Garett Jones  

Speed Bankruptcy: Half a Loaf is Better than Justice

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When a corporation's assets appear to be worth less than its liabilities--for whatever reason--the economists' normal solution (as discussed last week) is for the bankruptcy judge to legally convert the bank's rigid debt claims into flexible equity claims.  That's corporate bankruptcy in one sentence.  

In a financial crisis, when megabanks are supposedly too big and too complicated and interconnected to wait for a formal, years-long bankruptcy process, I recommend doing the debt-to-equity conversion of the course of a weekend: I call this speed bankruptcy.  I wrote a short piece on this in Fall 2008 here, a later academic version here

One of the major complaints about speed bankruptcy is that it's not fair: It rips off bondholders who were promised a fixed payment, it doesn't follow a formal legal proceeding where bondholders can argue that the firm really could repay its debts, and it could even run afoul of the Takings Clause of the U.S. Constitution by transferring wealth without just compensation.  

I won't discuss the Takings issue, too far afield. And I'll only discuss the rip-off claim by noting that bankruptcy is all about people getting less than they were promised--the pie is probably too small for us to all get our contractually agreed slices.  [Cue sad horn --ed.]

But I will note that in real-world corporate bankruptcy a major legal doctrine is the "value maximization norm," which says that if you want to make an omelette you have to break some eggs.  Less cavalierly, a major goal of bankruptcy should be to maximize the firm's value going forward.  That usually means violating justice: so even if legal precedent and contract say "group X gets paid before group Y," group Y will get paid first if that helps the firm become more productive in the future.  That's called violating the priority of claims.  

The maximization norm gives weight to efficiency and opposes the dead hand of history--and justice.  In spirit, it reminds me of parts of Coase's "Problem of Social Cost." 

In a classic paper, Lawrence Weiss showed that most real-world corporate bankruptcies violate the priority of claims.  And the priority violation at least prima facie is driven by the quest to maximize firm value. So tossing contracts out the window to help the firm is typical.  

Of course, if you want to convert bank bonds to bank shares in a weekend, you're going to violate a lot of prior claims.  For instance, the guy who waters the plants might have a line in his contract saying he gets paid only after bondholders do.  But notice: If the megabanks are right--if they can't survive a normal bankruptcy process, if they really are too big to fail--then that strengthens the legal argument for weekend debt to equity conversion.

How?  Because if the megabank can't survive normal bankruptcy, then wealth maximization demands that we rip off the bandage quickly--even if it rips off some skin.  The fragility of the megabanks strengthens the case for crude triage. 

Absent bailouts--or some well-run, widely-trusted bankruptcy system that doesn't yet exist for megabanks--the best way to maximize the megabank's future value is probably for a bankruptcy judge to grab all the tradable bank debt she can find and legally declare it to be shares.  With bank liabilities now smaller than bank assets, the new shareholders have a strong incentive to grow the future firm; the new shareholders will treat their firms the way a householder treats his home when he has home equity.  They'll take better care of the place, because they've got skin in the game.  

Those who oppose speed bankruptcy--also known as bondholder bail-ins or shared sacrifice--are hollowing out the middle range, leaving only the stark alternatives of a theoretically pure, years-long bankruptcy process or massive bank bailouts.  I know which option real politicians will choose.  

Coda: Take a look through the comments section of last week's post, where practitioners offered real insight into corporate bankruptcy.   

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COMMENTS (19 to date)
david writes:

I invite you to consider the possible side-effects on corporate financing of ruling non-traded debt as worthless...

Besides which, because traded debt is itself tied up in contigent contractual obligations (that may, worse, be managed by a failing megabank itself), "use only traded debt" is a non-answer. The debt certainly exist. Who owns it?

Shayne Cook writes:

Dr. Jones:

Lots of metaphors here - eggs and omelets, tossing important things out windows, ripping off bandages/skin, etc. And all in the sole interest of applying allegedly economic principles to justify political expedience over due process.

In doing so, you've glaringly omitted economic principals, and blissfully ignored not just their prior rights under law, but the very essence of why they purchased debt over equity positions in the first place. I'm wondering if you and folks like Mankiw, Stiglitz, et.,al. even understand the difference between debt and equity, that they are decidedly two different products, and more importantly that they are different for a critically important economic reason - capital cost reduction.

For investors, debt instruments have a dramatically reduced risk profile relative to equity, by virtue of being afforded protections under contracts law. That reduced risk profile decreases capital costs of debt for business entities.

If your "weekend bankruptcy" expedient were to be implemented, I can assure you the investment community would notice. I know that because I'm an investor. And the result would be that debt capital costs would increase immediately and dramatically - for ALL business entities, not just the trivial few which may enter bankruptcy. And it would do so specifically because your expedient eliminates the risk-profile difference between debt and equity. That added risk would immediately be priced into cost of debt.

Per Lawrence Weiss and others, many bankruptcies do resolve to debt to equity conversion. And you are certainly correct that bankruptcy courts strive to maximize firm value. But they do so, not in the interest of judicial bias, fairness or just because many judges want it to be that way. They do so specifically at the behest of the claimants - it is in their best interests!

So I'll pose questions to you: Do you, Mankiw, et.al., actually believe your "weekend bankruptcy" political expedient is economically superior to due process, under law? Do you also believe it has no profound and costly economic negative externalities that you've failed to consider? Finally, and most importantly, do you actually believe the discipline of economics should be applied (contorted) to serve the interests of political expediency, over the legal rights AND best self-interests of investors, business entities and ALL other economic actors within the U.S. jurisdiction?

Toni writes:

I think the key point you're forgetting here is that corporate value stems from entrepreneurial risk and strategic management. The point is really who does exactly that - who's capable of it and who's willing to bear the entrepreneurial risk.

And that's the whole idea why we have exactly two asset classes: equity and debt. The people who actually manage equity for a living are professionals are good at deciding how to run a company, incentivizing management and choosing a strategy for the company to implement. All the debt people care is balance sheet optimisation and minimising losses.

I have lots of first hand experience from restructuring projects in the Nordics. We have a huge amount of large corporations that could be bankrupted any day by the banks but they don't want to. They wouldn't know what to do with the company! They don't know how to run it, they don't want to take the risk of administering the company, etc.

So most real life situations I have seen regarding corporate restructurings are e.g. situations where the bank cuts debts in half (a really bad option) and the owner puts e.g. 10% of debt as equity to the company and just sells the company. The owners get this incredible deal because they are familiar with the actual company, what strategies are viable and how to best maximise the corporate value. After a restructuring, they only have a year or a maximum of two to work things out in the company by perhaps some cost cutting and other turnaround stuff and then just selling the company to a new investor (who will by default repay the company's loans).

That's of course just the situation here in Northern Europe. Maybe our banks just lack the competence to take over bankrupt companies and there's no third party they trust to do business administration, but they're scared shitless of anything to do with equity. (Plus it screws up their balance sheets as well due to Basel and other regulation, they cannot de facto hold equity unless it's via some really weird offshore vehicle.)

Just as a benchmark (off the top of my head), in the last major depression when the Soviet Union fell, we had less than 10 major corporations that were given to the banks in all of the Nordics. That's probably less than 10% of the cases.

[Edited lightly, with permission.--Econlib Ed.]

Greg G writes:

I agree with those who think that this will prove a lot more problematic in practice than in theory.

Even so, this idea moves the policy debate in a productive direction. Bondholders need to have more skin in the game and ordinary bankruptcy is way too slow and costly to work for TBTF companies.

Of course this would raise capital costs. That is a feature, not a bug. We have seen the results of underpricing credit risk.

Shayne Cook writes:

@ Greg G:

Just a couple of observations from my perspective.

You and Garett, et.al., note that the bankruptcy process is slow and cumbersome. I quite agree. But, in your words, that is a feature, not a bug. It is slow and cumbersome precisely in order to deal with every single claimants rights, in context with all other claimant rights, when prior assumptions of viability have obviously failed. It thereby has to be a slow, cumbersome process in order to be thorough. And thoroughness is critical, as well as desirable - from an economic as well as legal perspective.

You note this will raise capital costs, and rightly note "we have seen the results of underpricing credit risk". Again, I concur - obviously, given my comment above. But I suggest you are hopelessly underestimating the magnitude of capital cost increase that will result from making debt risk fully equal to equity risk.

And lastly, there are no TBTF companies! None! Never! The entire concept of "Too Big to Fail" is fully and completely inoperable - and dangerous. That is historically true of whole nations, by the way, not just business enterprises. Any acceptance whatsoever of the notion of TBTF invariably leads to political expediency and failure.

Greg G writes:

@ Shayne
I may have been a little unclear. I think the slowness of bankruptcy is indeed a problem no matter how necessary it may be. Speeding things up is the main advantage of Garett's idea. No doubt the advantages come with costs.

No one is proposing "making debt risk fully equal to equity risk." Debt holders will always have the added protection of having their claims come ahead of the equity holders who owned the company when those debt holders invested in their bonds. Even in an ordinary old school bankruptcy debt holders do risk huge losses in a worst case scenario.

You can say there shouldn't be TBTF companies. You can't say there aren't any.

Thomas DeMeo writes:

Wow! Bankruptcy isn't just slow and deliberate. It is spectacularly inefficient and destroys value. The smaller the firm, the worse the result.

We don't need special bankruptcies, we need better bankruptcies.

Steve Z writes:

It might be helpful to see a worked case example of what you are talking about. The illustration I have in mind would identify all the creditor classes, and explain the post-speed-bankruptcy shape of the company. In short, the devil is in the details.

It seems like you are proposing wiping equity out when there's not enough value to pay bondholders off. Since this is already the rule, it's hard to understand why we need a new system. If the issue is that we need a faster valuation: that could be true, but it's complicated. We allow secured creditors to credit-bid, but with a huge book of illiquid securities in a dried-up market, this might not produce a good valuation. It is hard to even determine whether such a company should be in Chapter 11 or Chapter 7. It's fine and dandy to talk about snatching up securities and converting bondholders to shareholders - that's what Chapter 11 does, in principle -- but without a way of rapidly valuing the underlying assets, the exercise could easily devolve into a corrupt cash-grab.

In any case, these are all problems that can occur in a vanilla Chapter 11. Happily, pre-pack bankruptcies are becoming more common - creditors can even take a security interest in all of a debtor company, prior to bankruptcy, via the new(ish) parts of Article 9. The old bankruptcy principles (well, the ones from the 1970s) have given way to DIP financing. Banks are special due to the increased valuation difficulty, and the greater possibility of systemic effects (or so I am told). I don't see why vanilla bankruptcy shouldn't work for banks, it's just that it hasn't been tried.

If the point is a public choice one about how government interventions in bank bankruptcies are bad, that's true, but just saying "we need a bankruptcy norm that's respected" isn't going to stop various creditor classes from warring, whether in the courtroom or in the fancy restaurants around the Potomac. IT would be just as easy to say "the government should just let the bankruptcy courts do their work, and it would work if everybody respected the process." Doesn't get us far.

SheetWise writes:

This has the smell of conceit. Efficient breach arrogantly assumes that a damaged counterparty can be made whole -- even when that party doesn't agree -- and presumes that someone other than the parties who entered the contract has a better understanding of value and the best use of resources. If breach is better for both parties, then let them agree to it -- otherwise, respect the contract.

I will never understand how economists -- who generally oppose the concentrated benefits and distributed costs imposed by trade restrictions and tariffs -- can concurrently believe that the law should maximize a firm's value and discount the distributed benefits and opportunities advanced by its failure. In the absence of agreement, both legal actions simply interfere with and distort market processes.

Shayne Cook writes:

Greg:

Where we agree - "debt holders do risk huge losses in a worst case scenario". I do NOT propose to absolve debt holders of their risk, nor does the bankruptcy process.

Where we disagree:
1.) The "slowness" - deliberateness - of bankruptcy proceedings is the necessity. It is only a problem to those who prefer expediency to justice. I do not.
2.) Garett and Mankiw are precisely proposing "making debt risk fully equal to equity risk." That is the essential core of their proposal. As an investor and a depositor, I will warrant that is exactly how this would be received, perceived and risk-weighted/priced in the U.S. financial markets.
3.) I most emphatically can and do say, "There are NO TBTF companies" - anywhere. It is due to that absolute fact that investment risk exists! Are you asserting there are no investment risks? I know better!

Bankruptcy courts, contracts law, and due process were contrived and exist to afford protections - not punishment - to all who subject themselves to the jurisdiction. What Garett/Mankiw propose is to negate those legal protections, and supplant them with punishment. In the interest of expediency? I'm not impressed.

Greg G writes:

@ Shayne
Of course I am not claiming that "there are no investment risks." Neither is anyone else I have ever seen using the term. "Too big to fail" is not, and never was, a metaphysical claim that a company is certain to live forever with no loss to bondholders.

It is simply conventional shorthand for "very widely believed to be in line for a government bailout if needed. " It is also shorthand for the widespread belief that allowing such companies to fail would have catastrophic consequences.

Are you really unaware of this conventional usage of the term?

Maximum Liberty writes:

My biggest problem with this is that it enshrines a violation of the freedom to contract that is the default legal rule in the US. If we are contemplating exceptions to that rule, we should constrain the exceptions to the problems that led to that contemplation.

So, if we are concerned with financial institutions that are too big to fail, let the banking regulators require them to issue at least some value of junior-most bonds. Or, if we are worried about the effects of the identification, require all banks (and other identified classes of financial institutions) to do so. If this tier was large enough, it could be converted over a weekend. Presumably, this tier would carry a hefty risk premium, so converting it would reduce interest expense by a fairly large fraction. It would shield trade creditors, depositors, and other bondholders. This would also alleviate the control issue. Tracking a single set of bondholders and issuing pro-rata shares is simpler than adjudicating multiple types of claims and issuing differing amounts of equity for each claim (or, even worse, issuing them over time depending on the outcome of operations).

The problem will be that the junior-most tier has to be large enough to assure the markets that its conversion makes the company creditworthy going forward. Othwerwise, there's no point to it. There are some obvious cases where no amount of bondholder conversion would do the trick. For example, where the company mainly backs the tail risk on derivatives for a small fee, the class of companies on the other side of the derivative will have claims that could greatly outweigh the bonds that the company could have issued based on its fee income. So this is not a panacea. It just addresses some kinds of risks for many kinds of financial institutions.

Max

Shayne Cook writes:

Greg:

I am most certainly aware of this "conventional usage of the term [TBTF]!

And I am even more certainly in contempt of it! IT IS A LIE!

Mathieu Bédard writes:

I think contingent capital instruments and resolution schemes in general are an exciting development, but I must admit that I am somewhat skeptic of speedbankruptcy.

Just a few quick thoughts that I think you need to address:


  • I'd just like to point out that there is a large literature challenging Lawrence Weis' paper.

  • There is nothing suggesting that bond holders are interested in becoming equity holders. If they were, they'd have bought equity in the first place.

  • It still seems to me like speedbankruptcy might be much more trouble than it's worth. First just think of how predictable and orderly the Lehman bankruptcy has been. If anything, Lehman is proof that Chapter 11 is just fine as it is. Second, this is all addressing counterparty contagion, which empirical literature has shown not to be a serious threat. There are attempts to salvage the models by saying that what they really meant was another kind of more intricate interconnectedness, but it still doesn't work. Banks are always too diversified for counterparty losses alone to push them into insolvency. SIFIs go bankrupt one after another not because of contagion, but because they've invested in the same kind of assets. Systemic risk is pretty much a myth.

  • An interesting question that isn't addressed by speedbankruptcy is the detection of the insolvency. If insolvency could be detected and resolutions initiated before firms could enlarge their losses, regular insolvency procedures would be just fine and their results much more politically acceptable. More research into alternative methods of initiating bankruptcy is greatly needed.

Joe Cushing writes:

If debts are converted to equity and the organization turns out to be in better shape than previously thought, it's not the bond holders that get shorted because their new equity claims will grown in value, it's the equity holders who get shorted because their positions are either wiped out or highly diluted. All converting a debt to equity does is it says that you get to have everything the company is capable of paying you--even if that means you get more than you were owed down the line.

Alex writes:

Dr Jones' speed-bankruptcy is not designed for typical companies, but rather megabanks that are deemed TBTF. These institutions are dramatically different from other corporations because bankruptcy--or even a hint of BK--causes liquidity to disappear: counter party requests for more collateral and potentially NO ability to roll over short term debt.

This means a standard drawn out BK proceeding is not an option. The only options are government bailout or liquidation. My understanding is that the weekend BK is a potential alternative to that.

Mathieu Bédard writes:

The flights Alex describes are present in pretty much any bankruptcy. They are not special or exclusive to large institutions.

Here's for a thought; the FDIC's "bridge bank" resolution technique was especially designed for large bankruptcies and involves a long drawn out process in the hope that the bank becomes solvent again, in a sense similar to Chapter 11. Even the FDIC's most expedient resolution techniques involve selling assets no less than 4 years after the initiation of insolvency procedures. Obviously these resolutions involve insured depositor payoffs by the FDIC, but they show that speed is simply not THAT important to the maximization of the value of large banks or financial holdings bankruptcies.

Garett Jones writes:

@Alex and Mathieu:

I agree with you both. Alex notes that this shoehorning is only a good idea because the plausible alternatives are worse.

And Mathieu notes that the FDIC's bridge bank is gets much the same job done over the course of a weekend. Dodd-Frank empowers FDIC to try the same thing with TBTF financial institutions (banks and non-banks), but we don't yet know if that process is credible.

Belt-and-suspenders is my preferred solution: Contingent convertibles (CoCos), FDIC resolution, higher capital requirements, living wills, with Speed Bankruptcy as a backup.

Let's push for them all. Because they're all better than 100-cents-on-the-dollar bondholder bailouts for TBTF firms.

Mathieu Bédard writes:

That's the exact opposite of what I wrote.

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