Twofish's Blog

October 25, 2008

More about failing gracefully

Filed under: finance — Tags: , — twofish @ 6:01 pm

I think that there is a huge misconception here about what happens when a company “fails.” When a company goes bankrupt, the first thing that happens is that you infuse the company with “debtor in possession” financing. If you don’t immediately infuse a failing company with emergency cash, then everything will fall apart quickly, and the creditors will end up with nothing.

Immediately after Lehman went bankrupt, it got an emergency loan of several billion dollars in cash to keep itself operating while people figured out what to do with it. People are willing to lend to bankrupt companies, because the bankruptcy laws insure that those loans will be repaid regardless of what the balance sheets look like. Also bankruptcy laws *encourage* these sorts of loans in precisely to prevent a bankruptcy from destroying suppliers, employees, and yes even creditors.

So yes, I agree with Ms. Schwartz that what we have is a solvency problem rather than a liquidity problem, and that the thing to do is to let the bad banks “fail.” The difference is that people don’t have an accurate idea of what a “corporate failure” looks like. The problem with using standard bankruptcy laws with financial institutions is that you not have a company that goes bankrupt, you have an entire system, so a lot of what has happened are ad hoc efforts to adapt the concepts of bankruptcy to the financial system, and one of those concepts is to deal with a bankruptcy by flooding the company with enough money to pay for its immediate cash requirements so that people will still do business with it, and so that you have time to figure out what to do with the rest of the company.

One bit of annoyance I have with people in academic economics is that they seem really out of touch with the day-to-day activities of how markets operate. If the solution to the problem is “let the banks fail” (and I think that it is), then the question should be “what are the standard procedures for dealing with corporate failure” and standard operating procedure is to put the company under the control of a government official (i.e. usually a bankruptcy judge) and flood the company with immediate emergency cash under the oversight of that government official. We have to change the play book somewhat but what is going on right now in the financial markets looks a lot like a bankruptcy proceeding.

1 Comment »

  1. Current bankruptcy law doesn’t really address the problem of troubled firms that make markets or act as counterparties. Chapter 11 reorganizations assume that the assets of the firm are not affected by the filing itself, and that it’s the liabilities — the claims of various creditors and stakeholders — that need adjustment. However, the bankruptcy of a market maker or counterparty destroys its most valuable asset — trust.

    Comment by Bob — November 20, 2008 @ 1:32 am

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