Bankruptcy

Chapter 11 & Financial Institutions

By Stephen Lubben

The FT has a good story today about "living wills," the idea that banks and other large financial institutions should provide a plan for the own wind-down in the event of a future financial crisis. The hope is that such a plan will necessitate simplification of corporate structures and provide the basis for an orderly, pre-described resolution of the firm's troubles.

Although I have yet to see the discussion move this way, it seems to me that these living wills need to be designed in conjunction with a system for resolving an institution's financial distress. Be it chapter 11, chapter 11 modified, or a new chapter entirely, in the United States living wills should essentially plug directly into a pre-existing statutory structure.

Because investment banks like Lehman Brothers are entirely dependent on their credit rating and reputation ? to the extent those are different things ? traditional reorganization is unlikely to be an option. One alternative might be to design a system, either within chapter 11 like the current railroad-specific sections or as a distinct chapter, that offers a limited chance for a quick reorganization under the Chrysler/GM model (quick sale of the good assets, liquidation of the remainder), followed by an orderly chapter 11-style liquidation if the sale does not happen within the specified time period.

The trick is, to allow a true 363 sale of a company like Lehman, in a way that maximizes the value of the estate, you need to repeal the safe harbors, or at least place them on hold until it becomes clear that such a sale is not possible and the bank is going to liquidate.  A lot of Lehman's value was lost when half of its derivative portfolio was terminated and the other half ceased to function.

The safe harbors essentially allow a run on the bank. Staying the safe harbor provisions might calm the market, while at the same time maximizing the value of the estate and reducing losses to creditors, both of which seem like good things in the quest to avoid the next Lehman.

Full post as published by Credit Slips on September 15, 2009 (boomark / email).