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Bankruptcy and the financial crisis

Bankruptcy and the financial crisis. Andrei Shleifer IMF presentation May 26, 2009. Reorganization of insolvent firms is a crucial institution of a market economy It works poorly in most countries, especially developing ones The problem is critical now, in the middle of the crisis.

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Bankruptcy and the financial crisis

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  1. Bankruptcy and the financial crisis Andrei Shleifer IMF presentation May 26, 2009

  2. Reorganization of insolvent firms is a crucial institution of a market economy • It works poorly in most countries, especially developing ones • The problem is critical now, in the middle of the crisis

  3. Discuss a study of insolvency in 88 countries conducted with S. Djankov, O. Hart, C. McLeish (JPE 2008) • Consider some implications for insolvency laws

  4. Setup Hypothetical Case Respondents: Insolvency Practioners from International Bar Association Committee on Bankruptcy Date: January 2006 (several rounds before) Total: 344 lawyers All countries with: GDP per capita > $1000 Population > 1.5 million Total: 88 countries

  5. Case Facts Insolvent Firm called “Mirage” Limited liability, domestically owned, medium-sized hotel Located in most populous city 201 employees 50 suppliers (each owed money) Five years ago, borrowed from Bizbank Loan has collateral, i.e., is secured Loan has 10 year term Mirage has met all obligations until now Loan has seniority

  6. Case Facts (cont’d) Mirage owned 51% by Mr. Douglas No other shareholder has > 5% Mirage has a manager, with no special human capital Mirage has 136 units of debt Suppliers, Tax Authorities, employees each owed 12 These are unsecured creditors Bizbank is owed 100 All normalized to country’s GDP per capita

  7. Case Facts (cont’d) Mirage has been losing money and is about to default due to industry shock Assume going forward can cover costs But cannot cover debt payments Version A: Going concern worth 100 Piecemeal liquidation worth 70 Version B: Going concern worth 70 Piecemeal liquidation worth 100

  8. Data Time = T Cost = C Whether get the efficient outcome: EO = 1 Efficiency = Assume zero net revenue during procedure and costs incurred at end (but robust) Also get structural features of procedure

  9. Figure 1: Options for Mirage

  10. Limitations of the Case • No informal workouts allowed • Capital structure does not adjust to law • Only one secured creditor • Complex conflicts minimized • (Indeed, foreclosure has correct incentives) • 4. Respondents know what is efficient from the start • 5. Do not need new financing • 6. No public interest, politics involved • 7. No tunneling (looting)

  11. (Tentative) Conclusions • Lots of inefficiency in a very simple case: wrong outcome, slow, high administrative costs • How to do better? • Encourage foreclosure and floating charge • Circumscribe Appeals • Discourage automatic cessation of operations • Don’t allow suppliers/customers to rescind contracts • Reorganization seems a bad idea in poor countries, where, arguably, institutions are not good enough to support complex procedures.

  12. What are the implications for today? • Assume bankruptcy reform cannot be done on short notice • Massive bankruptcies would be terrible for efficiency • Fire sale liquidations are bad for everyone • But also do not want debt forgiveness • Suggestion: encourage private renegotiation, perhaps even subsidize it

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