Next financial crisis

How a GOP bill could cause the next financial crisis

A reboot of bankruptcy law for the big banks would put Wall Street in line before Main Street, again.

By BRUCE GROHSGAL and SIMON JOHNSON

Wall Street’s gambles and risky borrowing directly led to the financial crisis, causing the collapse and near-collapse of megabanks and greatly harming millions of Americans. But thanks to government bailouts, those megabanks recovered quickly and top executives lost little.

In response, Congress passed the Dodd-Frank regulatory law to ensure that no failing bank ever receive such special treatment again. But legislation that favors very large banks and undermines those reforms is in the works again. The bill is called the Financial Institution Bankruptcy Act, or FIBA. The measure already has been passed by the House, and the Senate may take it up soon.

In theory, the bill attempts to solve a major issue in the Bankruptcy Code that prevents failing megabanks from restructuring through traditional Chapter 11 bankruptcy protection. In effect, though, FIBA offers banks an escape route, creating a subchapter in the Bankruptcy Code through which the Wall Street players who enter into these risky transactions will get paid in full while ordinary investors are on the hook for billions of losses. Not only is that deeply unfair, but it will encourage Wall Street to gamble on the very same risky financial instruments that caused the recent crisis.

Under Chapter 11, a failing company can get a reorganization plan approved to keep its business operating while paying its creditors over time. It then can emerge from bankruptcy as a viable business. During Chapter 11 bankruptcy protection, creditors are prohibited from suing the debtor to collect on their debt, a key provision that ensures all creditors are treated fairly and enables the business to reorganize. This is known as an “automatic stay.”

But Chapter 11 bankruptcy protection has never worked well for large banks. One reason is that, thanks to a series of special laws that Congress passed prior to the financial crisis, the automatic stay does not apply to specific financial instruments — technically called derivatives and repurchase agreements, or “repo” — which are largely held by Wall Street banks. In other words, while most creditors must wait out the Chapter 11 process to receive payment, financial institutions holding these specific financial instruments can sue immediately. Ordinary creditors must sit idly by, restrained by the stay, while the other financial institutions drain the assets and value of the failing bank.

Congress tried to address this problem in Dodd-Frank in two main ways. First, it required megabanks to have “living wills” under which they would limit their derivatives and repo exposure in advance so that they would be able to resolve themselves in Chapter 11 without putting the financial system at risk. Second, if the megabank is failing and its collapse in Chapter 11 would put the financial system at risk, the government can put it into an FDIC receivership, which allows the FDIC to wind down a failing megabank outside a bankruptcy court.

Republicans on Capitol Hill consider these changes unworkable and have proposed the new bill. The theory behind FIBA is that, if we can just tune up Chapter 11 bankruptcy law by enacting a new subchapter V to the Bankruptcy Code, then a large, failing financial institution will be better able to resolve itself in bankruptcy just like any other company. But in fact, FIBA’s subchapter V doesn’t do this. It just stacks the deck even more thoroughly in favor of Wall Street.

Here’s how it would work: Under the legislation, within 48 hours of a failing megabank declaring bankruptcy, a court would hold a hearing to allow the bank to transfer selected contracts and liabilities, consisting mostly of its derivatives and repo agreements, to a newly formed company. This so-called bridge company’s sole purpose is to take on the liabilities owed under these financial contracts and loans. The bridge company will be required to pay 100 percent of those liabilities, without any writedown, even if the property transferred to the bridge company is worth only a fraction of the debt. Once the transfers are made, the bridge company is outside of the jurisdiction and supervision of the bankruptcy court.

At the same time, Main Street creditors — such as the 401(k)s, pension plans and other businesses that extended credit or invested in the failed megabank the old-fashioned way — would receive no payment at all. Instead, the bankruptcy process would wipe out those debts and give the former creditors stock in the newly formed, post-bankruptcy bridge company. As the bridge company emerges from bankruptcy and restarts its businesses, those shares could be valuable. But the new entity’s very first job would be to pay back Wall Street banks 100 percent of their money — thus likely wiping out much or all of its value to its unfortunate new owners. Only after Wall Street gets paid would average Americans receive anything. And if those Wall Street liabilities exceed the new bridge company’s assets, then the stock held by Main Street creditors would be worth nothing.

Supporters of the bill argue that a Chapter 11 bankruptcy case is a tried-and-true way for a distressed company to restructure its debt, in a transparent proceeding governed by rules of law, in which creditors, shareholders and other parties can negotiate and advocate for themselves and their interests. But in practice, FIBA would take away all of this, and just leave Main Street vulnerable while putting Wall Street at the front of the line. Main Street creditors wouldn’t be able to protect themselves in this process — and in a big change from current law, most would not even know they were being ripped off. Under current Chapter 11, transfers of a debtor’s property must be in the best interests of creditors, at a fair price and, notably, after notice to creditors so that they can appear at the hearing and object. Under FIBA, only the largest creditors would even receive notice of the hearing. The ordinary creditors would not receive notice.

Even if they do know about the hearing, they wouldn’t have the representation and expertise necessary to object. Under the Chapter 11 bankruptcy law, the failing company pays for an “unsecured creditors committee,” which advocates for all unsecured creditors. But under FIBA, that committee would not even have been formed by the time of the 48-hour hearing. Main Street creditors would only find out what was done to them later, once they see the losses in their 401(k) or when their pension plan becomes underfunded.

FIBA thus represents a huge change to current Chapter 11 law. The negotiations with creditors and the deliberative process by which the debtor and its creditors advance their positions before the bankruptcy court wouldn’t happen. In effect, FIBA’s subchapter V would create a kind of fake bankruptcy case staged for the benefit of the holders of derivatives, repo and other Wall Street debt, while putting Main Street investors at the end of the line.

Even worse, though, is that FIBA would make the financial system more unstable for two reasons. First, FIBA also would give special, new protections to the megabank’s directors, by shielding them from liability — to creditors, shareholders and bank regulators — for their actions, however risky and destructive, taken in good faith if “in contemplation of” the subchapter V filing and the transfers to the bridge company. This represents a dramatic change from rules under Dodd-Frank which require directors and senior management of a failing megabank to forfeit bonuses and other compensation. In effect, FIBA would encourage excessive risk-taking by directors, who would be sure to argue that their damaging actions taken in the months leading up to the bank’s failure were in contemplation of the bankruptcy, and thus that FIBA’s good faith standard would protect them from Dodd-Frank liability.

Second, the wholesale transfers and special protections for Wall Street creditors would weaken the bridge company’s balance sheet, thus decreasing its ability to obtain the financing that it would need to remain viable. That wouldmake a run on the new bridge company only more likely.

The Bankruptcy Code is a key element of the U.S. economy. A good bankruptcy bill for large financial institutions would be a welcome addition, if it enabled a megabank to effectively restructure its debts and maximize the value of its assets and the distributions to all creditors. A bill such as FIBA would do none of these things. Instead, it favors Wall Street over Main Street, provides the prelude to the repeal of the FDIC receivership authority under Dodd-Frank and sets the stage for the next financial panic.