The conventional wisdom about the bailouts of 2008 goes something like this. Federal regulators started off on the right foot by bailing out Bear Stearns and midwifing its sale to JPMorgan Chase. They were right to bail out AIG six months later, but botched the execution. And Lehman Brothers, the only exception to the bailout rule, showed once and for all that bankruptcy is not an adequate way to handle the collapse of a large financial institution.
But what if regulators hadn't bailed out Bear Stearns? If we conduct this simple thought experiment, it raises serious questions about both the conventional wisdom and the Obama administration's new proposals for regulating investment banks and bank and insurance holding companies. Bankruptcy starts to look much better, although it could use several market-correcting tweaks.
The Bear Stearns saga unfolded in March 2008. After the markets lost confidence in Bear and its $18 billion of cash reserves began to disappear, Bear Stearns chief executive Alan Schwartz called Tim Geithner, who was head of the New York Federal Reserve Bank. Geithner, then-Treasury Secretary Hank Paulson, and Ben Bernanke pushed Bear into the arms of JPMorgan, a much healthier bank. The deal was structured so that the creditors of Bear Stearns were fully protected, Bear's shareholders took a serious haircut, and the government kicked in a $29 billion guarantee of Bear's most dubious assets.
If regulators had decided not to bail Bear out, the short-term effects might have been jarring. Regulators were particularly worried about the extremely short-term loans--known as "repo" loans--that investment banks depend on for financing. A repo loan is structured as a sale of securities by the borrower to the lender, with a promise by the borrower to buy the securities back the next day. If there were a major default in this previously safe lending market, the market might have frozen up and major repo lenders who were not repaid might have been destabilized or even failed.
Some of these consequences might have ensued, but the risk of widespread ripple-effect collapses--also known as contagion effects or systemic risk--was almost certainly overstated. The creditors of Bear Stearns would have suffered losses, and the shareholders would have been wiped out. But this hard medicine would have sent a very clear message to the managers, creditors, and shareholders: Better watch what the company is doing, or you could get burned. In more technical terms, a Bear Stearns bankruptcy would have eliminated moral hazard--the tendency not to take precautions if you'll be spared the consequences of bad outcomes.
When Bear Stearns fell, Lehman Brothers was widely viewed as similarly vulnerable, since it too was highly leveraged and heavily exposed to subprime mortgages. Yet Richard Fuld, Lehman's chief executive, rejected a proposed investment by Warren Buffett and refused to seriously consider selling the company in the months after the Bear Stearns bailout. When Lehman filed for bankruptcy six months later, on September 15, 2008, no one even knew who Lehman owed money to and who the counterparties on its derivatives contracts were.
AIG was similar. The most impressive document produced by AIG on the eve of its collapse was a secret report designed to show federal regulators just how devastating a bankruptcy would be. As summarized in the New York Times, the report predicted that derivatives markets and the insurance industry could collapse if AIG defaulted. These responses made perfect sense if you assumed--as everyone did after the Bear Stearns bailout--that regulators would bail out any big, troubled financial institution. Not only was there no need to plan for bankruptcy, but the bailout strategy gave Lehman and AIG an incentive not to prepare for the worst. The more unprepared they were, the worse the bankruptcy option would look and the more likely a bailout would be forthcoming.
This, not the bankruptcy system, is why Lehman's collapse was so disastrous. Lehman, its suitor Barclays, and everyone else assumed the government was standing by with buckets of money. But regulators played bait and switch, deciding at the last minute not to provide bailout funds after all. Lehman's failure to prepare, and the way it was dumped into bankruptcy, were the problems. The bankruptcy itself has gone remarkably smoothly.
If Bear had been left to file for bankruptcy back in March, the managers and investors of Lehman and AIG surely would have acted differently in the weeks before their failures. The prospect of bankruptcy would have given them a very different perspective on the implications of their financial difficulties. At the least, they would have gotten their books in order and started looking for buyers for their businesses much earlier.
By all accounts, Paulson, Geithner, and Bernanke--the three musketeers of the financial crisis--never seriously considered stepping to the side and allowing Bear Stearns to file for bankruptcy. Why is this? One reason is that the mere whisper of systemic risk strikes fear into the hearts of financial regulators. If regulators agree to a misguided bailout, there are few immediate consequences. But if they forgo the bailout and the default infects other institutions, they could face a marketwide collapse and eternal condemnation. Given the stakes, regulators routinely overestimate the likelihood of systemic risk.
These particular regulators--Geithner, especially--were even more wired for bailouts than most. Paulson, the former head of Goldman Sachs--one of the healthiest investment banks--is a problem solver and deal maker. His instinct is to make a deal and move on--which is what regulators did with Bear and JPMorgan. Bernanke, as is well known, was a scholar of the Depression at Princeton prior to his appointment to the Federal Reserve. The mistake he vowed never to repeat was being too tightfisted with government money in a time of crisis, as the Depression-era Fed certainly was.
With Bear Stearns and AIG especially, Geithner seems to have been the point man. Geithner cut his teeth in the international affairs division of the Treasury, and as a key underling to Larry Summers, when Summers was secretary of the Treasury in the Clinton administration. The 1990s saw two key crises that seem to have permanently shaped Geithner's instincts: Mexico's currency crisis in 1994, and the collapse in 1998 of Long Term Capital Management, the giant hedge fund run by superstar economists and mathematicians. Both times, regulators opted for a bailout (funded by private banks in LTCM's case), and both bailouts are widely viewed as successful interventions. Mexico's crisis passed, and Long Term's collapse had little evident lasting effect on the market.
What is often forgotten is that these bailouts, successful as they were, did have a cost: They protected investors against the downside risk of lending to developing countries. Investors kept pouring money into these markets after the Mexican bailout, which contributed to crises in Asia and elsewhere at the end of the decade.
But the bailouts are remembered as successes. The lesson Geithner learned is that bailouts are always the best response when a large institution or country is in trouble. This lesson lies at the heart of the Treasury's proposals for reforming U.S. financial regulation. In addition to requiring hedge fund advisers to register with the SEC, imposing disclosure requirements for derivatives, and expanding the Fed's systemic risk authority, the proposals authorize bank regulators to step in and take over "systemically important" nonbank financial institutions, as the FDIC already does with commercial banks (that is, banks that take deposits). By taking resolution authority away from the bankruptcy courts and giving it to bank regulators, this proposal extends and institutionalizes the bailout policy of the past year. If the proposals pass, large financial institutions will have the same incentives that Bear Stearns, Lehman, and AIG had: to make sure a default would be as messy as possible, and count on negotiating a bailout with banking regulators if things go sour.
A more sensible approach would be to give the bankruptcy laws a chance. The prospect of bankruptcy at the end of the line would discourage excessive risktaking in the first instance, encourage creditors to monitor the institutions they have invested in, and if dark clouds do develop, encourage managers to make plans for an orderly bankruptcy. Bailouts will be even less necessary, and bankruptcy more sensible, when the administration's other reforms are put in place. As one of their principal justifications for bailing out Bear Stearns, regulators claimed that Bear's books were so unclear that they had no idea what its exposure was. The new disclosure and capital requirements will significantly reduce this opacity.
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.