Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Wednesday, September 24, 2008

The Zengales Plan

Prof. Luigi Zengales (University of Chicago) has presented an interesting alternative to the Paulson Plan. Zengales recommends establishing a special fast-track, pre-packaged form of Chapter 11 Bankruptcy to restructure ailing Wall Street investment banks and get them operating again. By way of encouragement, the Federal Reserve would only open its lending window to investment banks which accept this restructuring.

As I understand it, this plan would force banks that now have opaque, questionable balance sheets to write down and finally accept the diminished value of their devalued mortgage-backed securities. This would be a painful process that would entail corporate restructuring, but the special Chapter 11 Bankruptcy procedures would get these firms solid and running again as fast as possible. Zengales describes his plan thus:

Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants.

Again, as I understand it, the credit markets are freezing because banks are unwilling to lend money to institutions with opaque and questionable balance sheets. This was not a problem before, but now everyone is worried that that these banks are not solvent. This tough proposal would force banks with too much exposure to deal with the "toxic" assets once and for all. Ultimately, this should restore confidence in the financial markets, and the cost would be borne entirely by Wall Street without any infusion of taxpayer cash.

I am intrigued by this "tough love" proposal and I would very much like to hear our bankruptcy experts explain the plan... Because, frankly, I have to admit that really don't understand it. I hope what I have said here is merely distorted instead of dead wrong!


Anonymous said...

My expertise is in a much more arcane area of bankruptcy law, but I'll give this a try.

To me, this seems like a fairly reasonable counter-plan based on one possible outcome in a Chapter 11 reorganization. That being said, banks and other financial institutions are regulated by agencies and rules that are far outside the general purview of the bankruptcy courts. This problem isn't uncommon for businesses in Chapter 11 (e.g., hospitals have to comply with various state laws), but it can get really tricky since a bankruptcy court decision may have unintended effects on the corporate debtor.

I'm also incredibly wary of any comparisons to the Great Depression - our financial system has changed drastically since the 1930s and while it makes for good copy, I think it terrifies the general public.

I was pleased to hear Obama say on the radio that he wanted bankruptcy reform, but that he thought it would be best to leave that until after the election. Bankruptcy law (not unlike tax law) is really complicated and homeowners would be better served by real, thoughtful reform that would allow "cram-down" of housing debt under Chapter 13. This would give debtors some real bargaining power with their mortgage holders and allow people to keep their houses and pay back some debt over a period of years. Right now, bankruptcy judges *can't* modify debt on a primary residence, which is pretty crazy once you learn that pretty much every other type of debt (second home debt, jewelry, payday loans) can be modified.

Also, real bankruptcy reform (not the crap that got passed in 2005) has the potential to make bankruptcy counsel more affordable and available to Joe and Mary Debtor, which would be a positive development. Good bankruptcy lawyers can help people avoid pitfalls, including whether they should even file in the first place.

-Seventh Sister

The Law Talking Guy said...

I'm not sure this is needed. Many Chapter 11 proceedings these days in big cases are "pre-packs" where negotiation is done in advance and everything is rammed through in a few days. That can still be done now. At any rate, I think that this just places all the burden on bankruptcy judges to perform the asset valuation that nobody seems to be able to do.

Dr. Strangelove said...

LTG, would this plan suffice as an alternative to the Bush administration's plan?

Spotted Handfish said...

I know this is a dumb statement, but I just realised I had always assumed that Chapter 11 bankruptcy proceedings were so named because it was 11th hour, which goes to show how you can assume something basic which really isn't.

For goodness sake, I have a basic understanding of economics -- at least I thought I did -- so I have no idea how everyone else manages. Thought I'd share my dumb moment.

The Law Talking Guy said...

SH, that's okay. I recall an entire session of constitutional law class my first year of law school where we discussed Title "X". After about 30 minutes, the perplexed professor said to us, "You all know that's Title TEN of the statute, right, not some unknown portion of the US Code?"

We had been that dumb.

FYI: Chapter 7 is liquidation (the normal bankruptcy for most people, or what was normal until the "reforms" a few years ago) where the assets are sold to creditors (including the house, car, etc.). Chapter 11 is reorganization, where the business stays in business, but makes a plan to pay some % of debt. Chapter 13 is a sort of personal reorganization plan (Ch. 11 is available for the rich) that allows a person to keep a house and car and other assets, but requires a 5-year paydown plan. Chapter 13 rarely works, because individual people who could stick to budgets aren't usually in bankruptcy anyway. Chapter 13 doesn't take account of unexpected medical bills and things, that which often is the main cause of bk.

USWest said...

I sort of don't get what is really going on, although I am reading and reading, trying to grasp this. Like SH, I thought I had some basic grasp of economics. And because I do, that is why none of this makes much sense. I need a School House Rock or something to help me.

The problem is that we are dealing with abstract financial instruments - rebundled securities. We don't really know who the creditors are, and to a certain degree we don't know who the debtors are, except that the home owner is at the bottom of the heap and the INVESTMENT banks (Not the commercial banks) are at the top.

I follow that just fine. But then I loose the thread. When it gets into Naked selling, and short selling, etc. I get lost. It doesn't make sense to me. The bottom line is that most of the so called "wealth" in this country has been based on credit, not real financial stability. So when I talk about investment the old fashion way, I am talking about real wealth, the kind that is backed up by real dollars and sweat because I am a middle class girl from a hardworking, middle class family. I don't understand theoretical credit for theoretical services. I am beginning to wonder if things are as serious as we are being led to believe. When Republicans are suddenly sounding populist and saying things like, "maybe we should let the market shake out and do nothing." It all sounds odd.

Anyway, I am just brain dumping here. But my friend send me this from the NYT where the head of PIMCO is offering to assist the Treasury on a Pro Bono basis. Interesting.

The Law Talking Guy said...

Dr.S- I don't really see how this solves the whole problem.

Dr. Strangelove said...

LTG, could you explain please? Really, I want to understand what this proposal would do (and why you say it does not do what we need). I frankly do not really understand what it does.

Raised By Republicans said...

I also would like a school house rock translation of this alternative.

Anonymous said...

Do any of you think this is a good time to break these large superbanks up into smaller banks with a limit on size. "Too big to let them fail" is destroying healthy competition. Superbanks are getting more concentrated and more powerful in this crisis.