Category: Bankruptcy


Bankruptcy Reform & the Force of Selection

ark.jpgMichael Heise highlights a very vigorous debate in the American Bankruptcy Law Journal on the empirical study of bankruptcy reform.

  • It started with a paper by Bob Lawless, Angela K. Littwin, Katherine M. Porter, John Pottow, Deborah Thorne, and Elizabeth Warren (hereinafter the “Six”), Did Bankruptcy Reform Fail? An Empirical Study of Consumer Debtors, 83 Am. Bankr. L. J. 27 (2009). The authors of that paper found that there was “no change in the income levels of bankruptcy filers after the [bankruptcy reform] amendments [and that] debtors filing for bankruptcy in 2007 have even greater debt loads than their counterparts from 2001.”
  • Rafael Pardo responded in Failing to Answer Whether Bankruptcy Reform Failed: A Critique of the First Report from the 2007 Consumer Bankruptcy Project , 83 Am. Bankr. L. J. 47, in which he made several critiques of the Six’s method and lack of nuance regarding the Code.
  • Pardo’s critique seems to have pushed the Six to a very defensive response (not yet on SSRN, but which you can find on WL), called “Interpreting Data: A Response to Professor Pardo”
  • Pardo has now responded.

You should read the papers, if you are interested in empirical analysis of bankruptcy, or if you just relish a well-articulated methods discussion. I’ll leave the merits largely alone, with one exception. The papers appear to disagree about a relatively fundamental question of predicted selection effects.

Selection effects operate at various stages of litigation to remove certain cases via settlement or unilateral withdraw from the fight. As is well known, these “missing” parties and claims make it quite difficult to analyze the effects of changes in law on datasets of outcomes of litigation. (As an illustration, imagine that Noah had a policy that denied snakes entry into the ark (as some posit). Rational snakes, knowing about the policy, wouldn’t approach the choosing point, and, therefore, we wouldn’t see the policy’s effects in action.) A law might make it easier for plaintiffs to win, but the resulting set of cases will be unaffected because more defendants settle both before and after filing. Selection turns out to play a very important role in this bankruptcy dispute.

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CDSs and Bankruptcy

Megan McArdle correctly notes today that much of the CDS-hatred out there comes from political pundits who are not — to put it charitably — particularlly knowledgable about or interested in law or finance. (“Credit default swaps certainly caused AIG to fold, and they’ve undoubtedly made all manner of things worse, but giving them single-handed credit for the financial crisis is like blaming Italy for World War II.”) She goes on to argue, however, that CDS’s may be having the perverse incentive of pushing firms into bankruptcy. The gist of the argument is that debtors have a harder time renegotiating debt with creditors who are protected by a CDS in the event of default, and this presents a systemic problem. I’m skeptical.

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The Bard of the Financial Crisis

shakespeare.jpgOver 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)

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Jonathan Lipson’s Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System

lipson.JPG[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.

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There is, Perhaps, a Grimmer Truth

down.bmpLawrence 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.

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The DIP Financer of Last Resort?

bankruptcy.bmpOver at the ‘Glom Michelle Harner has an excellent post on prospects for a GM bankruptcy. For me one of the striking things about the current financial crisis has been how big of an issue bankruptcy hasn’t been. After all, Chapter 11 is supposed to be the way that one restructures over-leveraged firms that maintain some core of profitability. GM cannot go into bankruptcy, so the argument goes, because among other things there is no way that it could get the debtor-in-possession financing that it would need to operate. (DIP financing consists of loans extended to companies in bankruptcy. The financing gets priority as an administrative expense of the estate, so it is less exposed to bankruptcy risk than the pre-petition financing, but it still consists of a bet on a successful reorganization.) The Economist is reporting that some have suggested that the government should provide DIP financing to GM. I suspect that there will be little political enthusiasm for this approach because any Chapter 11 will require a substantial rewriting of GM’s labor contracts, and I think that in a large part it is the political clout of the UAW within a resurgent Democratic party that is giving GM’s panhandling much of the serious attention that it has received.

The non-political case for government DIP financing for GM is that the company’s inability to get money to operate in bankruptcy is a product of the credit crisis rather than a realistic reflection on the company’s ability to reorganize. This is essentially the argument made a couple of weeks ago when the Fed intervened directly in the short-term commercial paper market. The claim was that the freezing up of the short-term paper market couldn’t possibly reflect a spike in the real risk associated with what are, after all, regarded as some of the safest commercial loans that it is possible to make. DIP financing, however, is something different. Unlike short-term paper, loans to DIPs are some of the riskiest bets than a lender can make. It may well be that GM really cannot get enough DIP financing to operate (I’m not entirely convinced, as I suspect that in part the DIP financing claim is a ploy to get direct infusions of government cash), but if this is the case it is by no means clear that GM’s woes are driven entirely by the credit crunch. Indeed, the withholding of DIP financing is one of the ways in which the market signals that we are better off taking a business out behind the barn to be shot rather than keeping it on life support in Chapter 11.

It is worth pointing out, on this front, that Circuit City, which filed for Chapter 11 last week, was able to get a $1.1 billion line of credit as DIP financing. Obviously, $1.1 billion is chump change in comparison to what it would cost to operate GM in bankruptcy, but it isn’t true that the DIP finance markets are closed to all comers.


The State of Email Bankruptcies

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?


Broken Records: It’s About Bankruptcy Relief, Stupid

If hypocrisy is your cup of tea, you can’t get much better than this. The New York Times reports that hedge funds—who stand a good chance of being the direct or indirect beneficiaries of about $1 trillion in U.S. financial bailout money—do not think homeowners should catch a break. They—like banks and bondholders before them—have come out against any proposal to amend the Bankruptcy Code to provide relief to homeowners by giving judges the power to modify mortgages to fair market value. According the the Times,

“Hedge funds are fighting proposals to ease the terms of home mortgages, arguing that such a move would hurt their investments. Two funds recently warned mortgage companies that they might take action if the companies participated in government-backed plans to renegotiate delinquent loans in a way that undercut the funds’ interests”

Although there is evidence that that there has been some drop in mortgage foreclosure numbers in the last month, it remains true that we are experiencing record numbers of home foreclosures, and this will likely continue well into the future absent some sort of government intervention.

One reason for the recent dip is that some states are apparently making it more difficult to foreclose, although this would seem only to forestall the inevitable. For her part, Sheila Bair, FDIC chair, has proposed streamlining restructuring procedures at the homeowner level in order to facilitate renegotiations.

While these are laudable attempts to address the fundamental market failure that has occurred by virtue of the investor-servicer-homeowner CF (“CF” is a term of art. The first letter stands for the word “cluster.” I cannot print the second word), I remain convinced that the most fair and efficient way to deal with this is through bankruptcy.

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The Biggest Fraudulent Conveyance Lawsuit Ever

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


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Maverick-Backed Securities

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.

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