New Bankruptcy Policy Can Avoid Mass Bailouts

Article excerpt


Maybe we can breathe a collective sigh of relief - now that we've dodged the bullet of a catastrophic collapse of America's entire financial system.

But how do we avoid a possible repeat performance?

To be sure, we need to revive and reform the housing market. Fortunately, lenders have stopped giving huge mortgages to practically every would-be borrower with a pulse. But we must straighten out the clueless congressional and administration oversight system.

However, we also need to rethink the approach to those too big to fail key financial institutions, such as American International Group Inc. insurance and Citibank, which ended up getting billions and billions of taxpayer-funded bailout money when they seemed about to go under.

The argument at the time was that these institutions were so large, and so intertwined with virtually every other financial institution in the country, that allowing them to go bankrupt would have doomed the whole financial system.

We will play What if? for years, second-guessing decisions that, in some cases, had to be made in a matter of hours. But one thing is clear, my Heritage Foundation colleague David John says in a new study. Our bankruptcy procedures are so far behind the curve when dealing with today's financial institutions that forcing huge banking or insurance firms into liquidation could easily have led to an uncontrollable collapse. Without a realistic bankruptcy option, Fed Chairman Ben S. Bernanke and then-Treasury Secretary Henry M. Paulson Jr. had to make it up on the fly, often stopping up the breaking dam with taxpayers' money.

What's needed now to address the too big to fail part of the problem, says Mr. John, is two things.

The first is to enact a new chapter of the bankruptcy statute (in addition to well-known parts like Chapter 11) specifically for large financial institutions. The new bankruptcy chapter would enable a court to act very quickly to preserve asset value of the failing firm.

Doing this would temporarily protect the firm from lending contracts that today mean creditors can seize assets without going through a legal process, causing the firm to collapse and jeopardizing other companies doing business with the firm. Properly designed, this would enable insolvent banks and insurers to be restructured or closed down in an orderly way to avoid a domino collapse. …