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Bankruptcy Phobia--Skeel

 Almost the only tool the government hasn’t seriously tried in its battle against the economic crisis is bankruptcy. Rather than bailout out Bear Stearns, AIG or GM, it would have made more sense to address their financial distress in bankruptcy. The most sensible strategy for addressing the foreclosure crisis is a proposed amendment to the bankruptcy laws that would let a homeowner write down her mortgage to the value of the house if the house is worth less than she owes.

Both strategies have met fierce resistance, on precisely the opposite grounds. The argument against letting AIG or GM file for bankruptcy is that it would be disastrous to leave these companies to market forces, rather than intervening to prop the companies up. Lehman’s bankruptcy, which roiled the markets, is widely cited as proof that bankruptcy doesn’t work. But the problems with Lehman had very little to do with bankruptcy. They stemmed from a bait and switch by the government—the government had strongly suggested it would bail out every large troubled investment bank (see Bear Stearns), then refused at the last minute to do so with Lehman. And it’s hard to argue that the AIG bailout, which occurred at the same time, has been more successful than Lehman’s bankruptcy.
With the mortgage write down provision, the concern is too much interference with the market, rather than too little. The same banks that are taking billions of dollars of government handouts complain that the provision would undermine the enforceability of mortgage contracts.

In each case, an irrational fear of bankruptcy seems to be coloring people’s perceptions. 

Even experts assume that bankruptcy would mean death for General Motors, despite the fact that General Motors would be better able to deal with many of its problems in bankruptcy. Many people think that allowing consumers to write down their loans in bankruptcy would terrify lenders and make the mortgage lending crisis even worse. But the bankruptcy provision is more likely to provide a way out—a way to deal with troubled mortgages that still aren’t being refinanced in serious numbers.

It isn’t too late to try the bankruptcy strategy-- bankruptcy is still an option for AIG and GM, and a watered down version of the mortgage writedown provision is making its way through Congress this week. But the government has wasted a lot of time, at what looks like great cost.


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Comments ( 4 )

Prof. Skeel,

I fear I must disagree with your assessment of the situation here, both as to the relative virtues of bankruptcy for financial companies and homeowners and the primary arguments in opposition thereto.

On bankruptcy for financial companies: You may be right that the wiser course would have been to allow AIG or GM to enter bankruptcy. But Lehman, AIG, and GM (and Bear Sterns for that matter) all present very different circumstances. The government did indeed step in to keep Bear Sterns out of bankruptcy, but it did so because it believed that Bear Sterns faced a problem of liquidity, not solvency (i.e., a run on an otherwise solvent bank). Perhaps the government's greatest mistake with Bear was to let the company reset the sales price at $10 a share rather than $2 after the deal was signed -- this mistake came back to bite the government in September.

In September, Lehman too claimed that it faced a lack of liquidity. But rather than acquiesce to a government-sponsored takeover (as Bear did), Lehman engaged in a bit of brinksmanship, betting that the government would rather cough up better terms than allow it to fail. As we know, the government called Lehman's bluff and let it fail. But consider the government's other option -- caving to Lehman and giving every other close-to-bankruptcy bank leverage in future negotiations. Although it may have accelerated the financial crisis, the government's thinking was certainly not unreasonable.

In contrast to Lehman, AIG played ball with the government; and to the extent that evidence suggested that banks and insurance companies were profitable in their new ventures (even if hampered by tremendous losses from their old ventures), a loan to AIG made some sense. After all, the government has never seen such a large and interconnected bank enter bankruptcy nor would it have been wise to experiment with two banks at once. (Of course, the government's continued support of AIG can be rightly criticized and there comes a point when AIG's cry of "more time" simply rings false.)

Finally, the government should never have bailed out GM. Setting aside the legal manipulations that Treasury had to go through to advance GM cash, few thought in October, let alone December or today, that GM is suffering a liquidity crisis rather than something deeper. And while bankruptcy was not designed to prevent a bank run, it *was* expressly designed to address companies that are insolvent in every sense of the word. And if we can learn anything from Japan's experience in the 1990s it's that propping up unproductive companies is neither a good investment nor a way to restart the economy.

On homeowners: There are several points to be made, so I'll go through them quickly. First, bankruptcy law has long prevented homeowners and lenders from modifying home mortgages in bankruptcy, so to the extent that we modify bankruptcy laws to favor homeowners, that's a windfall profit for them and unexpected losses from lenders. Second, allowing modification of mortgages would upset a long-time quid pro quo of bankruptcy -- that mortgages are non-recourse loans. Now there is a decent argument to eliminate these rules in tandem as it would prevent speculators from buying leveraged properties and simply walking away when the market turns; but such modifications are better targeted a preventing future crises rather than repairing the present one. Third, given that consumers have long been prevented from modifying mortgages in bankruptcy, many consumers have been careful with their finances and particularly careful with not overextending themselves on a home purchase. Setting aside the economics, it is morally vicious for a government to reward those who acted irresponsibly and borrowed more than they could afford precisely because they acted irresponsibly. Fourth, the problem with mortgage modification in bankruptcy is that it gives even the most virtuous citizen a terrible incentive to declare bankruptcy even when the economic crisis has not affected his ability to pay the mortgage: How could a man making $80,000 a year and paying down a $160,000 mortgage turn down the possibility of reaping a year's salary tax-free windfall by declaring bankruptcy?

Finally, the last problem with mortgage-modification in bankruptcy is that it would accelerate the crisis in the banking sector, and not because it would lead to higher mortgage rates (which might happen, or lenders may simply require much larger down payments). No, the problem is that, amidst all this terrible economic news, we forget how many are still paying their mortgages; even with a home worth half of a mortgage's face value, 97.5% of prime borrowers and 90% of subprime borrowers are making their mortgage payments on time each month. See http://tinyurl.com/ak9d2c. With such numbers, it is unsurprising that our banks discount their subprime assets at 25% on a held-to-term basis, rather than the 60% discount the trading market is demanding. But these numbers are premised on the bankruptcy system's prevention of mortgage modifications -- should modification become an option, the percentage of underwater borrowers declaring bankruptcy would surely increase by leaps and bounds, and the value of these assets would drop like a stone.

I must respectfully disagree with some of Anonymous Skeptic's comments with respect to home mortgages.

1. Statement: [A]llowing modification of mortgages would upset a long-time quid pro quo of bankruptcy -- that mortgages are non-recourse loans. Now there is a decent argument to eliminate these rules in tandem as it would prevent speculators from buying leveraged properties and simply walking away when the market turns . . . .

It is not in general the case that mortgages, be they residential, commercial, or otherwise, are non-recourse loans. Certain states, notably California for example, have anti-deficiency statutes which effectively make purchase money mortgages for primary residences non-recourse. See, e.g., Cal. Civ. Proc. Code s 580b. To the extent certain states have, in fact, adopted such laws, they tend to only cover purchase money loans--in California, for example, refinancing a puchase money mortgage loan destroys the anti-deficiency protection. These provisions generally protect only mortgagors of primary residences. Thus, to the extent that the owner of the property is a speculator who does not occupy the mortgaged property, he generally will not be enitled to anti-deficiency protection.

Moreover, the bankruptcy code already permits mortgages on non-primary residences to be modified in bankruptcy. See 11 U.S.C. s 1322(b)(2) (allowing "modif[ication] [of] the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor's principal residence) (emphasis added). So to the extent that Anonymous Skeptic is concerned with creating such perverse incentives by virtue of the bankruptcy code, the provisions which would create those incentives already exist. The proposed modification would, instead, allow asset prices to rationalize and the market to clear. Instead, no bargaining range generally exists at present between sellers and buyers, because banks are currently loathe to allow short sales for the true value of the property and thus immediately be required to write down the value of their mortgage assets.

It is true that banks will likely require larger down payments in the future as a result, but this is also a positive. There is no such thing as a free lunch, in capital structures or otherwise, and no asset is ever purchased without equity participation. Rather, when lenders agree to finance the entire purchase price of an asset with debt, they have simply agreed to buy all the downside of the equity piece, but leave the equity upside to the purchaser. Essentially, they have purchased the property themselves, and sold a call option on it to the supposed purchaser in exchange for the loan origination fee. To the extent that we prefer lending institutions to not engage in real-estate speculation, there is great benefit in incenting them to require the buyer to put sufficient equity into the asset purchase as to actually have some "skin in the game."

2. Statement: [T]he problem with mortgage modification in bankruptcy is that it gives even the most virtuous citizen a terrible incentive to declare bankruptcy even when the economic crisis has not affected his ability to pay the mortgage: How could a man making $80,000 a year and paying down a $160,000 mortgage turn down the possibility of reaping a year's salary tax-free windfall by declaring bankruptcy?

The incentives here are probably less worrisome than you think. First, the amount written off of the loan would not disappear (assuming that the terms of the loan or applicable state law did not make the loan non-recourse). Instead, it would become an unsecured claim in bankruptcy, which the debtor would have to pay on for the life of the plan (3 to 5 years, depending on whether the debtor's income exceeded the median income in his state). To the extent that the deficiency would not be entirely paid off over the life of the plan, and the lender objects to the plan, the plan would have to require that all of the debtor's projected disposable income be devoted to making payments on the unsecured claims for the life of the plan. See 11 U.S.C. s 1325(b)(1). For a debtor able to afford his mortgage payments, but way underwater on his mortgage, the requirement that he take a vow of poverty for 5 years in order to strip down his mortgage seems rather unappealing. Moreover, to the extent that the debtor has sufficient personal assets to cover more of the deficiency than would be paid under the plan, the plan would be unconfirmable. See 11 U.S.C. s 1325(a)(4) (requiring that the value of property to be distributed under the plan is at least as much as would be distributed if the estate of the debtor were liquidated in chapter 7). Thus, an otherwise wealthy debtor who is underwater on his home mortgage could not escape a deficiency judgment by filing in chapter 13 (or chapter 11, which has the equivalent provision) and force the bank to eat the loss despite the buyer's ability to satisfy it.

Dear Prof. Skeel:

I have been reading all the reaction to the AIG bonuses and other payments that it has been making in what I see is the ordinary course of business and I can't happen but wonder whether we shouldn't start thinking of maybe a new chapter in the bankruptcy law to address institutions who are deemed to be to big to fail.

You see, these institutions (not only AIG, but other banks and also GM) and the government do not see Chapter 11 as an appropriate way of reorganizing these companies but they are left with all the problems that are somehow solved in bankruptcy and they don't know how to deal with it. I am pretty sure that if this bonuses were being paid in bankruptcy dollars there wouldn't be a lot of complaining.

By the way, congratulations on your blog.

From your former student,

Luis Alves

Hi, Luis: This kind of proposal has been made-- either a new chapter, or the introduction of new powers to resolve the distress of systemically important debtors. I can see the argument, although it seems to me that it's not really necessary to change the bankruptcy laws. Nothing about the bankruptcy rules prevents the government from guaranteeing senstive assets (such as GM's warranties) or from lending money to the debtor. And the existing reachback provisions already could be used to challenge the bonuses in a case like AIG. It's generally much easier to force repayment of bonuses in bankruptcy than outside of bankruptcy.