I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, [...]]]>

Our Roving Bankruptcy Correspondent

I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, acquired The Inquirer and its related properties (The Daily News and Philly.com, their collective website), from the McClatchy papers in 2006 for about half a billion dollars.

Like several other newspapers, including The Chicago Tribune, The Inquirer could not service its massive acquisition debt.  Thus, in February 2009, the paper (and its affiliates) filed a Chapter 11 case in Philadelphia.  In August, management filed a proposed reorganization plan where Tierney (who manages the papers and owns some equity) and some of his supporters would buy the papers out of bankruptcy, for about $90 million, leaving most large creditors—i.e., the ones holding the acquisition debt–with a very small recovery.  The management buyout would be subject to higher and better offers.

According to the official Creditors’ Committee in the case, the Inquirer’s “keep it local” campaign is designed to make sure there are no better offers.  Management’s ad campaign warns of dire consequences “[i]f out-of-towners were to seize control.”  Allegedly hailing from such illiterate venues as New York, Beverly Hills “and even Lausanne, Switzerland, these out of towners would feel little commitment to, or understanding of, [Philadelphia’s] local non-profit needs.”

This may be true.  But, of course, The Inquirer is at least purportedly a for-profit venture.  Thus, the more realistic concern is that outside investors would further cut an already thin staff, and perhaps eliminate The Daily News entirely in order to boost their own dividends and management fees. “Keeping it local” is, at least in part, about preserving jobs in Philadelphia.

Not surprisingly, the Creditors’ Committee—which wants higher and better bids for the paper–has objected to the advertising campaign, and filed a motion asking the Court to enjoin it.  “This entire campaign is designed to dissuade otherwise interested bidders, who will think twice before participating in the auction . . . . This is bid chilling, plain and simple.”

Three things are ironic about all of this.

The Committee Objection

First, the Committee’s objection is as interesting for what it omits as what it says.  Thus, while it gets at the basic issue—bid chilling—it misses the easiest objection, which is that the ad campaign is a bald attempt to solicit votes on a reorganization plan before a disclosure statement for the plan has been approved.

At the risk of asking CoOp readers to become bankruptcy geeks, the basic idea here is that a plan (such as management’s) can only be approved if a sufficient number and amount of creditors vote for it.  But they cannot vote on it without having first received a court-approved “disclosure statement”.  Until the court approves a disclosure statement, you are not supposed to solicit votes on a plan.  So, if management wants to tell the story that its plan beats any alternative, it can only do so through an approved disclosure statement.  Not adjacent the editorial page.

While management has filed a disclosure statement, it has not, so far as I can tell, been approved.

Maybe the Committee omitted the argument because of the Third Circuit’s controversial 1988 opinion in a case known as Century Glove.  There, Judge Roth gave a fairly relaxed interpretation to these rules, holding in essence that a creditor with a competing plan could solicit particular creditors to oppose the debtor’s plan and support its own instead.  Century Glove, Inc. v. First Am. Bank of New York, 860 F.2d 94, 101 (3d Cir.1988)

But even Century Glove acknowledged that the Bankruptcy Code “bars certain solicitation activities, regardless of the intent of the actor. Whether that provision is violated is not a matter left to the discretion of the bankruptcy court, but is a matter of fact and law.”  860 F.2d, at 97.  The point of Century Glove was to permit creditors and debtors to negotiate about potential plans notwithstanding the requirement that there be a disclosure statement in place.  That’s not what’s happening here.

To be sure, the ad campaign contains the disclaimer you’d expect: “The statements and information contained herein are . . . not intended to solicit and are not provided for the purpose of soliciting or otherwise obtaining approval of a plan of reorganization.”  (Interestingly, the disclaimer does not print from the web).  And, it goes to the world—not just creditors.  Still, it’s hard to see what it is if not a request to support management’s plan.

Similarly, but perhaps not surprisingly, the Committee does not identify any actual or potential bidders who might be chilled here.  This may be because they don’t exist.  Newspapers are not exactly hot investments these days.  Moreover, it is difficult to imagine hedge fund managers in Switzerland (or Beverly Hills) saying “you know, let’s not bid for The Inquirer.  True, it could make us rich.  But that ad campaign has really made us think twice.”

In any case, the real play here may be for the banks that lent Tierney the half-billion dollars in 2006 to do what’s called “credit bid” for the assets.  This essentially means they would foreclose on the newspapers unless someone paid them in full.  Explaining whether that is likely to happen, and what it would mean, would tax the endurance of even the most-die-hard CoOp reader.

Venue Choice

The second thing to note is that the whole case could be viewed as an ironic data point in the raging academic debate about venue choice in Chapter 11 cases.

The venue rules which govern where a company can file a Chapter 11 case are quite liberal. They permit a debtor to file where any company in the group is incorporated.  So it is usually not hard to find a connection to New York or Delaware, which happen to have the two most popular bankruptcy courts, so far as Chapter 11 cases are concerned.  Thus, the Chicago Tribune case is in Delaware, not Chicago; GM and Chrysler are in Manhattan, not Detroit.

UCLA law professor Lynn LoPucki has argued that, as with corporate law in Delaware, there has been a “race to the bottom” in the selection of courts that hear large Chapter 11 cases.  According to LoPucki, the Manhattan and Wilmington bankruptcy courts have captured most of the large bankruptcy cases because, among other things, company managers and bankruptcy professionals in those cities believe they can get away with anything in those courts, no matter how harmful to investors or employees.  These courts permit this sort of behavior because they want the notoriety and excitement of large and complex cases.

Others, in particular Penn law professor David Skeel, have responded that venue choice in Manhattan and Delaware isn’t evidence of anything nefarious.  It’s just the market for Chapter 11 cases.  These courts have the most sophisticated lawyers and judges, and (thus) produce the best results under the circumstances.

There is no doubt that the largest cases often do end up in Manhattan or Wilmington—and not in Philadelphia, or wherever the debtor’s “local” operations are.  What we can infer from that, however, is a more complex proposition.  I have avoided wading into the debate, in part because I am not sure it really asks the right questions.

But if you do think Chapter 11’s venue rules are too liberal, and the process would better serve investors and employees if conducted in the “local” venue of the debtor, then you may want to think about what’s been going with The Inquirer.

Here, we have expensive lawyers from large, far-away firms (Proskauer-Chicago and O’Melveny-Los Angeles, respectively), representing the company and Creditors’ Committee, locked in what appears to be a scorched-earth battle to control the fate of these papers.  Insiders and professionals may do well in this process.  The newspapers—and the “locals”?  Not so much.

Who Cares?

The third irony is that all this squabbling may not matter much.  Even if Tierney and his group want to keep the papers afloat—and even if that is the best deal going—they may not succeed.

If we are to believe Philadelphia’s Mayor, Michael Nutter, the city is on the brink of experiencing its worst financial shock in modern history due to shenanigans in the state legislature that have left Pennsylvania the only state in the union without a budget.  If the worst comes to pass—and it might—Nutter says he will have to eliminate 3000 jobs and severely curtail city services.

If Harrisburg tells Philadelphia to drop dead, it is hard to see who will be left to read any newspapers, whether the owners live in Philadelphia or Lausanne.

Believe me, no. I thank my fortune for it

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year.

Therefore my merchandise makes me not sad. (I.i.41-45)

Having ignored the problem of fat tails and black swans, Antonio decides to engage in [...]]]> Over the weekend, I re-read A Merchant of Venice, and I was struck by the fact that Shakespeare manages to include in the play virtually every element of the current financial crisis. Scene one begins with a discussion of risk assessment, and Antonio’s belief that he has managed to tame the vagaries of commercial fate through diversification. Asked by Salarino if he “Is sad to think upon his merchandise” (I.i.40), Antonio responds:

Believe me, no. I thank my fortune for it

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year.

Therefore my merchandise makes me not sad. (I.i.41-45)

Having ignored the problem of fat tails and black swans, Antonio decides to engage in a bit of dodgy finance. He borrows in the wholesale market from Shylock under terms that appear favorable, but have a huge downside in the unlikely event of his default. Antonio, of course, is unconcerned. From his point of view he is getting cheap money by taking on what seems like an extremely remote risk. He then takes these borrowed funds and uses them to make what can only be described as a no doc, subprime loan. Bassiano wants money for a speculative venture — the wooing “In Belmont [of] a lady richly left” (I.i.161) — and Antonio agrees, in effect renting out his credit rating:

Try what my credit in Venice can do;

That shall be racked even to the uttermost

To furnish thee to Belmont to fair Portia.

Go presently inquire, and so will I,

Where money is; and I no question make

To have it of my trust or for my sake. (I.i.180-185)

Shylock, for his part, does not approve of the loose monetary policy in Venice, which he rightly blames on wild lending practices, such as Antonio’s loans:

How like a fawning publican he looks.

I hate him for he is a Christian;

But more, for what is low simplicity,

He lends out money gratis and brings down

The rate of usance here with us in Venice. (I.iii.38-42)

Faced with such low returns on normal loans, Shylock is forced into the shadowy world of loan-to-own, in this case targeting, as he tells Antonio, “…an equal pound/ Of your fair flesh, to be cut off and taken/ In what part of your body pleaseth me” (I.iii.147-149). As he later reveals, Shylock is engaged in a bit of arbitrage in the commodity markets and wants Antonio’s flesh “To bait fish withal” (III.i.49).

When all Antonio’s “argossies” reportedly wreck at the same time — a wildly improbable event predicted by none of Antonio’s complex statistical models and, as we have seen, completely discounted by him — his over-leveraged balance sheet sends him spinning into bankruptcy and ruin. For his part, after Lorenzo makes off Madoff-like with Shylock’s daughter and his savings — “A diamond gone cost me two thousand ducats in Frankfurt!” (III.i.77-78) — he is left to lament (albeit in prose):

Why thou loss upon loss! The thief gone

with so much, and so much to find the thief, and no

satisfaction, no revenge, nor no ill luck stirring but

what lights o’ my shoulders, no sighs but o’ my breath-

ing, no tears but ‘o my shedding. (III.i.85-89)

Of course, once his ill-fated bet on Bassiano and the power of risk management starts to unwind, Antonio’s surrogates begin lobbying the government to change the rules so as to avoid unwanted contracts. To his credit, the Duke resists these entreaties, because, as Antonio acknowledges:

The duke cannot deny the course of law;

For the commodity that strangers have

With us in Venice, if it be denied,

Will much impeach the justice of the state,

Since that the trade and profit of the city

Consisteth of all nations. . . . (III.iii.26-31)

His laudable concern for the commercial reputation of Venice, however, does not prevent the Duke from using the bully pulpit in an attempt to brow-beat Shylock into renegotiating his contract with Antonio:

Shylock, the world thinks, and I think so too,

That thou but leadest this fashion of they malice

To the last hour of act; and then ’tis thought

Thou’lt show thy mercy and remorse more strange

That is they strange apparent cruelty’

And where thou now exacts the penalty,

Which is a pound of this poor merchant’s flesh,

Thou wilt not only loose the forfeiture,

But touched with human gentleness and love,

Forgive a moiety of the principal,

Glancing an eye of pity on his losses,

That have of late so huddled on his back,

Enow to press a royal merchant down

And pluck commiseration of his state

From brassy bosoms and rough hearts of flint,

From stubborn Turks and Tartars never trained

To offices of tender courtesy.

We all expect a gentle answer, Jew. (IV.i.16-34)

The Duke’s speech, of course, falls into the standard rhetorical tropes from the perennial battle between Main Street and Wall Street, finance and the “real economy.” Shylock is asked to forgive the principal out of “human gentleness and love” and Antonio’s unfortunate losses “huddled on his back,” nevermind, of course, that it was Antonio who got himself into the problem with the first place through irrational exuberance and shoddy lending practices. Of course, beneath the velvet appeal to mercy and solidarity there is the steel fist of an unstated threat. Shylock is “Jew,” the member of a hated minority and the memory of young men following him through the streets taunting him over the loss of his daughter just a few scenes before must be fresh in his memory. The duke is willing to stand behind the “justice of the state,” but for how long in the face of an increasingly belligerent public that his sided decisively with Antonio?

Of course, the story is resolved when deus ex machina Portia arrives with clever legal arguments that allow Antonio to escape his obligations while giving the city a fig leaf behind which it can hide its ultimately thin commitment to contractual sanctity. (Of course, realist that I am, in the end I think that that it is Portia’s rhetoric — “The quality of mercy is not strained…” (IV.i.182) — rather than her legal analysis that does the real work.) The ending, however, requires the forced conversion of Shylock and what amounts to public control of his capital through a series of strong-arm negotiations rather than outright legislation.

Needless to say, finance and capitalism will never be the same in Venice again. With Antonio and his friends in control, I shudder for the prospects of efficient capital allocation in the future. I think that we can expect more loans to well-connected folks like Bassanio with questionable business models.

Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”

Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.

According to the Times, the President now believes that: bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for [...]]]> [Jonathan Lipson has been a terrific, episodic, contributor to CoOp on the bankruptcy aspects of the financial crisis and the bailout. He approached me about posting the following very useful set of thoughts about the auto-mess, which I'm happy to now share with you.]

Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”

Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.

According to the Times, the President now believes that:

bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for the American automakers at this time,” Mr. Bush said, noting that consumers would be unlikely to purchase cars from a bankrupt manufacturer.

While I am ordinarily a cautious supporter of the Chapter 11 reorganization system — and suspect much of today’s trouble could have been averted (or at least minimized) if Bear Stearns had been permitted to go through Chapter 11 — I think this is probably the right move, albeit for the wrong (stated) reasons.

Two Weak Arguments Against Bankruptcy

Two principal arguments are made against auto-maker bankruptcy: (1) as the President suggests, bankruptcy might scare off customers, and (2) it might cost jobs.

There is some truth in both—but probably not much.

First, I am skeptical of claims that people will stop buying cars because a manufacturer is in Chapter 11. After all, virtually every U.S. airlines has been through Chapter 11 at least once. People continued to strap themselves into pressurized metal tubes and fly at 30,000 feet despite bankruptcy’s dislocations (no pun). In any event, the only thing of concern to consumers that bankruptcy could likely affect would be warranty commitments. While there’s no guarantee of success, there are ways to deal with this, including acquiring third-party assurance of performance, etc. In any case, if the company reorganized, it would almost certainly “assume” these obligations—and probably work hard to let consumers know that it intended to honor them.

I am sure bankruptcy would scare off some customers. But I suspect that the real problem for consumers (and thus the industry) is, as it has been, the financial services sector, which continues to suck enormous value from the public fisc without, apparently, converting it to productive uses (by, for example, lending to credit-worthy would-be car purchasers).

I know, I know: Detroit makes inferior products. That may be true. I don’t own a car at all, and the one that I once had was a pre-Ford Volvo (it was blown up through no fault of the Swedes). But my sense is that U.S. cars have been getting better and, if the companies survive, this is likely to continue. In event, it doesn’t really matter. If, as was reported today, Toyota can’t sell cars in the U.S., no one can.

The second argument—about lost jobs—is doubtless true, but likely exaggerated. The Center for Automotive Research has estimated that millions of jobs would be lost if the car companies went under. But Chapter 11 probably wouldn’t eliminate all of these jobs. Rather, at least in an “orderly” reorganization (more about this below), the companies would restructure and likely emerge in some newer, smaller (perhaps better) form.

Don’t get me wrong: Even a successful Chapter 11 would cut plenty of jobs and benefits. The Bankruptcy Code specifically gives debtors the power to reject or modify (breach) collective bargaining and benefits agreements. This is a gross simplification, but if this power were used (and there are plenty of impediments), it could convert workers’ rights into unsecured claims against the company (very small dollars) or shift these obligations to the Pension Benefit Guarantee Corporation, which may not be quite so generous as GM. In any case, bankruptcy could be used to dilute the companies’ obligations under their ostensibly outsized union obligations.

But it wouldn’t be pretty. Indeed, the prospect of a nasty fight over these contracts may be one reason the administration relented: They may understand that no auto industry bankruptcy could be “orderly” for this reason alone (and there are others discussed below).

Moreover, many of these jobs and benefits already have been lost or reduced. Indeed, if you look at what has happened (and is continuing to happen), a slow-motion, herky-jerky form of “workout” is already taking place. The UAW and (to some extent) management have already made significant concessions. The union has taken over some legacy health care costs and cut some of the fat from its workplace rules.

According to the Times, today’s proposal would accelerate this:

The loan deal also requires the companies to quickly reduce their debt obligations by two-thirds, mostly through debt-for-equity swaps, and to reach an agreement with the United Auto Workers union to cut wages and benefits so they are competitive with those of employees of foreign-based automakers working in the United States.

As I’ve noted in prior posts here, these are the sorts of moves that should accompany any restructuring, within or without bankruptcy. The parties, not the taxpaying public, should share these losses if at all possible. While I would prefer no bailout, these are the sorts of conditions I would have hoped attached to all TARP money.

If the stated reasons for avoiding bankruptcy are not persuasive, why do I nevertheless think it’s the right move here?

Chiefly because bankruptcy reorganization today is not what it once was, and those changes may matter in this context. The Administration’s (currently abandoned) hopes for an “orderly” reorganization are likely to be unrealistic—and not just because of fights over wages and benefits.

The Shadow Bankruptcy System

The real problem may be what we can think of as the rise of the “shadow bankruptcy system”®. We have all (sadly) become familiar with the notion of a “shadow banking system”—the unregulated mass of hedge funds, private equity funds and investment banks that got us into this mess in the first place.

Bankruptcy has not been immune from this phenomenon, although we don’t talk about it much. But the same sorts of players that got us here—hedge funds and private equity funds, in particular—also play the market for claims against distressed firms. And this can make the shadow banking system look like sunshine itself.

As I argue in this draft paper (written last summer), Chapter 11 increasingly looks like an unregulated securities market. This is due to the explosive growth in trading claims against distressed firms.

Historically, when a company went into Chapter 11, creditors (and perhaps irrationally exuberant shareholders) would wait—often years—to get paid some fractional amount of their claims or interests. Beginning in the 1990s, however, smart people with money recognized that they could purchase these claims and shares—often at bargain prices.

The original creditors would want to sell because they would get cash up front, even if significantly discounted. The purchasers would want to buy because, if successful, they might be able to acquire enough claims to reach what is now known as the “fulcrum point”—sufficient investment across the capital structure to influence the case and (more important) to make money no matter the outcome. Think of it as a sort of applied version of the Capital Asset Pricing Model.

Like secondary markets for securities generally, there is much to be said for the development of claims trading. At least in theory, it probably does—or at least could—link capital and assets in a more efficient way than a bankruptcy court.

But, like all unregulated markets, the potential for abuse is enormous. Claims traders may have very different interests than original company creditors. Odd as it may sound, they may, for example, want to see the reorganization fail, not succeed.

Why? Two reasons.

First, these same folks may also want to buy the debtor’s assets. This is especially likely if they have purchased claims secured by those assets (in which case they may be able to “credit bid” their claims). Assets are likely to be cheaper in a liquidation than if sold (or retained) as a going concern. Lynn LoPucki and Joseph Doherty have recently made the case that these sorts of “fire sales” are occurring with disturbing frequency even in Chapter 11 reorganizations. As I argue in the linked draft, if they are right, it may be in part because the reorganization process has been distorted by the shadow bankruptcy system.

Second, and more ominously, there is (as also discussed in the linked draft) some evidence that these sorts of folks may also hold credit default swaps that pay off only if the reorganization is worse than expected. That is, they may have purchased credit protection that is triggered when a company sells certain assets, or pays less than a defined amount on its debt, and so on. Either way, the moral hazard is obvious.

Thus, the real problem here, as with any unregulated securities market, is opacity that permits (and perhaps encourages) these sorts of perverse incentives. Given the velocity and secrecy of claims trading, we do not know who holds what claims against what debtors, in what amounts, and what their real goals are. We thus lack the capacity to know who can really control cases.

For lots of bankruptcies, this may not matter much. But the auto industry is different. I admit that it is unlikely that any one investor could acquire enough GM debt or shares to control a bankruptcy. The problem is that we just don’t know who is out there, or what they are doing in this context. To paraphrase the great epistemologist, Donald Rumsfeld: In reorganization we increasingly don’t know what we don’t know. That lacuna is likely to matter here.

Moreover, while it may be true that Detroit’s products are not great, U.S. manufacturers cannot be credibly blamed for their predicament. The auto industry (as such, and not owners such as Cerberus) had no obvious and direct role in the events leading to the Great Credit Seizure of 2008.®

The industry—and its thousands of direct and indirect employees and suppliers—are nevertheless vulnerable victims of it. They are to credit system failure what an immune-suppressed person might be to, say, avian flu. While they may not have caused the infection, their condition may frustrate their ability to survive it.

Thus, the “auto immune system” (sorry) is literally compromised. But the traditional hospital for sick companies—Chapter 11—may be infected with the same sorts of diseases that hurt these companies (and the rest of the economy) in the first place. Much as it pains me to admit it, I think the administration may have it right, here—for reasons that it doesn’t even know.

Federal Reserve Board Chairman Bernanke recently reported that foreclosures in 2008 will number approximately 2.25 million. Neighbors see their home prices decline from blighted nearby properties, and foreclosure sales saturate the real estate market with lowpriced inventory, further pushing down home [...]]]> Lawrence rightly notes that the first round of oversight reporting to Congress on the bailout makes for grim reading. Unfortunately, I suspect that some problems are grimmer than even Elizabeth Warren and her associates make out. The TARP Oversight Report is quite insistant on the need for the Treasury to take action to decrease home foreclosures. It points out, quite rightly, that foreclosures tend to reduce the value of abutting property, further fueling the drop in home prices. The report says:

Federal Reserve Board Chairman Bernanke recently reported that foreclosures in 2008 will number approximately 2.25 million. Neighbors see their home prices decline from blighted nearby properties, and foreclosure sales saturate the real estate market with lowpriced inventory, further pushing down home prices. Foreclosures also place a double burden on local governments, as they impose direct costs from crime and fires while eroding the local tax base. Global asset write downs and credit losses relating to home mortgages currently exceed $590 billion and may eventually rise to $1.4 trillion by some estimates. Moreover, foreclosure rates have continued to increase in recent months, and one in ten American mortgage holders are now in default or foreclosure. Rapidly rising unemployment is likely to increase mortgage defaults and drive foreclosure rates even higher. Several economists have identified the unresolved foreclosure crisis as a key causal factor in financial instability and economic decline.

There are basically three different approaches on the table for dealing with the problem. First, the Treasury department can work to make more credit available for home financers. Second, the government can encourage institutions to voluntarily renegotiate loans, perhaps by putting some of the government’s own credit behind the renegotiated loans through some sort of guarantee. Third, we could amend the bankruptcy code to allow the loans to be trasformed in bankruptcy from subprime monsters into more managable beasts like 30-year-fixed rate obligations.

It seems very unlikely to me that any effort to rengotiate mortgages voluntarily will succeed. The problem is that the ultimate lenders are hopelessly fragmented holders of MBSs with whom one cannot practically negotiate. The servicers, with whom one can negotiate, have little incentive to do so and face potentially huge liability if they do. Refinancing is a better option, in that the negotiating problem is much simpler. A home owner only has to negotiate with a single new lender to obtain funding, rather than with hundreds and perhaps thousands of untraceable holders of MBSs. The problem here is economic. Who wants to refinance a home loan that is already underwater?

This leads us to modification in bankrtupcy, which of these approaches strikes me as the most promising. On the other hand, I am not sure how promising it actually is. The question is how many of these loans would actually end up performing were they coverted into, say 30 year fix rate mortgages? There was a reason that these borrowers could not actually obtain 30 year fixed rate mortgages to begin with: lenders didn’t think that they would pay them off. Notice, these were the same lenders who were so wildly optimistic about rises in future asset prices that they were making no-doc, no-equity loans. If a wildly optimistic market before the bursting wasn’t willing to make 30-year-fixed loans to these borrowers, it seems rather unlikely to me that — facing a nasty recession — these borrowers have suddenly become a good bet on those terms. If they aren’t a good bet, then we haven’t actually halted foreclosure. We’ve simply delayed and prolonged it. Of course, if you believe that lots of these folks were denied 30-year-fixed deals on the front end because of abusive lending practices, then maybe we would be right to think that the market improperly assessed their risk back then. I’ve no doubt that this is true for a large number of borrowers. On the other hand, I would be surprised if the number of good-risk borrowers shunted into subprime mortgages by over-reaching brokers is large enough that we can seriously stem the flood of foreclsures by giving them in bankruptcy what was denied them ex ante by the market.

Unfortunately, I suspect that there is a grimmer story to be told here than hard-working middle-class families caught up in the abusive greed of over-reaching home lenders. If that was the problem, there would be a relatively easy and reduced pain (if not painless) solution. The grimmer story is that we have a huge over-supply of housing in this country. Certainly, the unoccupied housing rates are at historic highs. If this is true, then we have a classic problem of supply and demand. When supply is too high, the market will only clear if prices drop. Dropping prices, however, will fuel foreclosure and scare off lenders, who quite rightly will not be eager to write loans unless they believe home prices reflect a market clearing price. We can push government policy designed to keep prices up in order to make home-owners like me feel more secure in their single biggest asset. We can try to maintain home prices in order to reduce the incentive for lenders to foreclose and for borrowers on a non-recourse basis to walk away. On the other hand, so long as we have an over supply, prices must come down, and until they do both lenders and buyers will want to sit on the sidelines. From my house I can see three homes that have been on the market since late summer. They will not sell unless their prices come down.

Unfortunately, we know what an economy looks like when government takes aggressive action to cushion the blow of a bursting asset bubble by working to prop up asset prices. It’s called Japan in the 1990s.

Part of this is that Professor Lessig is a visionary and very popular, and the same could be said of any well-known “public intellectual” figure (our very own set of celebrities!). But I think this question is still lurking four years later: how do you deal with the creeping numbers of emails? [...]]]> It’s been roughly four years since Larry Lessig called attention to the problem of so-called “email bankruptcy,” described in this article in Wired Magazine. Essentially it’s a type of sheer volume overload, where it becomes so overwhelming that the recipient “gives up” even trying to respond to the messages. In this case, the recipient sent out an automated message notifying the senders that they should not even attempt a reply.

Part of this is that Professor Lessig is a visionary and very popular, and the same could be said of any well-known “public intellectual” figure (our very own set of celebrities!). But I think this question is still lurking four years later: how do you deal with the creeping numbers of emails? I’m not talking about spam, but more just large volume from people you do know or should know or have some responsibility to.

I have a mixed relationship with email. I wonder if this is partially an age/lifestyle question. I went through high school without having an email account, only to go to a college where the phone sat unused and dates were made by sending a flirtatious email (far easier than getting up the nerve and getting past the awkwardness to ask out/be asked out in person!) All through law school, email was “fun.” I used to joke about my email addiction; partially I think the addiction is that it is a gamble – you never know what might turn up in your inbox. That long-lost friend gets in touch, someone starts a “flame” war, you get news of a breaking case.

Somewhere in there, working for the firms, actually, email (and keeping it up with it) turned into something to be “managed.” Step away from the computer to talk to someone and you might miss an entire conversation. Further, as easy as it is to insult someone on email (forget about tone), it’s equally as easy to insult someone by not replying at all, or in some cases replying late (if s/he really cared, my message would be opened rapidly and with glee).

I wonder though, if some of us don’t go through varying phases or cycles of email bankruptcy (perhaps selectively so). How many of us keep email open all day? Check emails from the phone? Read email only on weekdays? Read emails only during certain hours in the day? Print all their email out and mark it up (someone down the hall from me actually does this)? Check emails while on vacation? Go through a month where you answer only minimal emails only then to become very chatty the next month?

It is probably not the most efficient to keep email open all the time, but I always have had an email addiction, so I do that three or four days of the week when I’m working. I do try to prioritize student emails to make sure that they are getting answers fairly quickly, although that gets difficult when you have a Business Associations class approaching 100 students.

Are norms and best practices and efficiencies coming into place for this? Do any law schools have guidelines or suggestions for those who are getting overwhelmed? I ran into some short self-help articles and I’m sure if I went to the business section of the library or local bookstore I could probably find many general materials on effective use of email. But what about the law firm and specifically law school environments. Are there any special characteristics that might lend themselves to best practices there?

Cuomo’s leverage (so to speak) arises from, among other things, laws forbidding fraudulent conveyances and similar transactions. Fraudulent conveyance law is a complex, if vital, corner of debtor-creditor law. It essentially says that a company cannot convey property for less than “reasonably equivalent value” if it is “insolvent,” undercapitalized, or the like. If you’re in financial trouble, the saying goes, “you must be just before you are generous.”

Among other things, this means that if a company like AIG was paying bonuses (or redeeming stock) while it was in fact [...]]]> New York Attorney General Andrew Cuomo has been making headlines because he has strong-armed AIG into trying to recover “outrageous” bonuses and other perks while its financial condition was not so great.

Cuomo’s leverage (so to speak) arises from, among other things, laws forbidding fraudulent conveyances and similar transactions. Fraudulent conveyance law is a complex, if vital, corner of debtor-creditor law. It essentially says that a company cannot convey property for less than “reasonably equivalent value” if it is “insolvent,” undercapitalized, or the like. If you’re in financial trouble, the saying goes, “you must be just before you are generous.”

Among other things, this means that if a company like AIG was paying bonuses (or redeeming stock) while it was in fact in distress, those who received AIG’s cash—like Joe Cassano, who was paid millions for running AIG’s brilliant credit default swap shop–should have to pay it back unless they gave AIG “reasonably equivalent value.” Gifts are axiomatically not supported by any (much less reasonably equivalent) value.

But if AIG is Cuomo’s only target, he’s thinking WAY TOO SMALL. Today’s New York Times reports the following “grim milestone: All of the combined profits that major banks earned in recent years have vanished:”

In the case of the nine-largest commercial banks — Citigroup, Merrill Lynch, Bank of America, Morgan Stanley, JPMorgan Chase, Goldman Sachs, Wells Fargo, Washington Mutual and Wachovia — profits from early 2004 until the middle of 2007 were a combined $305 billion. But since July 2007, those banks have marked down their valuations on loans and other assets by just over that amount

.

What does this mean? Well, it may mean that all those profits they declared weren’t exactly, uhm, profits. Which may mean that they actually weren’t so healthy financially after all. Which may mean that all those bonuses and crazy severance packages—remember when we thought Stan O’Neal’s $57 million looked reasonable?—should, in theory, be as vulnerable as Joe Cassano’s $1 million/month “consulting” fee at AIG.

I know, I know. The accounting and bankruptcy wonks will start shouting that proving insolvency is a fool’s errand. And in any case, there will be serious defenses that the recipients of these companies’ largesse can assert (their brilliant performance was “reasonably equivalent value”, Cuomo lacks standing, etc).

Perhaps. But the real point is, as I observed here earlier, if we care about recovering some of the ill-gotten gains from the mortgage crisis, we need to reconceptualize the whole program. We can’t just give money to the banks and hope (against hope) that they will start lending. We might want to figure where the money went, and how to get some of it back.

“As president of the United States,” Mr. McCain said, “I would order the secretary of the treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes, at the diminished value of those homes and let people make those, be able to make those payments and stay in their homes. Is it expensive? Yes.”

How? He didn’t say. But he’d have to overcome a mountain of contractual and legal obstacles in the “toxic” securities (bonds) that these defaulted mortgages were supposed to back (pay for).

Georgetown Law Professor Adam Levitin has done a good job of explaining [...]]]> In last night’s debate, John McCain proposed that Treasury purchase defaulted mortgages, thereby providing relief to distressed homeowners.

“As president of the United States,” Mr. McCain said, “I would order the secretary of the treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes, at the diminished value of those homes and let people make those, be able to make those payments and stay in their homes. Is it expensive? Yes.”

How? He didn’t say. But he’d have to overcome a mountain of contractual and legal obstacles in the “toxic” securities (bonds) that these defaulted mortgages were supposed to back (pay for).

Georgetown Law Professor Adam Levitin has done a good job of explaining why simply purchasing the bonds themselves will provide little relief to homeowners: Unless the government purchases a controlling amount and number of bonds–meaning lots of bonds–it will lack the voting power, among other things, to cause any changes to the underlying mortgages.

It is possible the government could do this already under the Paulson bailout plan. in theory, it could also purchase individual mortgages from the trusts that currently hold them (which, in turn, issued the mortgage-backed securities that are said to be “toxic”).

But I am not sure the trustees of the trusts that now own these mortgages have, or want, the power to pick and choose which mortgages to sell to the government. Nor is it clear that the servicing companies that really manage the mortgages have the power–or the incentive–to facilitate these sales. There is some evidence that it is easier (and perhaps more lucrative) for them to foreclose than renegotiate the mortgage.

The real solution, as many bankruptcy hands have been arguing for years, is amending the Bankruptcy Code to permit bankruptcy judges to modify existing mortgages, bringing them in line with the fair value of the underlying property.

Until recently, banking and financial interest groups (and most Republicans) vehemently opposed this as a bailout of profligate borrowers. Banks would stop lending if Congress made this change, and all commerce as we know it would come to an end.

Now that the banks stand to receive in excess of $1 trillion in federal largesse (and commerce as we know it is coming to an end, anyway), I am not sure where they are on this. I have been informed that the Commercial Law League–not exactly a lobbying organization for profligate borrowers–has come out in support of these changes.

In the meantime, I look forward to learning how the Maverick plans to rewrite millions of pages of bond indentures.

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let’s consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied [...]]]> The credit crisis has provided ample opportunities for foolishness. Certainly California Republican Darrell Issa’s claim that the House bill would have been a “coffin on top of Reagan’s coffin” was an oddly necrophilic bunkmate to President Bush’s penetrating insight that “this sucker’s going down.”

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let’s consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied that the holders of illiquid mortgage-backed securities were the villains in this drama rather than the victims. They didn’t package the securities, or sell them; they bought them as an investment.”

Excuse me? I didn’t get that.

Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, Citibank and many others now in or near trouble did not package or sell these securities? Perhaps the league tables were just lies?

The reality, of course, is that investment banks were both issuers and purchasers. That was the point: To keep the paper moving as fast as possible, hoping that once the music stopped, there would still be a seat. No one realized (or admitted) that this game of musical chairs was being played on the deck of the Titanic.

2. It’s Minorities’ Fault

The real villains, McTeer would have us believe, are minority borrowers. This was because “the government had encouraged the purchase of mortgage-backed securities by giving banks C.R.A. (Community Reinvestment Act) credit for securities that contained mortgages made in ZIP codes.” While he concedes that this lending may not have played a “decisive” role, the implication is clear: It was lending to people who look like, you know, Barack Obama, who are really to blame here.

This is truly outrageous. There is not a shred of evidence that CRA-based lending had anything to do with the credit crisis. The CRA is an extremely weak piece of banking legislation that in theory requires banks to lend in their “communities,” which has usually (albeit mistakenly) been taken to mean “minority” communities. Excess liquidity doubtless resulted in mortgage lending to all sorts of bad risks, including minorities. But it wasn’t the CRA that caused this.

And, while it is true that a disparate amount of subprime lending was to African Americans, it wasn’t by banks. It was by non-bank originators like Countrywide.

You would expect a former Fed branch president to know this.

3. The Magic Cure: New Accounting!

To the extent the credit crisis is not the fault of minority borrowers, McTeer appears to believe it was caused by “mark to market” accounting rules that forced holders of toxic securities to write these assets down if they couldn’t offload them quickly. This is not really McTeer’s insight. Many, including William Isaac, who was the F.D.I.C. chair during the S&L crisis, believe this was a critical part of the problem, since it forces lenders to declare something valueless simply because it is illiquid, which really doesn’t make much sense.

I am not an accountant, so offer no opinion on whether this is true. But what McTeer doesn’t bother to tell us is what should now replace it? “Marking-to-model?” That got us into this problem in the first place, because it enabled sponsors—you know, McTeer’s victims—to claim unrealistical valuations and amortization rates for the securities they issued. Should we go back to that? How would that revive the market for these securities? If you add zeroes to the balance sheet, will the credit market miraculously revive?

4. Who IS this Guy?

McTeer is not only a former President of the Dallas Fed. He has a PhD in economics from the University of Georgia, is a former of Chancellor of Texas A&M, and self-published poet. He is a zealous free marketeer, whose insights include this: “The market system features consumer sovereignty, meaning that the consumer is king. We decide what will be produced by casting dollar votes for the things we want and by not spending on the things we don’t want.”

That may well be true–in a world where people have dollars that are worth something. So far as I can tell, his version of the free market has gone a long way to making sure that we have fewer dollars, and those we have are weaker.

He is also a management guru who’s maxims include this mind-bender: “Too long” and “too short” appear to mean the same thing. Go figure.”

Perhaps he’s right. Only a man who thinks opposites are identical could believe investment banks are victims and minority borrowers villains.

Why was the Bedford Falls S&L failing? We learn that the Bank had called their loan and the crazy uncle, in a moment of panic, shut the doors because there simply wasn’t any cash on hand to pay depositors. Depositors, in turn, took the shut doors as a signal of imminent collapse [...]]]> Over the last couple of weeks, the reputation of MBSs and CDOs have taken a drubbing, with folks insisting that they are little more than instruments of irresponsible speculation at best and fraud at worst. To which I say, “Nonsense!” To understand why, consider this clip from “It’s a Wonderful Life!,” which I used in my Article 9 class last week as a starting point for discussing the financial crisis.

Why was the Bedford Falls S&L failing? We learn that the Bank had called their loan and the crazy uncle, in a moment of panic, shut the doors because there simply wasn’t any cash on hand to pay depositors. Depositors, in turn, took the shut doors as a signal of imminent collapse and began clamoring at the gates for their deposits. George Bailey, in turn, puts up his honeymoon nest egg, and doles out dribs and drabs of cash to the good people of Bedford Falls, just enough to keep the doors of the Savings and Loan open through the day and thus put to rest the panic. I love this scene. Jimmy Stewart does a marvelous performance as heroic Everyman, and the vision that the film offers of community solidarity in a moment of crisis is in many ways inspiring. On the other hand, it is not clear that this is such a hot way of financing home ownership.

There are a number of problems with the “It’s a Wonderful Life” system. The Bedford Falls S&L has serious liquidity problems because it’s assets — the rights to payment of long-term home mortgage loans — while valuable would take a very long time to pay out. To deal with the liquidity problem it leveraged itself by borrowing money from the bank, but this leverage made it vulnerable in times of panic. There were other things that made it vulnerable as well, most notably the fact that its assets were geographically concentrated in Bedford Falls. If there is some economic shock to the community, the S&L is not diversified and is likely to go under, taking everyone’s deposits and home values with it. The solution is to move the mortgages out of the S&L. Turn those long-term payment streams into cash now. This solves the liquidity problem and eliminates the need to take on extra debt, and the associated brittleness in the face of crisis. It also means that the risk of a Bedford Falls specific shock can be borne by investors who can diversify that risk away by bundling Bedford Falls mortgages with Palo Alto mortgages and Milwaukee mortgages. This is all made possible by the securitization of the mortgages that George Bailey originates. In other words, MBSs are not a scam fixed up by greedy financial speculators. They are an investment instrument that provides a real solution to a genuine set of problems.

“Okay,” says the CDOs-are-evil skeptic, “but aren’t we witnessing the equivalent of the run on the bank right now? Aren’t MBSs what has made this all happen?”

Yes and no. To be sure the MBS has some systemic problems, the biggest one being the separation of information about risk from the holders of risk. As I told my class last week, notice that when push comes to shove, George put his own, personal money on the line to save the Bedford Falls S&L. This is what you call “skin in the game.” With what amounts to a personal guarantee of the S&L and an intimate knowledge of the community — “You don’t have to sign anything. I know you’ll pay me back when you can.” — his incentives and his information are perfectly aligned. Not so with bundling of mortgage loans into MBSs. In theory, however, we were supposed to have intermediary institutions — most notably the GSEs and the bond rating agencies — that were experts in the management of such moral hazards. After all, moral hazard problems exist virtually any time one has an agency relationship, and it is impossible to run anything other than a subsistence level economy without agency, so the mere presence of the possibility of moral hazard is not enough to damn any particular arrangement. This basic but not insurmountable problem was coupled in the case of the MBSs with a number of government policies designed to increase home ownership by incentivizing debt, as opposed to — for example — subsidizing equity. Finally, we have a large number of investors who thought that the success of their credit scoring models for subprime loans meant that they had overcome the basic risk of lending money — default — when in fact all they were observing were rising home values. This basic mistake, in turn, led the arrogant, the greedy, and the risk tolerant to leverage themselves to the hilt, creating a brittleness in the face of external shocks that would have made even George Bailey wince. It is worth remembering, however, that even George was living dangerously, floating on a sea of debt and the hope that his mortgage loans would perform.

And this gets to the final point in defense of MBSs. Right now these securities are functionally worthless because no one wants to buy them. The absence of a market means there is no price and without a price no one will guess at what they are worth. On the other hand, they can’t be worth nothing. Even in the subprime market the default rate is hovering below 20 percent. That means that even at the bottom of the market, 80 percent of the loans are performing. Those performing loans must ultimately have some value. So even the junk MBSs aren’t utterly junk. (Although the bottom tranch CDOs at this point are worthless.)

I actually don’t think that any of this has much to say one way or another about how best to restore confidence to the markets and prevent immediate financial Armageddon. But regardless of what the Congress does this week on the bailout, a monster of a debate about the best regulatory approach going forward is going to be launched, and it is worth remembering that vilified CDO is not a scam and we lose something important if we destroy the link between the home owners of Bedford Falls and international capital markets.

Now that we’re frying bigger fish, I wondered what Lipson would say. His comments follow:

There are many options for a bailout. One that has received surprisingly little (if any) attention in Washington is reorganization under Chapter 11 of the United States Bankruptcy Code.

Strictly speaking, Chapter 11—which governs business reorganizations—would not apply in any meaningful way to many of the entities that are concerned here. Nor should it. But its general approach may, by analogy, be instructive.

Chapter [...]]]> Last week, when all that was on the table was the mere collapse of a few investment banks and one large insurance holding company, I posted Jonathan Lipson’s lucid analysis, identifying the “selective socialism” of A.I.G.’s bailout as a consequence of the Bankruptcy Amendments of 2005.

Now that we’re frying bigger fish, I wondered what Lipson would say. His comments follow:

There are many options for a bailout. One that has received surprisingly little (if any) attention in Washington is reorganization under Chapter 11 of the United States Bankruptcy Code.

Strictly speaking, Chapter 11—which governs business reorganizations—would not apply in any meaningful way to many of the entities that are concerned here. Nor should it. But its general approach may, by analogy, be instructive.

Chapter 11 is a response to the collective action problem presented by a company’s general default. It is designed to enable parties to work out—restructure—legal and economic relationships with a mix of market incentives and government oversight. Some features of that system might, by analogy, help to avoid the growing stalemate in Washington while also creating mechanisms that actually resolve the underlying financial problems.

What, then, might a Financial Systems Restructuring Act of 2008 modeled on Chapter 11 do?

Stay

The Bankruptcy Code provides that the commencement of a case creates a stay of collection actions. This is vital, since it enables a troubled business to focus on correcting underlying problems rather than responding in ad hoc fashion to large numbers of collection suits.

Here, a stay might temporarily halt foreclosures on homes and enforcement of the various instruments currently in private hands that are apparently in default (or about to default). It could temporarily stay collection on credit default swaps. It would only be temporary, while a more fulsome plan is developed (see below).

Financing

Simply freezing the market, without more, would be the disaster Paulson legitimately seeks to avert. So, the government must inject capital and acquire some distressed assets to revive the capital markets.

Bankruptcy reorganization contemplates this through what is known as “debtor in possession financing,” where banks or other financial institutions make short term (usually) high interest loans to finance the process of a company’s reorganization.

Here, the Fed may lead a syndicate of lenders to provide short term financing to keep capital markets functioning, with the understanding that this financing would have to be repaid. It might be repaid in whole or in part by the Federal government, but that would depend on the development of a more fulsome plan (see below).

Today, of course, we do not know how much is really needed to stabilize markets in the short term. Paulson wants $700 Bn. But, like the claim that Iraq had weapons of mass destruction, I have seen no credible evidence supporting this number. Paulson and Bernanke admit that it may be too much or too little.

There is likely to be some smaller number that would stabilize the markets until, say, after the election. I don’t know what that is. But I would certainly hope that it was something far south of $700 Bn.

Market Testing—Treasury as Stalking Horse

The reason Paulson and Bernanke can’t tell us the right number is because there has been a market failure. No one, apparently, wants to purchase the toxic paper. If the market is what a willing buyer would pay a willing seller then, strictly speaking, the paper has a value of $0.

But in the long run, that seems unrealistic. I am sure that many CDOs were issued with nothing but smoke and mirrors behind them. They probably are worthless. But I am equally sure that many MBS are backed by real mortgages that really are worth something. We need to develop some mechanism for assessing the value of these securities, for many reasons.

Reorganization under Chapter 11 offers a helpful analogy. It contemplates fairly quick sales with auction mechanisms designed, at least in theory, to maximize asset values.

Here, rather than simply buying securities wholesale in the opaque and unaccountable way proposed by Paulson, perhaps the Treasury should be the statutory stalking horse in a series of controlled auctions, buying only where no one else will. I don’t know what formula should be used to set the initial price, but suspect that if this is done in some reasonably transparent way, it would produce better values and help to revive the market.

Reorganization Plan

There has to be some larger plan about how to address the underlying problems. In Chapter 11, this is called a plan of reorganization, and becomes the contract between the debtor and its stakeholders if enough of them support it.

A reorganization plan takes time to develop, but is essentially a set of rules that define how the affected parties will behave going forward. I am of the (admittedly under informed) view that much of the trouble here was driven by investment bankers’ and hedge fund managers’ fee incentives to issue and buy as much paper as possible, and the credit rating agencies’ incentives to provide unrealistic ratings of that paper because they were paid by the sellers, not the buyers. If these were the problems, a plan should include rules that address these problems going forward.

It should also contain a funding mechanism. Here, the initial funding might come from Treasury. But it seems possible to establish various mechanisms for recouping or minimizing some of the costs, whether through the auctions described above or in the form of fees paid by the largest beneficiaries of the bailout, or equity in those entities, or new debt issued by them, and so on. Some of these proposals are already on the table.

One of the problems with the Paulson proposal—which the Senate response does not really address—is how to value whatever it is the government gets in the bargain. Everyone now agrees that the government should get something–an “equity interest” or maybe debt of firms whose toxic paper the government acquires. But how much equity? At what valuation? With what rights?

These questions are usually at the heart of the negotiations over a Chapter 11 reorganization plan. We can’t really answer these questions now, however, because we don’t know enough about the underlying values.

I suspect part of what concerns Congress and the taxpaying public is that Paulson’s proposal simply sounded like more “planning by opportunity,” which is really no plan at all. Congress has legitimate concerns, many of which could be addressed in an intelligent plan. But that takes time. Using a stay, short term financing and controlled auctions may buy the time and gain the information we need to better understand the real problem and develop a more lasting and effective response to it.

Governance

A central feature of Paulson’s plan was that it made no real effort to change the governance of financial institutions. Executives would keep their jobs. The Treasury would acquire bad assets, not bad firms (although one could argue that enough bad assets make for a bad firm). Congress has responded with a much more rigorous oversight program, which might help.

Part of the logic of Chapter 11—and what distinguishes it from many other bankruptcy systems—is that management gets to remain in possession and control of the troubled company. But, there is considerably more oversight, both by the government (in the form of a bankruptcy judge and the office of the United States Trustee) and stakeholders (in the form of committees of creditors and equity holders) than in the marketplace generally.

Here, governance would remain with companies that participate in the program. But, picking up on the Senate bill, oversight would be provided by an Emergency Oversight Board, or similar entity. It would review not simply the decisions of the Treasury Secretary but consider how those decisions affect all stakeholders, including taxpayers and financial institutions. It might function like a combination of a bankruptcy judge and creditors’ committee. And, its decisions, like the decisions of the Treasury Secretary under the Senate bill, would be subject to some administrative and judicial review.

Recoveries

There’s a great deal of discussion about how much Wall Street executives should be “punished” for this. That’s an understandable sentiment.

But this sort of talk is not likely to get executives excited about any plan. Among other problems, merely capping future compensation simply gives executives an incentive to do nothing. If they are terminated by a board that wants them to compromise and work with Treasury, they may well sue on their employment agreements and hope for the best.

I am frankly less concerned about executive compensation going forward than I am about recovering from those who caused the problems. It seems to me unlikely that capping John Thain’s future salary (were Merrill independent and seeking a bailout) is likely to do much good. But getting back the $57 million Stan O’Neill took away might be a good (if small) start.

How would that be possible? Bankruptcy incorporates a number of traditional legal mechanisms for avoiding transfers of property, or remedying other conduct, that might have harmed a debtor.

Here, this would mean that someone like the special inspector general (SIG) contemplated under the Senate proposal might be empowered to investigate the banks and hedge funds that played a major role in this crisis and to sue under recognized (albeit perhaps strengthened) principles of fraudulent conveyance, breach of fiduciary duty, professional negligence, etc, with the recoveries going to the Treasury, subject to appropriate oversight.

The SIG would have to be given explicit standing to sue on behalf of these entities. This won’t sit well with everyone, but those who have little to fear should have little to lose.

Questions

Using reorganization as a metaphor would obviously leave many questions. After all, the whole point of Paulson’s initial proposal was to avoid the equivalent of bankruptcy—taking banks over.

The political standoff at this point seems to reflect competing ideologies. The administration says “trust us” and the market will heal itself. The Democrats seem to want something much closer to the Resolution Trust Corporation which really did take over failed banks. Republicans don’t seem to know what they want—other than to be (re-)elected.

None of this seems promising.

Restructuring as contemplated by Chapter 11 of the Bankruptcy Code can be seen as a third way, a hybrid, that might give us time and information that would permit cooler heads to really figure out what’s going on without an unchecked giveaway or total system meltdown.

Back in the Spring, when Bear failed, I asked my colleague Jonathan Lipson to offer a set of observations about Bear’s bailout. (Check out also Ribstein’s response to Lipson here.) Based on a recent correspondence [...]]]> Many explanations have been offered for the “why” of the Fed found it necessary to bail-out AIG, mostly centering around uncertainty and risk. It’s not exactly that AIG was “too big to fail,” but rather that no one could say, with any certainty, that its failure wouldn’t lead to a real market crash of enormous scope. That is, AIG is a good example of the precautionary principle in action. Maybe so. But I still am a little unclear why AIG is so exceptional in that regard.

Back in the Spring, when Bear failed, I asked my colleague Jonathan Lipson to offer a set of observations about Bear’s bailout. (Check out also Ribstein’s response to Lipson here.) Based on a recent correspondence with him about AIG, I thought it would make sense to share with you his unique & very interesting perspective on the problem.

Why did the Fed bail out AIG but not Lehman?

The conventional answer—which is true but incomplete—is that AIG was too big to fail. But that begs two questions: Too big how? And why?

In part, AIG was too big to fail because it could owe an astronomical amount—allegedly about $300 BN—on credit default swaps issued to support mortgage-backed securities.

The problem, however, is not just the amount AIG owes, but the fact that these obligations are not like other obligations. They occupy a series of loopholes that make them unusually dangerous. Perhaps the greatest loophole of all came in the 2005 amendments to the Bankruptcy Code. Although designed ostensibly to “get tough” on profligate debtors, those amendments also made certain that CDS holders would get special treatment in bankruptcy—special treatment that may have made the Fed bailout inevitable.

Credit Default Swaps and AIG

Credit default swaps (CDS) function much like insurance on another party’s debt. So, for example, investors that purchased a mortgage-backed security issued by, say, Lehman Brothers may also have purchased a credit default swap issued by AIG that would pay if Lehman defaulted on its bonds (e.g., by going into bankruptcy).

Credit default swaps are essentially unregulated insurance contracts. Not technically securities, they do not have to be registered with the SEC. Not technically insurance, their issuance by AIG was not overseen by state regulators.

Among other things, this meant that AIG was apparently not required to disclose the full extent of its liability, or to hold reserves against these contingent liabilities, as they would for the life insurance policies their (currently) healthy subsidiaries write. So, when the rating agencies threatened to downgrade AIG, it is not surprising that the counterparties to these contracts would have required AIG to pony up more collateral.

This, AIG could not do.

Thus, a liquidity crisis.

Chapter 11

Ordinarily, when an ostensibly healthy company (e.g., AIG) faces a liquidity crisis, it seeks protection under chapter 11 of the U.S. Bankruptcy Code. In chapter 11, the company benefits from, among other things, a temporary stay of collection actions, the exclusive opportunity to propose a reorganization plan, and the power to discharge debts.

So, if AIG merely had $300 BN in bonds that it could not pay because it found itself in a cash crunch, bankruptcy might be a sensible strategy. Bondholder collection actions would halt, and the company would be able to catch its breath and right the listing ship, or at least sell its parts for more than scrap value. Imagine Lehman Brothers, but to a higher order of magnitude.

Credit Default Swaps in Bankruptcy

That logic fails in the strange world of credit default swaps. Swaps are not like other debts. The 2005 amendments to the Bankruptcy Code were the culmination of a series of amendments which began in the 1980s, and which assure that CDS will essentially be untouched by the bankruptcy of any party to the swap.

Most important, the bankruptcy stay will not halt collection efforts by swap counterparties. Unlike other creditors, CDS counterparties may “net” their “positions”—claims—against the company. This simply means that if you were lucky enough to hold a swap issued by AIG, you would be able to enforce it even if AIG went into bankruptcy. If you were a bondholder, you wouldn’t.

For AIG, this presented a serious problem, because it meant bankruptcy could not realistically protect the company. Given the way the Bankruptcy Code treats CDS, an AIG bankruptcy would (likely) create a cascade of defaults, with all of AIG’s counterparties “running” the company to collect. Because the bankruptcy stay would not protect AIG, the CDS counterparties would simply be able to take their collateral and leave. With private lenders unwilling to lend, and bankruptcy off the table, this left only a Fed bailout as a viable alternative.

Is AIG a Disguised Lehman Bailout After All?

Last March, I put up some paranoid posts about the Fed’s bailout of Bear Stearns. I argued that chapter 11 of the Bankruptcy Code could solve problems like those presented by Bear’s failure.

I was suspicious of the motives to keep Bear out of bankruptcy. Who was being protected? The executives? The hedge fund managers? The folks on Wall Street and the Fed, however, believed that a Bear bankruptcy would have catastrophic results. It, too, was too big to fail.

The Fed’s resistance to a Lehman bailout was thus curious. Wouldn’t a Lehman bankruptcy be even more catastrophic than a Bear bankruptcy?

So far, the answer would seem to be: No. The stock market rose the day after Lehman’s bankruptcy. If the reaction to Lehman is any indication (and of course it may not be), in hindsight, a Bear bankruptcy may not have been so bad either.

Not so for AIG. After the AIG bailout was announced, the market plunged.

Why? One possibility is that the AIG bailout really isa disguised Lehman bailout. If Lehman’s bondholders purchased, say, $85 BN of AIG-issued CDS insuring against a Lehman bankruptcy, perhaps they are the ultimate beneficiaries of the Fed’s largesse. Perhaps no one cared when Lehman itself filed because insiders knew (or hoped) that the real money was coming from AIG. Then the only question was: Where would AIG get it?

This is rank speculation, of course. We may never know the relationship between the AIG bailout and the Lehman bankruptcy because—being unregulated—the general public has no idea who issues or holds CDS, in what amounts, or against whom.

The Real Problems—Selective Socialism and Deregulation

Ultimately, there are two problems here, one of regulation, the other of policy.

The regulatory problem is that once the Fed bailed out Bear, it created a new grade (tranche?) of moral hazard. Why wouldn’t every anxious Wall Street executive plead for a meeting with the Fed? If they did it for Bear, they might do it for Merrill, or Lehman, or Wachovia, or WaMu, or AIG.

But this was the worst of all possible regulatory strategies (and I use that word generously), because it is opaque, unpredictable and unfair. It’s selective socialism. It gave Wall Street nothing but an incentive to keep begging rather than doing the hard work of deleveraging.

If Bear had gone into bankruptcy, it may have caused some pain. But perhaps that pain would have prevented the much larger pain we see today. Bailing out Bear may simply have forestalled the day of reckoning.

Which, by the way, may still have yet to come.

The policy problem involves the choice in the 1970s to embark on a massive program to deregulate many industries. It is difficult to point to many success stories here. With the possible exception of certain telecom sectors (i.e., cell phones), few of the promised benefits of deregulation materialized. Electricity is more expensive, cable television is (generally) pretty lame, and transportation hasn’t exactly improved. And, while lightened regulation has been good for executives and hedge fund managers, average investors aren’t doing nearly so well. And they’re likely to do a lot worse in the near term.

The CDS Loophole: The Wormhole Cometh

The story of the CDS exemption under the Bankruptcy Code is part of this deregulatory story, which has seen Bankruptcy Code loopholes for all sorts of special interests. Swaps are not the only specialized financial contracts that are immune from bankruptcy. Among others, repurchase agreements and commodity contracts also get special treatment.

The difference is that those are generally regulated in other ways, whether by federal securities laws, by the Commodities Futures Trading Commission, under Federal Reserve Bank regulation, or state securities or insurance law. The decision to exempt those contracts from bankruptcy may not be ideal policy, but may also not be so harmful because those contracts get some regulatory reality check at some point. Not so for credit default swaps.

No one stops to think about the role that obscure and technical amendments to the Bankruptcy Code play in larger debates about regulatory policy. But here, the decision to exempt swaps from the ordinary operation of the Bankruptcy Code may have been the greatest deregulatory mistake of all. It may have helped AIG to become too big to fail in any way short of a massive Fed bailout. It may be the loophole that became a wormhole, sucking all value out of the financial space-time continuum.

First to the positive question. Greed as an explanation posits that we are in this mess because the single-minded pursuit of profit by financial speculators, irregardless of its wider consequences has caused our problems. On this view, the problem is that we have been suffering some sort of a unique [...]]]> How useful is it to think about our reactions to the current financial meltdown in terms of greed? It seems to me that there are two questions here. The first is positive. To what extent can I use greed as a concept to explain the current implosion in the markets?. The second is normative, namely to what extent does greed help us understand how to best deal with the crisis?

First to the positive question. Greed as an explanation posits that we are in this mess because the single-minded pursuit of profit by financial speculators, irregardless of its wider consequences has caused our problems. On this view, the problem is that we have been suffering some sort of a unique spiritual crisis that has come to a head at this moment with dire consequences. The question then becomes cultural. Why did we suddenly become greedy now in such a way as to create this problem?.

Frankly, I’m skeptical. Rather, it seems to me that what we are seeing is a classic bubble caused by sharply rising asset prices. Was the rise in prices fed by greed? No doubt in part, but a better candidate is, I think, the Fed’s loose monetary policy. In effect, we had a huge, government-sponsored intervention in the price mechanism that resulted in a massive misallocation of resources. Now that misallocation is getting unwound. Indeed, if the speculators were greedy, they were also stupid and many who were greediest — those who leveraged themselves the most and for the longest periods — are now the one’s most likely to lose their shirts. My point here is not that investors, brokers, and other players in the financial markets are all saints. There is more than enough greed to go around, I’m sure. Rather, my point is that I think that there are other causal factors that are more important.

What about in terms of our possible regulatory responses? Is greed a useful concept here? Again, I am skeptical. One response would be to somehow make people less greedy. Frankly, I am not sure how public policy can be usefully deployed to work such a spiritual regeneration. Alternatively, we could pass laws to prohibit or punish greedy behavior. This only makes sense, however, if greed turns out to be a major causal factor in the meltdown.

Consider, for example, the problem of no-doc loans, which probably contributed to the subprime mess. This seems a pretty clear example of greed to me. You have mortgage brokers paid on commission who were writing loans on an the basis of insufficient information in order to make fees off of the sale of the loan. Likewise, you had borrowers who got easy money — at least until the ARM kicked in — by in effect lying about their employment and income, lying that was facilitated by the broker. Lots of greed to go around. The financial problem with the no doc loans, however, was not that they were conceived in the original sin of avarice. Rather, the problem was that there was insufficient monitoring of the levels of risk associated with the loan. What we have is a failure of information. To be sure that failure was caused by a set of practices and misaligned incentives that encouraged the greedy to behave in deceptive ways. Yet it seems to me that it was this set of misaligned incentives — coupled with the asset bubble — that is the cause of the problem. The solution is to realign the incentives and avoid creating asset bubbles through unwise monetary policy. Notice, however, that greed doesn’t have much to say one way or another about the policy solutions. We can have lots of debates about how to best align incentives or structure monetary policy to be sure. These are thorny and difficult questions about which reasonable people will disagree. On the other hand, moral outrage about greed will be of limited analytic usefulness.

Don’t get me wrong. I actually like denunciations of greed. I think that sermons on the subject are good for the soul. I’ve taught Sunday school classes in which I exhort kids to learn how to live within their means and make sure that the pursuit of wealth is never at the center of their lives. A life structured around greed is ultimately an impoverished one. On the other hand, as natural and justifiable as our revulsion to greed is, I’m skeptical of how useful it is when thinking about systemic causes and solutions.

(Image source: Wikipedia)

Although it is hard to tell from the details that we have now, I am encouraged by the fact that the government didn’t simply shell out cash to save the company. I think that it is better if feds end up owning AIG, or at least holding the threat of ownership. This at least diminishes some of the moral hazard [...]]]> Dave asks “What do you think, Nate should “Berneke and Paulson [have] looked on in stony indifference” here too?” To be entirely honest, the answer is I don’t know. Frankly, I am not sure that anyone else really knows either. My instincts are for letting it fail. I have no idea how I am supposed to evaluate the too-networked-to-fail argument.

Although it is hard to tell from the details that we have now, I am encouraged by the fact that the government didn’t simply shell out cash to save the company. I think that it is better if feds end up owning AIG, or at least holding the threat of ownership. This at least diminishes some of the moral hazard effect, and I think that if the tax-payers are going to foot the bill for a company’s debt, then going forward the company ought to be managed in the interests of the tax payers. Better nationalization than a world of promiscuous government guarantees of private actors.

On the other hand, I have a hard time thinking that nationalizing the home-mortgage and insurance industries is a path to prosperity. Particularly, when the tax payers are left owning the bits of the industry that no one else wanted. In favor of a bit of creative destruction, I would point out that it is worth remembering that even when we are talking about sub-prime mortgages, most of them ARE NOT in default. At the margins they are in default, and the margin is a lot bigger than everyone expected. On the other hand, there are still — even in the troubled bottom end of the home lending market — a lot of valuable assets out there, and I am not convinced that letting the losses lie where the contracts put them will bring the entire system to its knees. On the other hand, I am a lawyer, which means that almost by definition I don’t know what I am talking about when it comes to finance.

Still, its a sad day when the silver lining for me is nationalization.

The value of all of the cement produced in China in 2006.

The amount of money, according to the EPA, that will have to be spent over the next 20 years to repair and update all drinking water systems in the United States.

The value of the Florida Retirement System, [...]]]> One of my students sent me the pages from Lehman’s filings listing the 30 top unsecured creditors. It’s a simple column of figures that makes sobering reading, even for a let-the-market-punish-them enthusiast such as myself. First past the post is CitiBank with $138 billion in unsecured bonds. Just for fun, I tried to find out what $138 billion will get you in today’s world. It is equal to:

The second quarter 2008 revenues of ExonMobile.

The value of all of the cement produced in China in 2006.

The amount of money, according to the EPA, that will have to be spent over the next 20 years to repair and update all drinking water systems in the United States.

The value of the Florida Retirement System, i.e. public pensions.

The amount of money spent under the Presevation of Public Lands of America Act, a bill originally introduced by my former Senator George Allen as a joke. (Okay, so my source on that one is The Onion.)

Looking just in the ball park and you get:

The total value of all goods purchased at self-checkout kiosks in the United States in 2006. ($137 billion)

The amount of money necessary to run the State of Texas for two years. ($139 billion)

The value of total U.S. investment in the Korean stock market in the last year. ($140 billion)

Interestingly, $138 billion is also exactly the amount of money that JP Morgan advanced to Lehman Brother’s yesterday and today in what Bloomberg calls “Federal Reserve backed advances.”