November 20, 2009

November 20, 2009 | Commentary on Financial Regulation

New Bankruptcy Policy Can Avoid Mass Bailouts

Maybe we can breathe a collective sigh of relief -- now that we've dodged the bullet of a catastrophic collapse of America's entire financial system.

But how do we avoid a possible repeat performance?

To be sure, we need to revive and reform the housing market. Fortunately, lenders have stopped giving huge mortgages to practically every would-be borrower with a pulse. But we must straighten out the clueless congressional and administration oversight "system."

However, we also need to rethink the approach to those "too big to fail" key financial institutions, such as American International Group Inc. insurance and Citibank, which ended up getting billions and billions of taxpayer-funded bailout money when they seemed about to go under.

The argument at the time was that these institutions were so large, and so intertwined with virtually every other financial institution in the country, that allowing them to go bankrupt would have doomed the whole financial system.

We will play "What if?" for years, second-guessing decisions that, in some cases, had to be made in a matter of hours. But one thing is clear, my Heritage Foundation colleague David John says in a new study. Our bankruptcy procedures are so far behind the curve when dealing with today's financial institutions that forcing huge banking or insurance firms into liquidation could easily have led to an uncontrollable collapse. Without a realistic bankruptcy option, Fed Chairman Ben S. Bernanke and then-Treasury Secretary Henry M. Paulson Jr. had to make it up on the fly, often stopping up the breaking dam with taxpayers' money.

What's needed now to address the "too big to fail" part of the problem, says Mr. John, is two things.

The first is to enact a new chapter of the bankruptcy statute (in addition to well-known parts like Chapter 11) specifically for large financial institutions. The new bankruptcy chapter would enable a court to act very quickly to preserve asset value of the failing firm.

Doing this would temporarily protect the firm from lending contracts that today mean creditors can seize assets without going through a legal process, causing the firm to collapse and jeopardizing other companies doing business with the firm. Properly designed, this would enable insolvent banks and insurers to be restructured or closed down in an orderly way to avoid a domino collapse.

This is not the approach the Obama administration or the House Financial Services Committee, which utterly failed in its oversight duties before the crash, is proposing, however. They want the Federal Deposit Insurance Corp., which currently handles failing banks, to have new powers to invest in collapsing financial giants or to guarantee their obligations with taxpayer funds. Or even take over and run the firms. In short, nationalize them.

But that approach has multiple problems. For instance, it would give the government sweeping powers to take over the central nervous system of the economy. And its open-ended funding mechanism would virtually guarantee more bailouts.

Instead, we should give bankruptcy courts stronger powers to move swiftly to appoint receivers to take over large failing banks, fire managers as needed, and rapidly sell off or close down parts of the firm. They can, and should, do this without using public money.

Bankruptcy courts are a far better option than government agencies to take tough action. One major reason is that they are free of the political pressure that led to the dawdling and politically motivated deals and handouts seen in such cases as the auto-industry restructuring.

The second necessary step is to increase the capital standards of those larger financial institutions that would pose a risk to the entire system if they collapsed. This means requiring such firms to keep a larger proportion of their assets in a liquid, safe form -- such as cash and government bonds - so that they can better weather any problem in their more speculative investments.

Similar higher capital standards, Mr. John says, should apply even to smaller firms if they are engaged in commercial activities critical to the functioning of the financial system -- for example, firms specializing in credit default swaps (in other words, insurance against bad mortgages or other debt).

Preventing a rerun of the Great Crash of 2008 will take many steps. But giving government agencies sweeping new powers to act like commercial bankers isn't one of them. It's time instead to give the bankruptcy courts the tools they need to take care of failing giants.

Stuart M. Butler, Ph.D., is Vice President for Domestic and Economic Policy Studies at The Heritage Foundation.

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First Appeared in The Washington Times