« The Australian Interchange Experience | Main | White House Dinner Crashers' Bankruptcy »

Proposals for Haircuts at the FDIC

posted by Bob Lawless

FDIC-sponsored haircuts have become a hot item in the blogosphere. My wife used to work for the FDIC, and I smile every time I hear the term as I think about the building on F Street with a big barber pole in front of it. Here, the term is not being used in its hirsuted sense but as part of the colorful vernacular that surrounds insolvency work. A "haircut" describes a situation where a creditor is paid less than that to which they are entitled.

The FDIC proposal comes from Representatives Brad Miller and Dennis Moore and would limit the recovery of secured creditors to 80% of the value of their collateral in FDIC takeovers of failed banks. (I can't seem to locate the original text of the proposal on the Internet, but it has been widely reported.) Academic types will remember a similar proposal from Professor Elizabeth Warren back in the 1990s that would have limited recovery to 80% of the collateral's value. While Warren's proposal would have applied to many types of secured lending (at that covered by Article 9 of the Uniform Commercial Code, the current proposal is limited to failed financial institutions taken over by the FDIC.

The usual criticism has arisen in the usual places, namely that the latest proposal will discourage capital formation in banks. In turn, it is said that banks will lend less. Growth will be deterred. And we'll see even more gruesome scenarios involving the cross-breeding of dogs and cats. All of that might be true--well the dogs-and-cats part is less likely--but these criticisms miss the point. The question is not whether we like capital formation and economic growth but whether the costs are worth the benefits. The costs here come from the moral hazard that is created by asset partitioning.

Suppose I am thinking about starting a fireworks business. That's great for me and great for the community because I'll employ lots of people. The only problem is that when my factory blows up, the victims are going to sue and get judgments against me. They'll use the judgments to take my home, my car, my boat, and my kids' toys. That's not so great so maybe I don't start the business. These are exactly the reasons why we have incorporation, which is a form of asset partitioning. I can divide up assets available to my business creditors--those in the corporation--and those available to my personal creditors.

Of course, the asset partitioning will create moral hazard. Because I won't bear the full consequences of my business's risk, I won't have full incentives to minimize those risks. These are some of the reasons we require things like licenses, insurance, and compliance with safety regulations. Generally speaking, we especially have these sorts of requirements when asset partitioning leads to especially bad moral hazard.

Secured lending is a form of asset partitioning as it commits some or all of the firm's assets to a particular creditor or group of creditors. In a manufacturing context, secured credit can remove assets that otherwise would be available perhaps to pay victims of defective products (or any other creditors unable to fully adjust to the increased risk created by the asset partitioning). In the context of the current proposal, secured credit removes value that otherwise would be available to pay the FDIC.

On the merits, the wisdom of the Miller-Moore proposal depends on whether we think the benefits to capital formation that comes from the particular form of asset partitioning at work with secured lending to banks exceeds the costs created by its risks. Maybe this is one issue we can move beyond the usual screeds about the end of capitalism from the business lobbies. One answer is for the FDIC to do a better job and use its regulatory powers to stop banks from using secured lending to engage in overly risky behavior. That answer rests on a false premise that the FDIC can do a better job given the practical and political obstacles that stand in the way of identifying and then acting on situations where banks should be taking fewer risks.

What we do have is a few years of financial crisis that provides evidence that banks were overinvested in risky assets. In addition to the many losses that have fallen all over society, it is clear losses have fallen on the FDIC; its insurance fund has taken a huge hit. Concededly, the Miller-Moore proposal will slow capital formation in the banking industry, but it might also avoid these sorts of losses in the future. Any intelligent discussion of the issue has to recognize not just the benefits that come from asset partitioning by secured lending but also its costs.

For other discussions of this issue (both pro and con), see:

Ira Stoll, "The Bair-Miller-Moore Haircut," on The Future of Capitalism
Felix Salmon, "Hitting Secured Creditors," on Sailing the Rough Rude Sea
Andrew Ross Sorkin, "Beware the Result of Outrage," on Dealbook
Ira Stoll, "Answering Felix Salmon," on The Future of Capitalism

Comments

The reasoning of the fireworks example is faulty. The reason we have licensing, insurance and safety regulations for fireworks is not because of asset partitioning or moral hazard. It has nothing to do with whether a corporate form is used. Those regulations apply to individual users, too. We have those regulations because fireworks are dangerous; severe injuries are not fully redressed by money damages; and the deployer of fireworks may be judgment-proof even if all of his/her assets are available to the tort creditor.

Speaking of tort creditors, note how a tort judgment is enforced - by a judgment lien. I don't see a principled difference between haircutting a contractual creditor's collateral and a tort creditor's collateral.

The rest of the post does not provide a reasoned justification of its dismissal of the perverse effects on capital formation. It seems very cavalier. Even setting that aside, a limit on secured creditors' recovery would be an ineffective way to deter risk -- secured creditors are the ones who take the least risk! Equity owners are the greater risk-seekers and it is their decisionmaking that needs to be altered, not secured creditors'.

Finally, a proposal to compel a fixed haircut on recoveries on collateral would have the same 5th amendment problem that underlies the requirement of adequate protection.

We do not often agree, MT, but I always appreciate your reasoned approach. And, I should say that your comment is much more reasoned than some of the stuff I was reading against the bill. Mainly, my post was a plea for a more reasoned debate on the topic rather than the "banks bad" vs. "end of capitalism" hyperbole we usually see in the media.

Responding to a few of your points --

(1) The 5th Amendment surely will have no applicability as the law would not be retroactive. I want to say the name of the case is Wright v. Central Union Life Ins., a Supreme Court case from circa 1940, but I may have that cite wrong.

(2) Contractual creditors and judgment lien creditors differ in a very important way. Contractual creditors can adjust by negotiating for different contract terms, and judgment lien creditors generally cannot. Academics usually talk about adjusting vs. nonadjusting creditors, which is a continuum rather than a dichotomy. I think, because of political limitations, the FDIC is closer to the nonadjusting end of the spectrum. If one thinks the FDIC is closer to the adjusting end of the spectrum, then the Miller-Moore amendment will not make as much sense.

(3) The fireworks example is stylized to easily illustrate the concepts in play. Moral hazard and asset partitioning help to explain licensing, insurance, and safety regulations in much more mundane settings like taxi cab companies, trucking companies, and even securities brokers.

Your reply on the constitutional issue confounded me as I am not aware of any case that says a prospective taking of property avoids the takings clause. I went back and re-read Wright v Union Central Life Insurance (311 US 273) which says that a secured creditor can be stuck with payment of a judicially determined value after a hearing on the value, in lieu of its state law right to sell the collateral at a judicial sale. That is the case that led to our current adequate protection requirement and that I believe supports the argument that a fixed haircut of recovery on one's collateral is unconstitutional, given that under the Miller proposal, no matter how clear and convincing the proof at such a hearing that the collateral value exceeds 90% of the debt, the secured creditor would be given only 90% of the debt and the rest would be confiscated by government without any compensation. I think you may be invoking a previous Wright opinion (reported at 304 US) which deals with a different question, whether Congress can extend the state law redemption period as against a buyer at a judicial sale. That case did not concern an explicit haircut of the value of the buyer's rights and thus does not address the constitutional problem.

It is the Union Central decision that I was thinking about. The language in the Court's opinion makes it pretty clear that the government can change the rules prospectively without violating whatever 5th or 14th Amendment rights creditors might have. E.g., "If the argument is that Congress has no power to alter property rights, because the regulation of rights in property is a matter reserved to the States, it is futile. Bankruptcy proceedings constantly modify and affect the property rights established by state law." I don't think it matters that it was an extension of the right of redemption and not a haircut specifically involved in that case.

Along with Radford and Vinton Bank (the prior Wright opinion you mentioned mt), Union Central is part of what is known as the Frazier-Lemke trilogy. The cases are inconsistent. At best, they stand for the proposition that some retroactive modifications of secured creditors might violate the due process clause. I am not aware of any case where the Supreme Court invalidated a prospective change to the rights of secured creditors.

I think the double negative in the final sentence suggests that one cannot find authority that the Court would validate a law that eliminates the value of a state law property interest merely because it was done prospectively.

Consider two laws:
1) Effective the date hereof, all secured loans in excess of $X are hereby confiscated without compensation.

2) Effective on the first anniversary hereof, all secured loans in excess of $X shall be confiscated without compensation.

The first is obviously not Constitutional. If prospectivity, if that's a word, renders a confiscation Constitutional, then the latter is Constitutional. I have a hard time believing the latter is Constitutional and thus doubt that mere prospectivity saves a haircut bill.

Consider these two laws:

(1) Effective today, all secured loans in existence shall be confiscated without compensation.

(2) Effective today, no creditor can enter into a secured loan, but all existing secured loans will be enforced.

The first probably raises constitutional issues. The second does not.

That's right, but your second example is critically different from what is proposed, which is a haircut if one obtains a legally valid state law property interest with a value greater than the haircut result produces, and then that state law interest is confiscated in a federal proceeding. The difference is: in the haircut scenario, you are permitted to create a state law property interest - think Butner - that has a value which the government takes away without compensation. In your "no creation" scenario, you ban state law rights ab initio, which operates outside of and has nothing to do with bankruptcy, but appears to rely on commerce clause preemption. Ergo no valid state law property interest comes into play due to the preemption; ergo the 5th amdt issue never arises.

Go back to mine: I just took an egregious taking and madeit prospective. If prospectivity is the cure, the second law has to be Constitutional. The secured creditor can always release its lien before the effective date so it can avoid the taking (by forfeiting the property). I don't think my second example is Constitutional but it is a more apt comparison to the haircut idea.

I am way out of my league here but if 80 to 90% is given in a FDIC takeover on a secured debt, how can it be "taken without compensation"? Isn't the 80-90% "compensation"?

The comments to this entry are closed.

Contributors

Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.

News Feed

Categories

Bankr-L

  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.

OTHER STUFF

Powered by TypePad