Law on Rice

Yesterday, Federal Reserve Board Governor Frederic Mishkin argued that there are two types of asset bubbles: benign and malignant. (Actually, I’m helping him with the analogy.) He says that the recent bubble was systemic in that it caused heavy leveraging (a “credit bubble”) and later deleveraging. By comparison, he says that the prior asset bubble (the dot com boom), was relatively harmless (a non-credit bubble).

As a matter of economics, I can only assume he’s right. A systemic asset bubble is obviously worse than a non-systemic asset bubble. I think all would agree on this point.

But who cares?

My professor has started to wear me down. I am a fierce believer in the power of markets. But he’s convincing me that markets may not have the primacy I thought they once did. Maybe the market is only a tool to make a big nation work. Surely it’s an extremely efficient and important tool, but maybe it really is subordinate to the overall need for us to make sure that people can eat, grow, and live together on fair terms.

And if that’s the case, then the only difference between Mr. Mishkin’s credit and non-credit bubble is that one is worse than the other. But both are bad. Both tear at the seams of the system we’ve put together. Both tear at the fabric that we’ve chosen to unite each other–the market.

* For the record, I do believe that Mr. Mishkin is really just trying to calm the nerves of those who argue for tightened monetary policy because they smell another bubble. That said, I think his arguments fail for all the aforementioned reasons–especially now. Most economic decision makers have a strained credibility with the public (to say the least). Best to spend that credibility wisely on sounder arguments, in my opinion.

Today I’ve been thinking about bankruptcy in a different way. In the past, I’ve thought of it as a kind of social safety net. And it is that.

But maybe it’s more important than that. Maybe it’s a way to maintain order in society by giving over extended people a way out of crushing debt so they can get back to work, staying on the grid rather than simply dropping off the grid.

I’m reading Sheila Bair’s comments to the House Financial Services Committee. She says something provocative:

The priority protection given to secured creditors under both the bankruptcy code as well as the FDIC’s resolution mechanism creates incentives to rely excessively on short term, secured financing. Too many creditors have looked to the value of their collateral — as opposed to the credit worthiness of their counterparties — in making credit decisions.

I’m still in school, so I’m just now beginning to understand the struggle between secured and unsecured creditors, just now beginning to understand what a fascinating struggle it is.

But Ms. Bair’s comments add a new dimension for me: does the Bankruptcy Code encourage creditors to focus on the wrong aspects of the overall credit risk? By extension, did it help fuel the asset bubble?

“The biggest long-term threat is that people are becoming and have become disheartened,” said Peggy Noonan in yesterday’s Wall Street Journal editorial (click here). On this point, I think she’s right. This economic disaster is more massive than anyone in modern history has ever dealt with; it is and will be hard. But economics is largely about psychology, and I don’t feel like our primary leader, President Obama, is much of a cheerleader.

Yesterday, Mr. Obama said, without cracking a smile in five minutes and twenty one seconds, “today, I’m pleased to offer some better news. While not a cause for celebration, it is certainly reason to believe that we are moving in the right direction.” Oh, wow. That sounds great. I can’t wait to break ground on that new factory I was thinking about. Mr. Obama didn’t stop there. He went on to give me a dry, boring explication of the gross domestic product and our economy with incessant reminders, qualifiers, and equivocations that times are going to be hard in the future.

I miss Bill Clinton. He made me feel good about America. He made me feel like we were going somewhere, and that I was playing on the winning team. He made me want to invest in the future, made me want to take a risk. Compared to Clinton, President Obama feels like he’s simply the Analyst in Chief.

Oh, I know he’s doing great work in the face of a massive disaster. I just want him to do it with a smile. I want him to remind me that America’s best days are still in front of it. I think it would make his job a lot easier.

I have a new idea that I’m sketching out here without too much thought: what if we had specialized financial institution courts? They would be highly trained courts with broad equitable powers.

These specialized courts would spur innovation and secure America’s lead as a financial powerhouse. You see this with the Delaware Courts of Chancery.

They would have jurisdiction over large financial institutions that pose a “systemic risk.” Congress would give them jurisdiction, and control their freedom of movement.

People would complain that courts move too slowly to solve high speed financial disasters, but I would solve that with a powerful stay that looks like a localized bank holiday. It would be not unlike the automatic stay imposed by bankruptcy courts under 11 U.S.C. 362(a).

Sure, they would be the playthings of lawyers, but at least there would be due process protection.

I think it’s a great idea conceptually. There are, of course, a million and a half ideas to work out.

As you know by now, Mr. Feinberg wants to cut a few compensation packages for a few lucky finance executives.

While I’m generally concerned about America giving regulators a say on executive compensation, I think my professor is right about a key feature of the move–America wants its pound of flesh from the bankers. America wants retribution.

So why not charge them criminally? I’m not saying that we should. I’m just saying that regulators should generally hand out regulation, not retribution. That’s what our criminal courts are for. At least the executives would have the benefit of a jury. If we want to exact revenge, we should seek it in the right tribunal.

My professor says that America is facing the biggest problem it’s ever faced. Bigger than World
War II.

Our banking system is still broken. The only thing the regulators are really doing is trying to buy time. But nobody has really proposed any major architectural fixes, and the banks have only gotten bigger.

Maybe he’s right.

Some in the class want to let the system crumble and let the market sort it out. The professor worries that this may cause instability that may overwhelm those in power, and so nobody is really willing to let it happen.

As absurd as this sounds, I actually think I have a solution that would work. I call it the Los Angeles plan.

Yesterday I was working on a client’s bankruptcy case. Her real problem wasn’t so much her unsecured debt as it was her secured debt, namely a car and a house payment.

Liquidation in these contexts isn’t really helpful, and chapter 13 reorganization doesn’t help because of the restrictions on home and purchase money restructuring.

If Congress really wants to help these people that are living on razor thin margins (and I’m surely not accusing Congress of any such thing), they should either add more cramdown power in chapter 13, add a reorganization component to chapter 7, or create a whole new chapter for these folks. Maybe it could be done for people who are a certain level below median income.

But likely it won’t be done at all.

We were talking about derivatives and securitization in class today. The professor acknowledges that these financial instruments aren’t necessarily bad (a point I’ve made in class a few times), but he does remind us that they took center stage in the latest financial drama.

I think I got tired or lazy or something because my mind wondered during the later part of the discussion. I imagined my professor writing a financial cookbook espousing the beneficial effects of securities taken whole and raw. Kind of like the whole food movement.

The day dream continued. You see, explains my now celebrity professor being interviewed by Cramer, direct investments made between entrepreneur and investor are healthy, not only for the economy but for the soul. He goes on the note the success of the new slow money movement followed by small indie bankers around the country…

Then I snapped out of it. I must be really tired. It must be the middle of the semester.

I was listening to Diane Rehm this morning on the way to work. She was doing a show on the merits of a new consumer financial protection agency.

I personally think the issue–should we have one or not have one–is a really, really hard question. On the one hand, it’s clear that people don’t understand really basic things, like how to balance a checkbook. That was evident just from the show’s callers.

On the other hand, it seems so hard to know how to fix that problem through “protections” offered by the government. What does it mean to “protect” in this context? Even more problematic, to me, is that the protections might create a lot of exceptions for the wealthy–and protect their ability to seek big returns while limiting little guys like me.

I think the healthcare debate is easy compared to this!