The Magazine

Give Bankruptcy a Chance

Let's not institutionalize the bailout approach. There's a better way to deal with financial failure.

Jun 29, 2009, Vol. 14, No. 39 • By DAVID SKEEL
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The current bankruptcy laws aren't perfect. The principal shortcoming is best illustrated by AIG. AIG had a huge portfolio of the financial derivatives known as credit default swaps in its financial products subsidiary. These contracts act like insurance, with one party buying protection from the other in the event a third party defaults on its obligations. Unlike most creditors, the counterparties to AIG's derivatives contracts would have been permitted to cancel the contracts and to sell any collateral they held if AIG had filed for bankruptcy, thanks to the exemption from the ordinary bankruptcy rules these contracts enjoy. (Both parties can claim credit for this special treatment: Alan Greenspan, the Clinton and Bush Treasury Departments, and the derivatives trade group all lobbied for it in the 1990s and 2000s.) If AIG had filed for bankruptcy, all of these counterparties could have canceled their contracts at the same time. Defenders of the AIG bailout argue that the mass cancellation of these contracts could have paralyzed the credit default swap market, driven down asset values as everyone tried to sell their collateral at the same time, and led to the failures of other institutions.

It is far from clear that the dire predictions were accurate. But with a simple, two-part tweak, the bankruptcy laws could be adjusted to respond to these systemic risk concerns. First, instruct the Fed to survey the nation's financial institutions, much as it did with the recent stress tests, and identify which are too interconnected to fail. This would remove any uncertainty as to who is and is not in the club. Second, add a small handful of provisions to the bankruptcy laws for these systemically important institutions. The key provision would simply apply the ordinary stay--the rule that creditors cannot cancel their contracts or try to collect what they are owed--to the derivatives counterparties of a systemically important debtor.

The derivatives stay would have one obvious benefit and one not so obvious one. The obvious benefit is that it would prevent the creditors of the next AIG from all demanding collateral or cancelling their contracts at the same time. By filing for bankruptcy, the company could halt the carnage that bank regulators worry about. The less obvious benefit is that this rule would encourage derivatives counterparties to deal with institutions that are not systemically important. A counterparty that dealt with an ordinary institution would always have the right to cancel its contracts, even in bankruptcy, whereas those that deal with behemoths would be subject to the stay in bankruptcy. Unlike the administration's proposals, which simply assume that we will continue to have institutions that are too big and interconnected to fail, the bankruptcy alternative would thus help curb the tendency for big institutions to grow relentlessly bigger.

The bankruptcy alternative would not prevent regulators from regulating. Nothing would stop them from imposing high capital requirements on systemically important institutions, for instance, to make them less risky. But it would give creditors an incentive to pay close attention to the creditworthiness of systemically important institutions. And it would give the managers of these institutions a reason to file for bankruptcy before the house of cards crumbled, rather than running to regulators to beg for money.

David Skeel is the S. Samuel Arsht professor at the University of Pennsylvania Law School.