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Reorganization Is the Worst Option . . . Except For All Others

posted by Jason Kilborn

The tried and true criticisms of bankruptcy procedures that salvage jobs while forcing creditors to internalize losses are making the rounds again. People just don't understand. In England, in particular, the financial press is all over "pre-packs" that allegedly allow "debt dodgers to revel in return of the phoenix" as companies are sold in fast-track reorganization procedures. The problem with breathless criticisms of these procedures--now attracting legislative attention in Britain--is that they seem to be based on the false premise that the alternative would be superior. Ironically, Churchill's tongue-in-cheek appraisal of Democracy applies in like manner to the pre-pack procedure in particular, and reorganization generally.

I know I'm preaching to the choir in making this observation on CreditSlips, but I just don't understand how sophisticated financial reporters can miss the point so badly. The challenge repeated in the linked stories above is that the procedure for allowing troubled companies to be sold (often to private equity, often to investors already associated with the business) somehow allows the management of these businesses to evade personal responsibility and improperly externalize losses onto small businesses, in particular (the darling of all conservative, anti-bankruptcy rhetoricians). The "moral turpitude" bent of these criticisms is explicit, but morality must be based at least in part on reality, it seems to me. These stories seem to miss that (1) the sale proceeds must be distributed to creditors, unless I'm totally missing something with respect to U.K. and other pre-packaged reorg procedures, (2) since the middle of the 1800s, general corporation law has shielded management and shareholders from personal liability to creditors, bankruptcy or not, and (3) the result for small business creditors would be in probably every case worse without a pre-pack, since secured creditors and other large, institutional investors would eat up most of the value of the business in a bankruptcy distribution, especially since a piecemeal liquidation bankruptcy would tear apart the going concern value of the business--and European law often requires management to seek this liquidation bankruptcy as soon as it becomes clear that the company is insolvent! What is a "moral" manager supposed to do? Creditors are getting the value of the business (defined by a market sale mechanism, the result of new money, be it from old management or not), which is rather clearly enhanced by an honestly conducted pre-pack. If the challenge were that pre-packs were being administered improperly (by public authorities), that would be one thing, but the challenge seems to be, instead, that pre-packs are being used improperly, which totally misses the mark, it seems to me.

These commentators are not comparing apples to oranges, they're comparing apples to unicorns! Yes, the result for small business creditors in these cases may well be sour apples, but the alternative is not a magical ride on a unicorn--it's no apples at all.


Pardon me if this observation is outside your area of expertise, but I'd like to know what you think anyway.

Say on a Sunday night in a month or so, the FDIC comes into Citi and BofA, declares them insolvent and now owned by the US Government. Management is gone. But all branches and services remain open by the same people, other than those in the boardroom. Equity is wiped out--other than the preferred stock already owned by the US taxpayer.

At this time, Geithner's "swarm" of accountants come in and begin the process of removing illiquid assets and sending them to warehouse. Nobody gets paid anything for this service. The warehouse has a figurative sign out front "call when Dow back to 10,000" or some such thing.

Income from these warehoused securities can be used to cover as much as possible, secured bondholder interest. At some future date these securities can be sold, the proceeds used to begin repaying bondholders.

If the new nationalised bank needs some taxpayer investment to bolster its balance sheet due to stripping out the illiquid securities, then that should be done.

Then, armed with a national bank, the government can begin the process of lending in furtherance of national policies.

I admit that this is outside my area of expertise, but hey, I'm a lawyer--so lack of expertise won't dissuade me from offering an opinion. :-) Though I am in a sense receptive to this kind of nationalization (which I half-jokingly advocated elsewhere: http://ucclaw.blogspot.com/2008/12/why-are-credit-card-issuers-undermining.html), I also acknowledge that banks run by government are generally not as healthy or effective in the long term as banks run by private bankers focused solely on the business of banking. The political pressures and constraints on the managers of such banks would in all likelihood lead to sub-optimal economic decisions and less constructive innovation, and international investors may well be less inclined to invest (either equity or debt) in such national banks. While I am VERY receptive to notions of state control of lots of things, along the Scandinavian model, I fear that U.S. government managers in charge of such institutions would not do a very good job of managing (especially if a radical Republican administration were in charge, as we've seen). Government generally is not as nimble, innovative, or even as talented, I'm afraid, as the private sector in managing day-to-day operations at banks, even very large banks. This could change--if national banks and other nationalized industries became the "go to" place for talented and energetic grads of top programs, and those grads found that their efforts were properly rewarded, maybe we could achieve the ultimate in risk-management and responsible growth (which is pretty close to what I have seen from afar in Scandinavia, though that culture has been highly eroded in recent years by an invasion of neo-liberal sentiment). I'm not confident that we in the U.S. are ANYWHERE near that stage yet, either in the culture or the rewards of government service.

If you want to read a beautiful treatment of the strengths and weaknesses of government operations, go to James Q. Wilson's Bureaucracy. He is a man of the right, but his political science work is extremely perceptive and without any patent ideological bias.

The nickel version: government bureaucrats, by and large, are no worse at management than those in the private sector. A bureaucracy succeeds when its mission is well-defined and limited. Business has an advantage here, because its mission is profit, for which a convenient scalar metric exists. However, a well-designed government operation can be every bit as efficient as private business.

The weakness with government, is therefore twofold. First, it is not nearly as nimble: even a beautifully-designed bureaucracy will eventually fall out of synch with reality. Second, Congress likes to lard its bureaucracies with all manner of righteous goals, which tends to blunt the mission, and thus effectiveness, of its bureaucracies.

As a corollary of this, smart bureaucrats avoid fighting for turf that blunts their mission.

Thanks for the answers. Maybe I'm naive, but I've noticed that a number of government institutions are very efficiently run. I think the administrative overhead for social security, for example, is something like 2%. I also believe administrative costs for government provided health insurance compare very favorably to private health insurance companies.

I also think that a national bank should not be compared in every way with private banks, which have an understandable focus on profit to reward shareholders. A national bank has other measurements that are important for purposes of common good. An example right now would be lending into depressed areas or communities who are seeing their infrastructures crumble to worthlesness.

Right now we seem to have no problem throwing money into private banks that are insolvent. I just can't understand why we don't throw all that money into a national bank that will, in fact, lend to Main Street immediately. It may not show much, if any, profit, but it will definitely profit the country to have an institution like that right now.

Beezer, I'm not so much concerned about efficiency as I am about effectiveness. As Joe S. observed, the primary problems with government are lack of nimble reaction to change and incentive/drive for innovation. My sense is that the SSA, for example, might be run fairly efficiently in its current form, but it could be run much better in a different form, and produce much better results, if the administrators weren't constrained by political considerations having nothing to do with the best way to manage SSA benefit delivery.

The Administrative overhead for SocSec is something like 30 basis points (0.30%). Otoh, it's a monopoly with a large amount of money--even bigger than Vanguard (I hope).

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