankruptcy act is another roach motel, you can check in by taking on derivatives with high returns and bonuses or that McMansion/World Trip at low interest rates for 1 or 2 years; but, you can’t check out once the rates go up or the market collapses. Interesting to hear firms/banks complaining of being held to the same law as what they clamoured for with the consumers and using similar complaints as well. Perhaps, if the derivative market was transparent; perhaps if those writing CDS were forced to maintain a reserve; perhaps, if . . . ; then perhaps we would not be here today.

    The irony of this is; in either case the very same person, the taxpayer, for whom this bill was designed to prevent from going chapter 7 is forced to pay for their mistakes and W$ also.

  5. LeeAnne

    Interesting how the “kings of the hill,” the best and brightest with their attorneys presumably of the same ilk did not perform the simple test of putting themselves in the other guy’s shoes.

    Common sense? Pumped up with gotcha financial schemes who needs common sense?

    Who amongst these shysters considered fiduciary responsibility?

  6. ben

    There is another, more fundamental, problem with the legal status of derivatives. They should be treated (and regulated) as insurance contracts. Insurance pays only to the extent of your insurable interest – you can’t buy a fire insurance policy on a house you don’t own. Derivative contracts should pay only to people who owned the underlying security at the time of default and continuously before it for some defined length of time.

  7. Anonymous

    The correlation between passing of the new bankrupcy laws and skyrocketing percentages of bad debt is so visible in all charts, that I think, there is causuation between these two. Rampant bad-faith lending started around and after bankrupcy laws passed. period.

  8. Gentlemutt

    The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements “”

    Bingo! You nailed the crux of the pseudo-libertarian delusion. Put it in your book. Excellent! Let ISDA read it and weep.

  9. Anonymous

    Yes, the state has done such a good job of carrying out its enforcement duties that an article has to be written detailing how incompetent the state is at carrying out its enforcement duties.

    If you’re looking to the state to solve social problems like bankruptcy you’re going to be disappointed each and every time.

  10. Anonymous

    “This idea that the bankruptcy laws coused the crisis is sort of the handmaiden of the notion that short-selling caused the crisis.”

    I don’t disagree with this statement, but it is important to note that the whole short-selling issue is a much more nuanced than “short selling is good” or “short selling is bad”. Yves or another guest poster would do well to look into this. (I could try but I fear I lack the stock wonkery chops to do it.)

    Many – if not all – of the publicly traded banking stocks that have been aggressively shorted downwards deserve their fate, in that they are insolvent and bankrupt. No disagreement there.

    The problem is the illegal *tool* used in these shorting attacks: _naked_ short selling. Naked short selling is where phantom stock is sold into the market that does not actually exist. Sounds crazy doesn’t it? But yes, it’s true: Millions of shares of these illusory, non-existant shares have been sold into existance during these shorting attacks, giving the attackers effectively free infinite leverage to destroy companies. The presence is measured by FTDs in the clearing process: fails-to-deliver, which in some cases run into the millions. Naked shorting is financial nano-thermite, capable of bringing insitutions down in days, be they solid or shaky.

    The problem is that the clearing organization, the DTCC, appears to be corrupt, since it allows market makers to generate these fails without regard to regulations that prohibit it.

    Guess who the exception these market makers use is named after? Yup, it’s the Madoff Exception. I shit you not.

    The key site that deals with all this is Unfortunately, the site suffers from confusing design and can be daunting to read. But if you can spare a few minutes to study the site, the picture of a lawless and corrupt *naked* shorting culture will become clear.

    It wasn’t until the financials themselves were attacked using naked shorting that naked shorting was even acknowledged to exist by the mainstream media. Until then it was obsfucated, ignored, or outright denied.

    The main confusion people talking about shorting have is between short selling and naked short selling. Naked short selling is illegal, and is the real source of the problem. The fact that it was used to attack deserving banks might make it seem virtuous, but it’s an evil tool no matter what company it is directed against.

    I apologize if I misprepresent this issue in some way – the topic gets wonky and I’m not a wall street guy.

    – StewPDX

  11. Anonymous

    In regards to debt, the government should just make buying debt/bonds on margin illegal. That would reduce the demand for all of these products based on debt.

    Why the heck would a lender want to lend someone money so they could buy some type of debt-based product anyway? I’ve heard that hedge funds were buying agency debt/mortgages during the bubble using 15-1 leverage. That means some idiotic/criminal lender was supplying ~94% of the capital while the ‘buyer’ of the debt was only supplying 6% of the capital and getting all the upside. That’s crazy.

    In addition, the only way leveraging up on debt makes sense is if you can get some fool to loan you money at a lower rate than what they debt you are going to buy pays. So the lender isn’t getting the appropriate rate of interest. This leads to mispricing of risk and massive bubbles (as we’ve seen)

    The government should pass regulations preventing commercial banks from lending to an entity in order for that entity to buy debt. Allow leverage on physical assets (up to about 4-1 or so), but disallow leverage on debt.

    Bond traders will argue that this leads to higher interest rates, but those ‘higher’ interest rates are actually ‘market’ rates of interest. If you can’t get someone to buy your debt without leverage, the interest being paid on that debt is below-market.

  12. apachecadillac

    U.S. bankruptcy laws, simply put, were designed for a world that no longer exists. We’ve experienced a phase change over the last couple of years that has upended the assumptions under which, at the end of a ‘golden age’ of economic prosperity, the bankruptcy code was last revised. So, yeah, the revisions contributed, but only tangentially, to how the internal contradictions of capitalism that developed during that time frame have played out since then.

    With chilly clarity the deficiencies of the current bankrutcy regime are becoming apparent. There is some warm humor in the fact that the exemption from the automatic stay for swaps and derivatives contributed to the Bear Stearns and Lehman outcomes. More seriously, from a human point of view, is that the assumption that the goal of a consumer Chapter 13 should be to keep the debtor in his house, has become, to use the immortal words of Ron Zeigler (Nixon’s Watergate press secretary) ‘inoperative’.

  13. Anonymous

    There is a danger here that we go further down the non recourse road where there are no consequences for those who take out loans and fail to pay up (Cahpter 7). Bankruptcy in most countries involves all parties loosing out with the debtors income assessed so that they have enough income to get by but still need to pay up some of their debt (like chapter 13)
    $200 food budget is a lot to some households, so I am not totally in agreement that IRS living standards are draconian, but if this is true then this is a reflection on IRS living standards rather than chapter 13.
    As to the issue of lending to those that cannot pay on the asumption that chapter 13 will protect the creditor then I am afraid I view this as dishonets and ought to be punishable by law. Here again the problem is not chapter 13 it is the inability of the law to prosecute lenders for inappropriate lending.
    Just as there needs to be a careful balance of consequences between the individual and the institution, so to should this apply to inter institutional lending.
    The legal fraternity may well have to answer for their own part in this downturn, with legal contracts being written that at best you could say were not in general societies interests. How should lawyers be answerablke to the society when their clients interest lead them into activities which may not be in societies interests?

  14. Yves Smith

    B. Mull,

    Straw man. Read the post again. Nowhere did Waldman or I say that bankruptcy laws caused the crisis.

    I suggest you read more carefully before making spurious claims.

  15. Anonymous

    “Bond traders will argue that this leads to higher interest rates, but those ‘higher’ interest rates are actually ‘market’ rates of interest. If you can’t get someone to buy your debt without leverage, the interest being paid on that debt is below-market.”

    Nail on the head. Well done!

  16. Anonymous

    Hooking consumers with unrepayable debt and then changing the rules once they’re hooked – that has to be one of the most despicable acts of a vile regulatory regime. Change the terms of debt relief, fine. But existing debts should have been grandfathered out so that the pain of stupid lending was borne by stupid lenders.

  17. Fraud Guy

    Personal 2 cents.

    With the current restrictions on bankruptcy filing, I have found myself in an enviable position.

    I earn more than the median for my state, and so cannot file Chapter 7.

    However, I do not earn enough to make the payments required under Chapter 13.

    The biggest single chunk out of my income is my mortgage, which cannot be impacted by BK as it is currently constituted, and I do not live in a state which exempts the primary residence from creditors; which doesn’t matter, as the value is now underwater.

    Here’s to hoping that they don’t literally bring back debt slavery, because figuratively I am a perfect candidate.

  18. Mark

    “The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements… Libertarians may have perfect freedom to contract, if their agreements are self-enforcing or voluntarily adhered to. For the rest of us, every contract is a negotiation between three parties, the two who put a signature at the bottom the document, and the state which will be called upon to give force to the arrangement when disputes arise or someone fails to perform….”

    YES! I’ve been screaming about this for years, but never so coherently.

    What some people call “regulation” of finance, I say is simply limiting government.

    Limited? Yes, limited in the power they have to enforce contracts, and the types of contracts they are obliged to enforce.

  19. Anonymous

    “[W]elsh on their agreements”? Why the need to slander the Welsh? I take it this was inadvertent, but several one-common terms like “Jewed” (Jews), “Gypped” (Gypsies), “Paddy wagon” (Irish), etc. are based on racial prejudices.

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