Monday, 23 February 2009

Bankruptcies, Nationalisations and Recovery. Two Important Elements Should be Taken Into Account, Say Experts

Too Big To Fail? seems to be the question these days. I have been discussing this with friends from UBS, The Economist, local Colombian banks and Brazilian analysts in previous weeks. Two things have come up from those talks. One, whether a bankruptcy system is efficient enough to permit quick recovery of assets and credits and less legal uncertainty -- which we could say is a sort of destructive creation. Second, if nationalisation was used to prevent bankruptcies and economic collapse, then whether its use would be long-term beneficial for the economic health of the country and the economic system as a whole.

We talked today about the rumours involving a nationalisation of Citigroup Inc. Some people say a nationalisation of Bank of America Corp. is looming too. Are they too big to fail? Some say yes, some say no. Check this graph we extracted from a Bloomberg News story on speculation over nationalising banks:
Citigroup and rival Bank of America Corp., beaten down in New York trading last week on U.S.-takeover speculation, are among more than 20 lenders that could wind up majority-owned by the government if such conversions took place. Executives at New York-based Citigroup have discussed the change as a way to quell concerns about capital adequacy while heading off all-out nationalization, according to a person familiar with the matter.
We have extensively talked about this subject in this blog and we have tried to post comments on the subjects by the best minds. I recall having published one excellent article by Stanford University (no relation to A. Stanford, phheeww!) professor Paul Romer in which he stated that some banks should be let fail as the entire society focuses on encouraging the creation of new financial institutions with a different risk-management profile. I liked his view. But some others insist that banks (some of which were way irresponsible and too greedy in the past) should be helped -- too much to ask to angry taxpayers who are losing their jobs because of this crisis. Let's focus on the points mentioned in the previous graph, and draw our own conclusions about the feasibility of nationalisations and the necessity of implementing effective, efficient bankruptcy systems.

An efficient bankruptcy regime often has a positive impact on a broad, solid economic recovery. Colombian central banker Fernando Tenjo, during his years as a research fellow at Universidad de los Andes, did extensive work on this. I always believed he was named to the central bank board in 2000 to help his colleagues understand the impact of this very microeconomic issue (bankruptcies and corporate finance) in monetary policy and help them implement policies to address that issue. At the time Colombia was undergoing its worst recession in seven decades, following the collapse of its housing market, a plunge in the peso that closed access to borrowing for the government and companies, and the impact of precedent international crises (the Asian currency devaluation, the Russian default and the fall of Long Term Capital Management.) At the time, the Andrés Pastrana administration proposed a thorough revision of the local bankruptcy law that ended up being very important in helping the country pull out of the recession. Tenjo understood that monetary policy should focus heavily on helping companies restructure debts while providing them with a stable macro environment, I recalled he told me around 2001 in an interview. The
Banco de la República
was aggressive cutting rates but was also quick in supplying companis and individuals with more dollars. For the past six years Colombia enjoyed a period of growth only comparable to the marihuana-led bonanza of the mid 1970s, or the coffee years boom in the 1950s. So, the bankruptcy overhaul helped on the recovery. Although illegal money keeps coming into the country, anyone sees there has been a flourishing of business activities -- investment has tripled under the current Alvaro Uribe administration. Thus, good bankruptcy laws helped speed up the corporate recovery while instilling confidence on investors.

Bankers at Dresdner Kleinwort say a stricter, more lender-friendly bankruptcy code with only weak punitive elements for the debtor leads to a larger number of bankruptcies, but also to a faster recovery afterwards. Interesting finding: ''In many countries -- including the U.S., which has generally been seen as the gold standard in the last century, and has historically been the one to recover fastest from recessions -- changes have been made to the bankruptcy code over the last few years, which will now face their first true test. Our preferred recovery play in this cycle remains the US: it is most likely to reach the peak in bankruptcy filings first, but most likely also to recover first,´´ the bank wrote in a report. But why that? An efficient bankruptcy recovery system. Thus, heavy state intervention should hamper this systemic advantage this time around.

Finally, if the number of moribund companies that are dependant on life support from their governments keeps increasing, recovery will falter or even fade at some point.
A recent report by Ernst & Young mentions the study case of Europe -- entire sectors were massively nationalised in the late 1970s there. With the exception of the U.K., where former Prime Minister Margaret Thatcher got rid of pachyderm-like state companies and reduced the size of government to a very small and healthy level, growth in European nations lagged behind that of the U.S. for years! Therefore, it may happen that state intervention, namely massive U.S. nationalisations of banks, autmoakers and other industries, end up only hurting economic recovery and hindering asset price and credit recovery. So, those thinking that nationalising these companies (Citi et alter) is gthe answer to prevent a collapse of capitalism should go back to their texts and revise their position.


  1. Don Guille:
    I agree with you. There is no such thing as "Too Big to Fail." Just ask the dinosaurs. I had a question for you, though: In your discussions, what kind of bankruptcies were people referring to: Restructuring (chapter 11 of U.S. Bankruptcy Code) or liquidation (Chapter 7 of U.S. Bankruptcy Code)?
    Nationalization (like nationalism) is a bad idea.
    Un abrazo,

  2. Hola J --

    Both (ch11 and ch7 and their local equivalents) About too big to fail looks like BS ... and it is such in fact. it maight assuage some short term concerns pero en el long run, it will cause the eocnomy too many problems, starting for the moral hazard .. que ahora nos castiga tanto.