A Bankrupt Insolvency System

Lawmakers need to move faster to create regulatory consistency across Europe's financial system.

By ANN CAIRNS

From today's Wall Street Journal Europe.

It's a truism that companies live globally but die nationally. The pace of companies' global expansion, and the consequent integration of functions across borders, has not been matched by the international harmonization of those laws which come into play when they face extinction. And the conflict between international insolvency rules has never been more apparent than in the restructuring and administration of Lehman Brothers.

Lehman is a tangled web of assets subject to 76 different insolvency procedures. Of course, the complex and tightly woven structure we see in financial services firms is not replicated to the same extent in any other sector. Yet the rapid deterioration of Lehman has raised numerous questions for all businesses with globally integrated business models, from automotive to technology.

Answers are somewhat harder to come by. Arguably, companies have become too big -- Lehman had more than 3,000 legal entities across the globe -- and too complex to be run comprehensively from one center. So there is no reason why running them down would be any easier. While politicians, insolvency professionals and industry associations have called loudly for governments to establish global insolvency protocols, it is hard to envisage the harmonization of deeply entrenched national rules. Yet only a complete overhaul of international insolvency regulation will result in the systemic change needed to circumvent the "every man for himself" approach.

So, what might insolvency harmony actually look like? I believe a coordinated and global regulatory insolvency process should be modelled on Chapter 11 of the U.S. bankruptcy code. There should be an emphasis on rescuing troubled companies and thereby maximizing benefit to creditors, either by an orderly unwinding or a resurrection of the business as a viable entity. While some say the Chapter 11 process is overly friendly toward debtors, there is no doubt that it enables troubled companies to concentrate on their healthy assets and plan a route to recovery or preserve value. It is conducted under the beneficial glare of the court, which fosters far better communication between creditors and administrators.

The unplanned way in which Lehman was placed into bankruptcy led to an unprecedented and rapid deterioration of value. As soon as the U.S. holding company had filed for Chapter 11 protection, different parts of the Lehman business around the world were ushered into insolvency. The wind-up mentality of local administrations, as opposed to Chapter 11's goal of preserving the business as a going concern, has resulted in unsecured creditors waving goodbye to tens of billions of dollars.

Global companies typically operate a business model according to the function or process they perform, rather than where they are physically located. In a restructuring or insolvency, however, they are forced to organize themselves by legal entity, whose patchwork structure is unlikely to correspond to how the business is organized operationally. Restructuring experts and insolvency practitioners in each jurisdiction have to balance the goal of maximizing returns to the creditors of the particular entity they control against the potential damage that can be incurred to the estate as a whole.

Sustaining, winding down or selling these operations is hugely challenging. Within Lehman U.K., London-based teams managed big swaps books, loan books and real estate assets, some of which were legally owned by the U.S. holding company. Local administrators were letting traders and staff go while the U.S. teams were trying to unwind the books to the benefit of the estate. This theme of having people and the assets they manage located in different places will continue to be a central challenge for years to come.

Certainly, in the absence of any current legal uniformity, we should examine what lessons we can take away from Lehman. First, it's vital to introduce transition services agreements between restructuring practitioners, in order to obtain consensus on how to manage people, premises, systems and data. While there will be multiple overlapping agreements between administrators and various buyers, these agreements go a considerable way toward halting confusion and in-fighting.

Second, if financial institutions are deemed "too big to fail," they are simply too big, period. In this globally interconnected and fragile system, a failure in a "big" institution can easily have a knock-on effect on the entire industry.

And finally, liquidity is king. Looking at the Lehman estate today, we can see how the mentality behind the U.S. Chapter 11 process has allowed the once-venerated firm to rebuild its cash coffers even in bankruptcy, to the ultimate benefit of its creditors. Lehman today is sitting on nearly $11 billion in cash, up from $200 million when the firm filed for bankruptcy. These reserves mean the firm does not have to sell its real estate and other proprietary assets until the markets for those assets sufficiently recover.

A freefall bankruptcy like Lehman's must never happen again. Efforts to create regulatory consistency across the European financial system are gathering momentum. So why shouldn't restructuring and insolvency laws follow suit? European lawmakers need to move faster if they are to genuinely support the growth opportunities of entrepreneurs in the complex reality of global business.

In this recession, there are likely to be too many "good" companies that will go bust because of the lack of a satisfactory restructuring framework. That is too high a price to pay for preserving national governments' right to be different.

Ms. Cairns, head of Alvarez & Marsal's European Financial Industry Advisory Practice, is overseeing the European aspect of the Lehman bankruptcy.

Large U.S. banks on brink of insolvency, experts say

By Steve Lohr

Some of the large banks in the United States, according to economists and other finance experts, are like dead men walking.

A sober assessment of the growing mountain of losses from bad bets, measured in today's marketplace, would overwhelm the value of the banks' assets, they say. The banks, in their view, are insolvent.

None of the experts' research focuses on individual banks, and there are certainly exceptions among the 50 largest banks in the country. Nor do consumers and businesses need to fret about their deposits, which are insured by the U.S. government. And even banks that might technically be insolvent can continue operating for a long time, and could recover their financial health when the economy improves.

But without a cure for the problem of bad assets, the credit crisis that is dragging down the economy will linger, as banks cannot resume the ample lending needed to restart the wheels of commerce. The answer, say the economists and experts, is a larger, more direct government role than in the Treasury Department's plan outlined this week.

The Treasury program leans heavily on a sketchy public-private investment fund to buy up the troubled mortgage-backed securities held by the banks. Instead, the experts say, the government needs to plunge in, weed out the weakest banks, pour capital into the surviving banks and sell off the bad assets.

It is the basic blueprint that has proved successful, they say, in resolving major financial crises in recent years. Such forceful action was belatedly adopted by the Japanese government from 2001 to 2003, by the Swedish government in 1992 and by Washington in 1987 to 1989 to overcome the savings and loan crisis.

"The historical record shows that you have to do it eventually," said Adam Posen, a senior fellow at the Peterson Institute for International Economics. "Putting it off only brings more troubles and higher costs in the long run."

Of course, the Obama administration's stimulus plan could help to spur economic recovery in a timely manner and the value of the banks' assets could begin to rise.

Absent that, the prescription would not be easy or cheap. Estimates of the capital injection needed in the United States range to $1 trillion and beyond. By contrast, the commitment of taxpayer money is the $350 billion remaining in the financial bailout approved by Congress last fall.

Meanwhile, the loss estimates keep mounting.

Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, has been both pessimistic and prescient about the gathering credit problems. In a new report, Roubini estimates that total losses on loans by American financial firms and the fall in the market value of the assets they hold will reach $3.6 trillion, up from his previous estimate of $2 trillion.

Of the total, he calculates that American banks face half that risk, or $1.8 trillion, with the rest borne by other financial institutions in the United States and abroad.

"The United States banking system is effectively insolvent," Roubini said.

For its part, the banking industry bridles at such broad-brush analysis. The industry defines solvency bank by bank, and uses the value of a bank's assets as they are carried on its books rather than the market prices calculated by economists.

"Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.

Edward Yingling, president of the American Bankers Association, called claims of technical insolvency "speculation by people who have no specific knowledge of bank assets."

Roubini's numbers may be the highest, but many others share his rising sense of alarm. Simon Johnson, a former chief economist at the International Monetary Fund, estimates that the United States banks have a capital shortage of $500 billion. "In a more severe recession, it will take $1 trillion or so to properly capitalize the banks," said Johnson, an economist at the Massachusetts Institute of Technology.

At the end of January, the IMF raised its estimate of the potential losses from loans and other credit securities originated in the United States to $2.2 trillion, up from $1.4 trillion last October. Over the next two years, the IMF estimated, United States and European banks would need at least $500 billion in new capital, a figure more conservative than those of many economists.

Still, these numbers are all based on estimates of the value of complex mortgage-backed securities in a very uncertain economy. "At this moment, the liabilities they have far exceed their assets," said Posen of the Peterson institute. "They are insolvent."

Yet, as Posen and other economists note, there are crucial issues of timing and market psychology that surround the discussion of bank solvency. If one assumes that current conditions reflect a temporary panic, then the value of the banks' distressed assets could well recover over time. If not, many banks may be permanently impaired.

"We won't know what the losses are on these mortgage-backed securities, and we won't until the housing market stabilizes," said Richard Portes, an economist at the London Business School.

Raghuram Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between "liquidation values" and those of calmer times, or "going concern values." In a troubled time for banks, Rajan said, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.

"If they had to sell these securities today, the losses would be far beyond their capital at this point," he said. "But if the prices of these assets will recover over the next year or so, if they don't have to sell at distress prices, the banks could have a new lease on life by giving them some time."

That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before.

In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

In the current crisis, experts warn, banks need to get rid of bad assets quickly. The Treasury's public-private investment fund is an effort to do that.

But many economists and other finance experts say that the government may soon have to move in and take on troubled assets itself to resolve the credit crisis. Then, they say, the government could have the patience to wait for the economy to improve.

Initially, that would put more taxpayer money on the line, but in the end it might reduce overall losses. That is what happened during the savings and loan crisis, when the troubled assets, mostly real estate, were seized by the Resolution Trust Corporation, a government-owned asset management company, and sold over a few years.

The eventual losses, an estimated $130 billion, were far less than if the hotels, office buildings and residential developments had been sold immediately.

"The taxpayer money would be used to acquire assets, and behind most of those securities are mortgages, houses, and we know they are not worthless," Portes said.