Our Bankrupt(cy) System

I’m surprised that I haven’t seen much discussion of the way in which the financial crisis is also a problem of the bankruptcy system. Recall that Treasury let Lehman fail because it was assumed that bankruptcy would do a reasonable, not-too-painfuul job of sorting out the claims. Oops.

I see at least two problems with the bankruptcy system here. First, there’s an institutional competence problem. It seems as though Lehman’s trip into bankruptcy court managed to destroy a whole lot of value very quickly, in a way that keeping it a going concern even a few days longer might not have. Preserving value for creditors, ur doin it wrong.

Second, there’s a serious secured-lending fiasco here, one whose story I suspect is only starting to be told. When it looks like a bank is about to rupture, bankruptcy is supposed to assure creditors that each will take a roughly equal haircut. Lots of assets are marked down, but none are supposed to be obliterated. Secured lending was supposed to make these results even more predictable; loan against collateral and you can feel safer that your buck won’t be broken too badly.

It now seems that neither of these reassurances is turning out to be true. In recent months, when a financial institution starts bleeding in the water, everyone doing business with it almost immediately goes into panic mode. Especially for things like short-term commercial paper, which ought to have been reasonably insulated from fancier instruments and longer-term investments like the now-infamous CDOs, this wasn’t supposed to happen. We were supposed to have counterparty risk under control, and I thought our bankruptcy system was supposed to be a big part of tamping that risk down. As the Lehman blowup shows, apparently not.

Do keep in mind that I’ve never studied any bankruptcy law. I may have crucial legal and financial facts wrong. But I’m still surprised not to hear more discussion of the role of the bankruptcy laws in all of this.