David Skeel on Bankruptcy and the Auto Industry Bailout
Jul 4 2011

David Skeel of the University of Pennsylvania Law School talks with EconTalk host Russ Roberts about bankruptcy and the government bailout of the auto industry. Skeel argues that the bailout damaged the rule of law by not allowing a bankruptcy procedure to take its course. Skeel speculates on how bankruptcy for GM and Chrysler might have proceeded. He also argues that the costs to the taxpayer of the bailout have been underestimated. The conversation concludes with a general discussion of the effects of bankruptcy.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Mads Lindstrøm
Jul 4 2011 at 1:37pm

I am wondering why we need bankruptcy law. Why is the rule of bankruptcy not just part of the lender contract? In this way industry X or company X, could use the bankruptcy rules most sensible for that kind of company or industry.

Nick Ronalds
Jul 4 2011 at 3:17pm

Great discussion. Two comments: Neither of you ever mentioned that there are at least two relevant “chapters” of bankruptcy, 7 and 11. I think you were talking about 11. Second, Skeel suggested that in countries with less forgiving bankruptcy regimes like Japan and Germany there’s less innovation. Don’t know about Germany, but as someone who lived in Japan in the run-up and aftermath of the Japanese bubble, I can say from close observation that the Japanese rarely, if ever, allow bankruptcy of a large company. They “engineer” mergers and otherwise inject politics into the process. In other words, politicized Bear Stearn-type approaches are the norm. So I think Russ is right that it’s at best an open question whether a harsher bankruptcy regime in itself suppresses innovation. A bigger factor is likely the biases and favoritism inherent in cronyist approaches.

Jul 4 2011 at 5:23pm

Big overlooked question.

Every defender of the auto bailout that I have read has stated categorically that if we had not bailed out the industry, government would have incurred much larger costs than the bailout through unemployment, lost taxes and such.

I have no idea if this is true or not, but it could provide a rational basis for the bailout.

Even the most ardent free-market capitalist will sometime make immoral decisions if doing so costs less that than the alternative. Think of all the examples when people choose to settle a lawsuit, even though they are in the right, because proving that they are right will cost far more than settling.

Jul 4 2011 at 5:47pm

Dr. Roberts,

You are the hardest working man in podcasting. No summer breaks and delivery of a great podcast on the 4th of July. I know you pre-record but still quality content every week is a tremendous accomplishment.

I like the discussion on the alternative process that the government could have used. I have a slightly different judgement on the financially sound vs econmically sound. Many insitutions are neither finacially sound or economically sound to pay all their creditors in the short run nor long run, but they are of greater economical value as a going concern as compared to being disolved. Isn’t the greatest return to the creditors the main purpose of bankrupcy.

Thanks Mr. Skeel and Dr. Roberts

Jul 5 2011 at 9:20pm

the more I listened the more this sounded to me like, in a perfect world how many angels could dance on the head of a pin. Free market assumptions piled on top of free market assumptions, when, at the time these companies went down you had multiple, massive and complex market failures. This discussion is akin to a speculation that if we didn’t use anesthesiology during major surgery the patients might wake up quicker with fewer side effects. Yeah, and they might also needlessly die from pain and shock during the operation, defeating the purpose of surgery in the first place.

I suppose what most grates with these people is that the workers got a better deal than they might otherwise have. That being the case the successive managements of C and GM are guilty of fraud (at some point in the history) in making promises that they knew couldn’t have been kept. So you either have the process as it went down or we should have statues that prevent the fraud at the beginning of the personnel recruiting and hiring process. These statues might also serve to prevent Hayekian malinvestment. So which do you prefer?

Extra credit questions: who has the better array of resources to detect fraud and malinvestment, workers making $50,000 year or institutional creditors? Would we have a better system of capital deployment and credit creation if the standard priority of claims reflected those differences in resources?

Frank Howland
Jul 6 2011 at 10:40am

A few thoughts/questions:

1) Could the bankruptcy (let’s look at GM to be specific) be analyzed as a series of transfers, e.g. from taxpayers and senior bond holders to workers and other creditors? I assume that the $45 billion in potential tax breaks got distributed in effect to various creditors.

2) I think a good case can be made that managers in US corporations are too entrenched–shareholder democracy doesn’t work, boards of directors are often in effect chosen by top managers, CEOs and other top managers seem to be overpaid. That doesn’t mean that our bankruptcy laws are bad, just that they worsen an already bad situation regarding entrenched management.

3) I liked the comparisons to the financial bailouts. I think that the not only is the same sort of thing going on in both the auto and financial sectors, but that there may be a direct connection. I wonder whether Obama felt political pressure to bail out the auto industry once the big banks and financial bondholders were bailed out. After all it would look awfully bad to see workers laid off (there would have been layoffs in any case) seemingly because the automakers weren’t rescued at the same time as the banks were rescued.

Jul 7 2011 at 8:47am

that was awesome, learned tons. a fine addition to the financial crisis related episodes. top shelf econtalk!


1- y not ask what were the 1 or 2 previous exceptions to bankruptcy proceedings that were large (like GM/chrysler) and dealt thru a sale structure (rather than typical bankruptcy)?

were market conditions, TBTF-like policy or other aspects different/similar to the GM/chrysler experience?

2- it seems true that bankruptcy is a legal construct that serves as a risk/consequence shedding device, thereby skewing/distorting incentives. ur dissatisfaction with this was expressed, but countered with the observation that economies with bankruptcy protections r more innovative and have more growth.

does this dissatisfaction not extend to certain aspects of corporate structure in general? after all, corporations r also legal constructs that serve as risk/consequence shedding devices that skew/distort incentives by diffusing and/or limiting accountability- quite often explicitly, as in “LLC”.

furthermore, a common defense for this risk shedding quality of corporate structure is also the same as that for bankruptcy: corporate structures enhance innovation and growth in an economy.

i think the link between the risk/consequence shedding of bankruptcy processes and corporate structure is bolstered by the fact that- as skeel pointed out- bankruptcy law is a product of corporate failure from the 1800s.

am i seeing things that arent there?

is this a case of “take the bad with the good” when the good is indeed good and the bad is subjectively kinda “meh”….basically, confirmation bias.

anyway…bravo econtalk!

Jul 8 2011 at 10:19am

The last Podcast was great.
But I’m sorry on this one I could only stomach the first 10 minutes. Listening to promoters of neoliberal economic policy and casino finance which more than anything sunk the global economy along with the auto industry tell us how the bankruptcy should have occurred and appearing to be serious is not helpful.

You need to have a little self-introspection. Maybe a little self doubt would be good. Is there any chance if we followed your scheme we might be in a far far worse place. Not just on GM but on all the recommendations you might have made on how to handle the collapsed financial markets.

Russ Roberts
Jul 8 2011 at 3:21pm


Which promoters of casino finance do you have in mind?

Bailing out losers helped create the problem. Continuing to bail out losers is a bad way to make progress.

Jul 9 2011 at 12:54am


im not too sure…i do remember skeel stressing more than once that the markets were not typical when the bankruptcy/liquidity/solvency issues arose, so that may explain/justify a large govt intervention as the markets were not sufficient to handle the gm/chrysler events optimally.

there was an honest to god “sudden stop” in credit. for all intensive purposes, money velocity briefly fell to near zero and recovered very slowly there after.

but the undeniable irony is that all the “free market is best” proponents make their claims while taking checks from the govt in their day jobs….if not completely, then a significant portion of their job security is.

sure. they expand into into honest private ventures (writing books- which is often a university press, benefitting from a univeristy brand name, they consult, collect speaking fees, etc), but have all benefitted from state subsidized education/collaboration and still enjoy a “baseline scenario” of income and research support that’s guaranteed/enhanced by the state.

even just living in the greater dc/maryland/virginia area is enjoying state subsidy cuz the govt is boooming and supporting local real estate and commerce.

i know it’s unrealistic to b a purist in these matters, but it’s still kinda wierd and worth remembering when we recognize it’s really just a matter of degrees and not a matetr of either/or.

the upside is we benefit from them sharing their knowledge/studies thru the auspices of the liberty fund- though while private, it seems the best talent available comes from the state/public sectors- not too mention special tax treatment benefits.

at the end of the day, it’s all very enriching and that’s what i try to focus on.

Jul 10 2011 at 2:20am

@Nick Ronalds,

“So I think Russ is right that it’s at best an open question whether a harsher bankruptcy regime in itself suppresses innovation. A bigger factor is likely the biases and favoritism inherent in cronyist approaches.”

I think the usual argument for lenient bankruptcy laws spawning more innovation relates more to small businesses than large crony capitalist situations.

The argument is that if I have an idea for a business I am more likely to take a chance on it if the downside isn’t too horrible if it fails. And through sort of an evolutionary process lots of ideas get a chance to present themselves to the market.

Jul 10 2011 at 10:46pm

ahbritton: +1

Jul 11 2011 at 10:31pm

Dr. Roberts et al. — a couple of nits to pick on the podcast regarding the so-called tax breaks given to GM and C and the ‘rule of law’ issues:

It is true that GM and C were able to keep their net operating losses after their sales through bankruptcy, which under the normal tax rules they would have lost when they sold their assets (i.e., the ‘change in control’ event).

However, the reason that the tax code requires companies to forfeit their net operating losses when they undergo a change in control is to prevent large (profitable) companies from gobbling up smaller companies with large net operating losses in an effort to reduce/eliminate their (the large companies’) taxable income.

The TARP regs created an exemption to this rule for TARP recipients, because many companies receiving TARP funds received the money via a sale of equity to the US government. And most of these equity sales would have triggered the change in control threshold resulting in the TARP company’s loss of its net operating losses.

Because the government wasn’t trying to gobble up net operating losses through its acquisitions (which the general rule aims to prevent with respect to acquisitions made by private companies), it made no sense to apply the standard rule (in which acquired companies lose their NOLs) in the TARP context. GM and C merely benefited from this general rule that was baked into the TARP regs. Calling it a special tax break for GM and C mischaracterizes what actually happened and why it happened.

As for the application of the ‘rule of law’ in the case of the bailouts, consider the fact that the C bankruptcy transaction went to the US Supreme Court and was effectively validated by the Court when it lifted the stay on the transaction. I don’t see how the rule of law was “damaged,” when the transaction was reviewed by our highest court.

Jul 12 2011 at 10:47am

Great discuss. But I think Russ was a little off with his concerns about our bankruptcy about letting a restructuring occur. If you’re an equity holder in an entity whose debts exceed its ability to pay, the equityholders get wiped out — not sure where the investors get a big help. The creditors get some percentage of their loans/investments, often taking ownership (equity) instead of their debt. Russ seemed to be concerned about equity holders owning and investing in a “bankrupt” company and getting to ride it out and come out clean on the other side, which isn’t accurate.

That said, David does say that managers may keep their job and employees may keep their jobs as well. That is sometimes the case, but often the “new” equity holders — the existing lenders — wants to kick out management and put their own in. Though that is different than the entire company being liquidated.

Lastly, I think Russ had a hard time understanding how a company can be “viable” but have too much debt and nevertheless be insolvent. It’s a lengthy discussion but gets into what is an earnings or income producing asset? If you liquidate, the assets that can be sold — physical stuff — earn cash in the sale but the going concern might have a “sum of the parts” aspect to it in terms of collective knowledge, branding, and so on that have value. Presumably if Coca-Cola’s debts exceeded its assets and/or equity there is value in keeping the organization together — people trust coke, there are many people who have specialized knowledge about developing tastes and flavors, and they have an international distribution system that would be difficult to replicate.

Overall though very good discussion.

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Podcast Episode Highlights
0:36Intro. [Recording date: June 20, 2011.] Bankruptcy, bailouts of General Motors (GM) and Chrysler and their interactions with bankruptcy law. The most optimistic view of those bailouts is that these were crucial; they saved hundreds of thousands of jobs, if not the direct employ of GM and Chrysler, their suppliers; it's going to cost taxpayers very little; we might get all of our money back, if not we'll get most of it back. You disagree on a number of counts. What's wrong with this optimistic view? Lots of things that are wrong with it. Almost each phrase of your sentence, I would disagree with somewhere. Let's go one by one. Well, I won't remember the particular order, but one point you made, which is a very common argument, is that the car companies could not have been restructured in any other way; it had to be done the way it was done. I don't believe that's true. I think something much closer to an ordinary bankruptcy--and we can get into what was not ordinary about these transactions--could have been used to restructure them. The idea which the Administration, an advocate of the bailout, seems to be backing away from a little bit now, that the bailouts were almost cost-free or there wasn't a significant cost to taxpayers, I think is very inaccurate. Even the Administration acknowledges now that they are likely to cost at least $14 billion, and this is leaving out some very significant costs that were not in the form of direct funds to the car companies. So, the idea that this had to be done, nothing else could have been done--almost everything about that, I think, is quite debatable. I think $14 billion--that's like zero. That would be one argument. But, I'm on the other side; it's not zero. Let's go to the alternative bankruptcy proceeding, because I think the very option of bankruptcy is forgotten by a lot of people. When you talk casually with folks who are not well informed--which would include me, because bankruptcy law is a little bit of an arcane topic--I think what's usually described is: Well, the companies were going to die. Or, they'd be saved. When in fact this was alternative of bankruptcy. Describe how that would have worked or might have worked if it had been put on the table. An ordinary bankruptcy is a bankruptcy where the company--in this case one of the car companies--files for bankruptcy. When they file for bankruptcy their creditors are required to stop trying to collect what they are owed. The parties get together, negotiate over the terms of a reorganization plan, over a period of time, which can be anything from a month or two to much longer than that. And then, when they've more or less agreed on the terms of a reorganization plan, there's a vote. Each class of creditors and shareholders votes on the plan, and if enough of the creditors or shareholders in each given class vote yes, then the plan is confirmed. That's the normal bankruptcy process that we've used in this country for well over 100 years. The working out of that plan is adjudicated by a bankruptcy judge? What determines what gets voted on? What determines what gets voted on in the first instance is the debtor, which means the managers of the company that is in bankruptcy. The beginning of the case, at least--the first four months of the case and usually a bit longer than that--only the managers can propose a reorganization plan. So, they are the ones who are making the decisions, and very obviously those decisions are policed in various ways. They have to negotiate with creditors. You don't want to propose a plan that nobody is going to approve. It may also be that the judge comes into the picture at various points. And the judge is, as you suggested, a bankruptcy judge who oversees the case. But, one thing that people often misunderstand about bankruptcy is it's not ordinarily the bankruptcy judge who is making the decisions. In a normal bankruptcy case, the bankruptcy judge is much more like a referee or an umpire. They are calling the balls and strikes; they are not making the actual business decisions. So, they can say: This offer doesn't comply with such-and-such. That's right. They can say it's not in good faith or not properly treating a creditor, or there are any number of issues that can come up. But the basic terms of the restructuring are largely determined by the parties themselves in a normal bankruptcy case. And I need to keep putting that caveat on. So, proposed by management, with the veto of the creditors. That is, the management has to gain the acceptance of the creditors.
6:28Let's take a step back. Why would you be in that situation to start with, and what determines whether a business is viable or not? Again, I think most people assumed, incorrectly, as far as I understand it--and let's focus on GM because it's the larger one: Well, GM is going to go out of business, and then all their suppliers are going to go out of business. And as an economist, my first thought is: If they go out of business, there are going to be people who aren't going to be buying their cars; they are going to be buying other people's cars; those other people are going to need suppliers, too; and so that these so-called second and third multiplier effects are going to be quite small. But put that to the side. The point is that GM was a viable enterprise, but they could not meet their commitments on a particular day. That is, they owed money that they could not meet all the obligations that they owed. Is that a correct way to describe their situation? That is a helpful way to put it. So that if you ask the question: What kind of company might file for bankruptcy and be restructured and come out perfectly healthy, one answer would be that if you have a company that is a perfectly viable enterprise, that's a relatively healthy company operationally but simply has too much debt--more than it is able to repay--that's the classic example of a company that can reorganize in bankruptcy. In the terms you economists often use: It is a company that is financially distressed but not economically distressed. It's underlying business is sound. With GM in particular, that was quite clearly the case. With Chrysler it was, and still is, more of a close call, whether there is an enterprise there that truly can survive for the long haul. But with GM, it was quite clear that it was a perfectly viable company that had too much debt. It simply had an unsustainable cost structure. It's hard--obviously these are technical definitions of viable, solvent, too much debt. The part that's strange about it is if I'm a company that lives beyond its means, it's hard to understand what it means that there's a viable business model. I guess you could argue that it squandered its past borrowings, but its current offerings to consumers, let's say, are large enough to cover the costs of producing the cars, but there's a set of promises made in the past--either to debtors or to past workers, and I want to add that in because I know that's going to be important in the story. So, when we talk about creditors and debtors, we are really talking about a wide array of promises GM had made in the past that it was not able to honor all of in the present. Is that correct? Yes. And it's a good explanation of how they could have too much debt and yet have a business that appears to be worth saving. So, if you don't know any economics and you don't know any finance, and you just hear that somebody's got too much debt, your first thought is: Well, everybody should get a pro-rated share. So, if I've got 90% of the money in hand to pay back my debtors of the money I owe, everybody's going to take a haircut and get .9 of what they were promised, and we'll all go on down the road happy and that's the best they can do because I don't have enough. But that's not the way it works. There's a line, and promise in advance of who gets to go in line, correct? That is correct. We can go into the line. Yes, let's go into it. People get dibs. They get first crack. Some people are privileged above others because when they made the investment, that was part of the reason they were willing to do it, because they were told they would be in a certain place in the line. So, in an ordinary bankruptcy, who gets first claim on the assets? Well, the principle line, and there are various small lines, is between priority creditors and in particular priority creditors who have taken collateral for what they are owed on the one hand, and on the other hand, general creditors. So, a senior lender that has lent money to the debtor has taken back collateral to secure repayment--that may be real estate, may be dealerships, may be car inventory--that creditor ordinarily gets paid first. And creditors that have not taken collateral, who are referred to as general creditors or general unsecured creditors, they usually come next. That's the biggest line in a bankruptcy case.
11:37Now, there's a special case, not what we are talking about, which is: The firm is not viable at all. So, in that case, the assets get sold off, and the line gets paid off by where you are in line; and when they run out of assets, that's it; you are stuck. This would be something like Lehman Brothers, right? Lehman Brothers is dead; it's gone; it's not a going concern. And the people Lehman owed money to, some are going to get all of what they were owed, some are going to get a fraction, some are going to get zero. Correct? Correct. Let me throw in one footnote as well. The fact that a financial institution like Lehman is sold in bankruptcy rather than restructured is not necessarily a failing of the bankruptcy process. So, when we say a successful bankruptcy is one where the company is reorganized, that's a little bit inaccurate. I think what you would want to say is a successful bankruptcy is a bankruptcy where the financial distress is dealt with well. So that if it's the kind of company that can be restructured and is viable in its current form, you would hope to see a reorganization. If it's the kind of company that for whatever reason you can't restructure in that way and it makes more sense to sell it, that can be a successful bankruptcy as well. So, in the case of GM, what do you think would have happened had the Bush and Obama Administrations stayed out of it, the natural legal process had gone forward; GM would have woken up one day with an inability to honor all of its promises, would have declared bankruptcy with all of its creditors. What might that reorganization have looked like? Do we have any idea? It obviously is simply speculative, but it would have looked the way we were describing earlier--negotiated structuring. GM had already been negotiating with all of its creditors well before it filed for bankruptcy; would have led to a proposed reorganization and a vote. That's what the process would look like. There are some questions about how it would have worked. One big question is whether GM would have been able to borrow money to finance the process. A big company in bankruptcy typically is going to have to borrow money to finance its operations while it is restructuring. I think GM probably could have borrowed from private creditors even in late 2008-2009, which was in the middle of the credit crunch, obviously. I think there's a possibility that they would not have been able to borrow money, and that's the point at which it would make sense, potentially, for the government to serve as lender. In my view, it would have made more sense for the government to lend the money without micromanaging the process the way they did, and simply acting more as an arm's length lender. To summarize that, if we'd done a normal bankruptcy, ideally what would have happened is GM would have borrowed money from private creditors; they would have renegotiated their obligations; and they would have confirmed the reorganization plan. Probably quite quickly. It probably would have been a matter of months, not of years, because it was clear they needed to restructure in short order. Alternative scenario would have been GM can't find financing, does need to tap the federal government for financing, but I still think you could have gotten a process that looked quite a bit different from the process the government used.
15:44Now, when you talk about restructuring, one way that firms restructure is they sell off a division that isn't profitable. You might close down some aspects of your business. Which GM did, if I remember correctly--they closed down some dealers. That's right. We'll come back to this, but it wasn't clear to me in a normal course of proceedings they'd be able to do that, normal bankruptcy proceedings. Those would be two ways a firm would respond. A third would be promises made to past employees--the union, etc. I think the most provocative part of your argument is that the way that the government intervened in an ad hoc way, rather than letting bankruptcy proceed and if necessary being a lender of last resort, instead they proceeded to appoint a Car Tzar--Steve Ratner--which allowed the government to change who got what compared to what a bankruptcy proceeding would have done; and in particular the unions did better than they would have done. What's the evidence for that, and what's the nature of that claim? This may require a series of answers. The short answer is: What looks problematic about the result in Chrysler and in GM is that in Chrysler, senior lenders were paid only a small portion of what they were owed. They were paid $.29 on the dollar. And yet the employees, particularly the Chrysler retirees, got a much, much bigger percentage of their obligations paid, and look to have been paid almost in full or something close to in full. So, when you look at Chrysler in particular, it looks like we've inverted the normal priorities--that the senior creditors didn't get paid in full and yet a lower priority creditor got paid either in full or something close to in full. In GM, it's not quite as dramatic. In GM, the senior creditors did get paid in full, but many of the junior creditors, the unsecured creditors, got pennies on the dollar, $.10 or $.12 on the dollar, while the unionized retirees got something that was much bigger. In that case it looked like the employees were getting more than other unsecured creditors. So, in each case, it looks problematic from the perspective of normal bankruptcy priorities. Now, we don't know for certain whether priorities were violated; and hopefully we can get into exactly why that is. There's another big piece to the puzzle, and that relates to the fact that these cases were structured not as normal bankruptcies but as sales. We'll get to that in a second. I just have to mention: I never blogged on this at Cafe Hayek, my blog, but it's sitting in a pile somewhere, a tab, my to-be-blogged somewhere on Chrome or Firefox, which is a Washington Post unsigned editorial where they wondered whether politics might have had something to do with the decision to intervene in this way. Of course politics had something to do with it; it's a bizarre question for a newspaper headquartered in the nation's capital to wonder whether this was a political decision. So, of course it was. But the question remains: What evidence do we have from past bankruptcy proceedings that would suggest this was something out of the ordinary? In other words, let's take the GM case. So, junior creditors got pennies on the dollar, 10 or 12 cents; retirees got more. Couldn't that have emerged from a bankruptcy proceeding, a more traditional one? It could, and that's why I put the caveat at the end. The real problem is the way the bankruptcy was structured. And maybe I'll just jump into that. Talk about that. The way the bankruptcies was structured was as sales. Rather than renegotiating the terms of their obligations and proposing a reorganization plan, what the government did in each case is purported to sell all of the assets to a new entity--a new Chrysler and new GM as they were colloquially referred to--and distributed the proceeds of the so-called sales to the old creditors. So, they were structured as sales. Whose idea was that? That's creative. It's not remotely unheard of. This does happen regularly in bankruptcy cases. What was unusual about it was the size of the companies that were being sold. Normally when you sell a company in bankruptcy you are selling an appreciably smaller company. When you get a company the size of GM or Chrysler, in the past, they have always, with one or two major exceptions, been restructured under the normal bankruptcy route. So, the first really clever thing the government did, and this was clever, but I believe it was ultimately too clever, was to take this sale technique and apply it to a kind of company where it ordinarily isn't applied. The way this could have been completely kosher is if this were a wide-open auction for Chrysler and GM's assets and the price that the government set on the assets, which for Chrysler, the case I've written most about, was $2 billion--if there were a wide-open auction and $2 billion were the best price available for the Chrysler assets--then what was done would be defensible. And the way it would be defensible is, what the government would say, is: We paid full value for these assets, $2 billion; the $2 billion was used to pay the senior creditors; it only gave them $.29 on the dollar but it was used to pay the senior creditors; so the proceeds all went to the senior creditors. And then the argument is the bankruptcy case, old Chrysler isn't actually paying the employees and the other favored creditors. The employees and other favored creditors are being paid by the new company, by new Chrysler. Once new Chrysler has bought the assets fair and square and paid full value for them, it's entitled to do whatever it wants. If it wants to pay the employees, it can pay the employees. If it wants to pay the old trade creditors--who were paid--it can pay the old trade creditors. That's the argument, and it's a plausible argument. The problem is that these cases were anything but wide open auction. They were basically structured so that essentially nobody else could bid. And the way that was done, is in each case there was an auction but it was subject to what is known as a qualified bidder requirement. To be a qualified bidder and to be sure you were able to participate in the auction, you could do anything you wanted to do--you could offer to buy just a piece of Chrysler, you could offer to buy, say, the Jeep division, as I mention in the article, for $2.5 billion and not buy anything else--you could do that so long as you promised to do precisely what the government did. As long as you promised to pay off the employees, to pay off the trade creditors. So, to sum up, it was structured so that nobody could make a bid unless they agreed to do everything the government wanted to do. Which was to protect the employees and the trade creditors, which obviously is not a real auction at all.
25:03So, who do you think--who was creating all this? Was this the Justice Department? What part of the government? Where did that come from? It's very creative, again. At that point, it is however beyond creative. At that point we have a sham auction, a sham sale. This isn't really a sale. Basically what the government is doing is saying: We will give some money to the senior creditors and we're taking the assets, and we're deciding what to do with them. Who decided? It was the Auto Task Force I think; I think, obviously, the President was involved in the decision making. They also were advised by a number of outside advisers, including bankruptcy lawyers, investment bankers, and folks like that. You don't have the minutes of those meetings. I don't. I would love to have the minutes of those meetings. And the one thing that just mystifies me is why they made it a sham auction, why they didn't have a real auction. Because I think the reality is it would have been tough for anybody to outbid the government; the government's fingerprints were all over these transactions. Why they didn't at least have a legitimate auction is just mystifying to me and I would love to know whose idea that was. I think what happened is they just felt like they had to dictate the terms and they couldn't take any chances that they would lose control of the process in any way. And they were willing to abuse the bankruptcy rules to do that. I can't help but think of two things as you describe that. I don't know if anyone out there listening has the same thought, but I keep thinking of New Coke. When I hear New GM and New Chrysler, I think of New Coke, a product launch that didn't make it. Probably the government does not want you to have that sequence of thoughts. They could just call it the Edsel, the new company. But the other thought I had is it's slightly reminiscent, similar but not quite the same, to the March 17 Bear Stearns decision, when over the weekend, on the grounds that we didn't have time to do anything differently, the government decided that Bear Stearns would be purchased by J.P. Morgan Chase for $10/share. But actually they decided initially $2. But that was too embarrassing so they raised it to $10, and then they said they'd take over $29 or $30 billion of toxic assets because you can't evaluate these over the weekend--you don't have time. And we understand that that's difficult to do in 72 hours or maybe 48, so therefore we have to have a sham transaction, which is a sweetheart deal rather than an auction--which would be the obvious thing to do in that setting. Because they don't know what it's worth. Maybe somebody would be willing to eat those assets that were potentially toxic; instead we were told there was no choice. JP Morgan Chase is the only viable bidder; they have to buy it; here's the price, and to make it easy for them we are going to guarantee these assets; oh, and don't worry Mr. Taxpayer, Mrs. Taxpayer, Ms. Taxpayer--you might make money on these assets anyway. It'll all turn out okay. The other part that strikes me as similar is the opacity, the non-transparency of this process to the average person. So, when you say you are mystified by what took place, the average person has zero idea, including someone like myself who is somewhat educated and somewhat interested in these incentive issues and public policy. I didn't get into the details of what actually happened; that's why I'm talking to you. So, one of the virtues of this I think from the policy-maker's perspective is: It's real complicated, bankruptcy, eyes glaze over; I guess the government saved the companies. That's it. The details, very few people followed. You followed them. And you are mystified. The rest of the people are just nodding along saying they didn't have a choice; they just had to do it; turned out okay. That's I think the average response. Or, there's another response that is somewhat typical: This sounds like they nationalized the companies. That doesn't sound very good; I'm against it. Different views, some ideological, some pragmatical or dogmatic. But I don't think many people were down in the trenches with those details. I'm glad to know them, glad to spread them as widely as the listenership of this program. Glad you are happy. Think that's very important. Agree with a number of things you just said, including the analogy to Bear Stearns. In both transactions there was a real "You have to trust us"-quality. And when I say "You have to trust us," it's really you have no choice. We know what we're doing, we're really smart, you don't need to know. And the alternative is apocalypse, catastrophe. Exactly. And another analogy between the transactions is in each case the government really cut corners with rule-of-law principles. So, I've been talking about the way corners were cut with bankruptcy rules with the car bailouts. With Bear Stearns, corporate law rules, corners were cut. That transaction was structured in a way that made it impossible for another bidder to come along if there were some other bidder that were willing to pay more than JP Morgan was going to pay for Bear Stearns. This was done in a way that almost certainly cannot be reconciled with ordinary corporate law. In each case: You just have to trust us; the world will fall apart if we don't do what we are going to do; and in addition there was a willingness to really bend the rules in for me a very worrisome way in order to achieve these results. I always think it's important to mention: I'm willing to concede the possibility that the players actually believed--they drank the Kool Aid; they really thought that they were on the edge of catastrophe, of an abyss. There may have been a real sense of panic. I just don't think that's a good reason to justify violating the rule of law or the Constitution or creating new things that the Fed's never done before. You are a corporate law expert and scholar, so you notice those violations. I look at the Fed's mission: It doesn't really say anywhere that the Fed's job is to make sure that creditors of large financial institutions who made bad bets should always get all their money back. That really bugs me as a principle of governance of the Fed. But you are suggesting there were other aspects of the process that were inappropriate. I absolutely am suggesting that. And I agree with you that the people who were making these decisions, who were primarily Ben Bernanke at the Fed and back in the Bear Stearns period, Hank Paulson; later Tim Geithner, and also Geithner as the head of the New York Fed at the time of Bear Stearns point. I absolutely believe that they thought they were doing the right thing. I don't have any doubt that they believed they were doing what was best for the country and for the world. But I think the way they went about doing what they did shows just how important rule of law principles are. They may be wrong about what they are doing; there's a reason those particular rules are in place, and there's a real cost to violating them, even in a crisis. Totally agree.
33:46Let's turn to the next question, which also gets whitewashed quite a bit through its lack of transparency, which is the "cost" of the bailouts. And I put that word in kind of scare quotes there, when I said "cost," because I think for all kinds of reasons, the cost of these decisions is usually meant to mean the cost to the taxpayer. Out of pocket cost. I think that's the wrong measure. We'll come back to that. The view is--the way it's written about these days in the business press--is: The government still owns some shares of various companies. If the value of the stock goes up enough--if GM or AIG can create enough value, the taxpayers will get their money back and the whole thing will just be a wash, allegedly. It's true that the whole thing was a gamble, but it turned out okay and the taxpayer was made whole. We'll come back in a little while to why I think that's the wrong metric; and I know you agree with that. But let's just talk about the fact of whether the taxpayer is going to be made whole and the way it's being accounted for in most of these discussions. Well, if you start with the metric that the government wants to use, and that people often use--to what extent are taxpayers on the hook for this, what are they going to end up paying--what you would say is that it now looks like the car bailouts will cost about $14 billion. They'll be somewhere in the range of $14 billion; those numbers may change, but that will not end up getting repaid even after all the government's GM and Chrysler stock is sold; etc. To that, if you are trying to get an accurate number, you would need to add the other cost to taxpayers of the bailouts, that don't in the direct loans by the government. And the cost I have focused on in my work is that the Treasury basically adjusted the tax roles to give GM a special break with respect to its taxes. That is a break that could be worth as much as $45 billion in tax write-offs. When you run that through the 28% corporate-level tax it's probably in the $12 or $13 billion range. So basically what happened is, GM had a lot of tax losses, that, depending on how the transaction was structured might disappear, and depending on whether the government held onto its stock or sold its stock. Treasury essentially said: Don't worry about what you do; we are going to let you have these tax write-offs. Which ends up saving GM about $12 or $13 billion. So, you need to be taking into account those kinds of things as well--things that the government did that took money from the taxpayers, and essentially gave it to GM or Chrysler, even though it wasn't a direct loan; it was a regulatory intervention. Or in this case, a non-intervention. As you are speaking--you can't see this because we are on a podcast--but I'm shaking my head in sorrow. It's a mournful head-shaking. The analogy would be: I'm having a tough time; I get audited by the IRS. I get a big tax bill. I say: What are some of the things you spent money on? I have a thing about electronics and gadgets; I bought the new iPad, and I bought a new MacBook Pro, and I bought some nice equipment for my house to play music through. Can we just make that tax-deductible? Just this year? Oh, sure. You're having a tough time, and you're a nice guy. We like you. This year, that's tax-deductible. It's a grotesque corruption. I hate to bring up these parallels--or maybe I don't hate to; I like it. It's very important to point these out. Fannie Mae and Freddie Mac bought mortgages from mortgage originators and guaranteed the payment to the people who held the bonds that had those mortgages in them. They did a bunch of other things as well. Until the fall of 2008, they were private--quasi-private--firms. They had stockholders, bondholders, like normal companies. In the provisions of those purchases, when they would purchase a mortgage from, say, Countrywide or Wells Fargo or Bank of America, there was a condition on those purchases, which was basically if those mortgages were issued in a fraudulent way or were not in compliance with Fannie and Freddie's regulations, Fannie and Freddie would not be on the hook for the fact that the payments weren't made, but the originators would be. Because there's always the potential for fraud; and that was the contractual arrangement between Fannie Mae, Freddie Mac, and its originators. Now that the government is the conservator--whatever that means. They've taken over. They've said: Well, we're not really going to try to collect that. Why not? Because the banks are our friends? It's mind-boggling what this has done to contractual relationships. So, similarly, you've made a bunch of decisions with tax consequences. If you are GM you get a do-over. It is mystifying. Not so mystifying, really--it's political. But it's deeply disturbing. I agree completely; and I really think as well that that feeds into the general impression that Wall Street has been bailed out, is being bailed out, and the little guy really isn't being helped. That's been an impression throughout the crisis, and I really think there's something to it. When you start suggesting that the rules apply differently for different people, I think it really erodes the economic morality, and erodes it in a way that really has affects everywhere. I think it's just terrible, that kind of behavior, and there has been a lot of it during the crisis.
40:51Let's turn to the real cost, because I think that's what we are starting to get into. The real cost to me is when your company is doing a bad job, either in managing itself or producing good products that people want to buy where the price exceeds the cost of producing them, instead of trying to do better, you can go to Washington if you are politically powerful and you can get a do-over. You focus on a different issue, which is the credit opportunities that are available to companies. Right, and I think those are both issues. To elaborate a little bit on your issue, if this is the way the government deals with private industry, what it suggests is that favored companies get do-overs. And, they are not policed by the market in the same way as everybody else. That seems problematic even from the perspective of the favored company, that we just shouldn't have companies like that. It's even more problematic from the perspective of some other company that's trying to compete in the same business. If you have to compete against a company that is going to be helped out no matter what it does, it really is impossible to compete. So, one effect of this is you really interfere with innovation and competition in the marketplace when you do these kinds of do-overs. I focused on another issue, which is, if I'm a creditor, or some a possible creditor, somebody who might be thinking about lending money to a business that's in trouble, and I am afraid that if that company continues to be in trouble, the government is going to step in and decide who gets what, I'm really going to think twice about lending to that company. So, after the carmaker bankruptcy, the message the treatment of those companies set, was: You'd better not lend to this company because your entitlements may be shuffled by the government. One of the big ironies there is it suggests the more politically sensitive an industry is, they'll be less likely to obtain private funding. Which is going to create even more pressure for the government to come in in the future. So, what we may be doing in cases like this is creating perpetual bailouts for publically favored companies. On the other side would be the argument that it's once in a lifetime; it's not that common to be politically favored; there only seem to be three politically favored industries really. That would be financial--it's hard to say this with a straight face because they are three really big industries. They only happen to take up 30-40% of the economy. Well, but they don't. The financial sector, insurance/financial stuff/real estate, and the auto industry. But the fact is that if you are a "normal" company, meaning you are not politically favored and you are not very big, you don't get bailed out. You are playing by different rules--thank goodness. Otherwise we'd be truly on the road to socialism. So, the glass is half-full argument is that although it's deeply disturbing, I don't think most lenders are going to assume that all companies have this kind of political power. There aren't that many cronies, almost by definition. Well, I think that's right. I think it is right that there are not dozens and dozens of companies in dozens and dozens of industries. It's important to recognize that the industries you referred to are broader than they might seem. So when we say the car-makers are a favored industry, that raises the question: Well, what about car suppliers? They may be a favored industry, too. What about the credit companies that deal with auto loans? They may be favored, too. So, it may be slightly broader than it seems. But I agree with you: this is not the whole industrial landscape. But the problem is, in my view, first of all, I think it's not the whole problem. But another problem is: There's a pattern here, I think; and the pattern, I wouldn't call it socialism, though it might end up in that direction, at least in theory, so much as what's often referred to as corporatism. Yes, crony capitalism. Which is relatively common in Europe. Latin America. Asia as well. The kind I'm thinking of is a situation where there is a partnership between the government and the biggest firms in a handful of key industries, and they do favors for each other. The government protects the car companies, protects the biggest banks; the car companies and biggest banks also help out the government when the government has a political objective. So, what might that mean? Well, one thing that means in the auto industry is green technology in cars. One of the provisions in the Chrysler deal was a provision that gives Chrysler a very big incentive to roll out a green car. It gives Fiat, the new owner of Chrysler, a very big incentive to roll out green cars. You see a lot of that sort of thing where it's not just the government bailing out these sort of industries, but we're slapping your back, so you slap our back.
46:59Let's turn to a more theoretical issue. Before I do that, I have to ask you one more thing. Ford. They didn't get any help. They are doing okay. Maybe they are not, but it seems to me they are. So, when you are talking about the difficulties of competing with these government-backed firms, we also know there are some disadvantages to being the government-backed firm. Some are psychological with customers, some are practical in terms of execution of strategy. So, it's interesting to me that Ford's doing pretty well. I think that is very interesting. One way I might put that is: There are some disadvantages to being a government-favored firm, as long as not all firms are government-favored. I think that Ford has probably been both helped and hurt by the bailout. It's been hurt because it's not the favored company; it's not the one that's getting all these handouts. But it's been helped because I have to imagine folks who are thinking about buying an American car are going to be a little more positively disposed toward Ford than toward Chrysler or GM. I think that's true. The theoretical question, the bigger question I wanted to ask you, is about bankruptcy itself. Which is: Why do we have it? You've made a case, and I agree with you 100%, which is the way the government intervened, in a very much against-the-rule-of-law, in a very ad hoc way, is very costly, can be very destructive; I think it's going to be very costly in the taxpayer sense. What's the virtue of bankruptcy? Why do we have it, and what role does it serve? Great question. Semester teaching my students. Why do we have the particular bankruptcy system we have, as opposed to bankruptcy in general? Why do we have a system that allows troubled companies to be restructured rather than simply shut down? The answer to that, I think, is that there has been a perception for a long time in this country is that failure in the sense of filing for bankruptcy does not necessarily mean that a business is not viable. The reason we have bankruptcy is to make the preservation and restructuring of an otherwise-viable business possible. So that if you look at the history of bankruptcy in this country for large corporations, it all began with the railroads in the 19th century. Lots of American railroads failed during economic crises. Everybody agreed that it would be a mistake to shut them down, that we needed the transportation. Bankruptcy emerged as a way to make that possible. So, that would be the core of the case. One thing I would add to that would be bringing in a little current bankruptcy theory: The more developed your markets are, the more you have buyers for any kind of assets, the less necessary the old-style bankruptcy seems. It starts to seem a little less necessary. As I said earlier in our discussion, I believe that bankruptcy continues to play an important role even if ultimately what you are doing is selling those assets rather than restructuring them. But the reason for bankruptcy, and in many cases it still is an important reason, is bankruptcy is a way to restructure viable companies that simply have too much debt. We could imagine a world where that option isn't available, where if you couldn't keep your promises, you were shut down, your assets were sold off. There would be a big role for the legal system, still: there has to be a way to deal with the fact that there isn't enough money to go around and you can't keep all your contractual promises. And your ability as an entrepreneur, certainly--corporate entities are a little more complicated, but certainly as an entrepreneur--your ability to borrow money would be greatly reduced. And more prudent companies would have access to capital and would provide the guarantees. I assume people in a world without bankruptcy would ask for a different set of assurances for their loans. That's exactly right. You just intuited what I spent the first 5 or 10 years of my career trying to figure out. I was looking at different things. What I was looking at was banking across the world. If you look across the world, what you see is that different countries have very different bankruptcy systems, and some countries--this is less true now because a lot of countries have moved in an American direction--but at least 20 years ago, many countries had bankruptcy systems that looked a lot like what you are talking about, where really there wasn't a bankruptcy option. If you defaulted, you were just shut down. And that ends up producing a very different business world. It might not be a bad business world, but it tends to be a business world where companies are more prudent, where more established companies have a leg up; there tends to be less innovation, less risk-taking. The business world just ends up having a different face. I think there'd be less innovation to the corporate structure, right? There might be more innovation elsewhere. There might be structures that would emerge or do better. I'm always torn--I was trained at the University of Chicago; a part of me says, this is my youth. In my youth it was, whatever bankruptcy law emerges in the United States, that's efficient because there are all these pressures; this is the Posnerian school of law that says there's competitive pressure on judges and there's a marketplace for law and efficiency is what emerges. As I've gotten older, I'm very skeptical of that argument. I don't see any reason for that; I don't see the institutional structures that push that forward. I just might say, well, I'm back to our discussion of cronies; if you are a corporate entity or stockholder, you are important politically. And what bankruptcy does is make it easier for you to play the game and makes it harder for other people to play the game. What are your thoughts on that? I'm not sure what you mean by: it makes it harder for other people to play the game. Take the United States today. Obviously from our earlier discussion there might be less innovation in corporate structures because people would be very uneasy about the potential for their company to exceed its grasp and suddenly find itself insolvent; and then you'd only get a fraction back and maybe very little. And this reorganization possibility wouldn't be there. You might get wiped out. And so you'd probably find yourself investing maybe in an angel way, maybe in a venture capital way; and those less corporate-oriented ventures would do better than they would in the current world. There would be more capital available for that venue. I don't know if that's right; but that's my first thought. Yes. That turns out not to be descriptively accurate. I'm not sure if there is a connection. I think there probably is, but I can't see it. In countries that have more draconian approaches to bankruptcy, they don't give you a second chance or opportunity to restructure or have historically had those kinds of approaches, historically you haven't seen as much innovation. So, you think of Japan or Germany, which had very effective capital markets in many respects, but you don't think of as having as much innovation as the United States. I don't know if there's a necessary connection between the two, and if there is, it may have more to do with personal bankruptcy than corporate bankruptcy. Personal bankruptcy because the opportunity to fail and then discharge your obligations and then try again can be seen as encouraging entrepreneurship.
56:35I guess my response to the cross-country evidence would be you'd have to control for everything correctly--which of course is impossible. Which would include cultural issues, character, etc. There tends to be something unusual about the American culture. I would add into that the kinds of factors we were loosely describing as crony capitalism, as well, which I do think play into that. I think one of the flaws in what I was saying--hard for you to find because it wasn't so clear. Let me ask it differently. Who benefits--which types of investors and creditors and players benefits from the fact that we have restructuring rather than just an orderly sale? You have to have some legal provision for what happens when you can't keep your promises. What's innovative, it seems to me, about this whole conversation is in the American system, we have this weird sort of thing where you can reshuffle and try again. Who benefits from that relative to: Well, you didn't make it; we're selling off the assets and we'll just deal out what we've got and then everybody is free to go do what they want with their resources? Well, the short answer to that might be the folks who are running the company. Invariably, a company, this difference with the managers of a company that defaults. In most countries, the managers are immediately kicked out. Whereas in the United States when a company files for bankruptcy, the baseline assumption is that the managers will not be kicked out. That has the effect of making managers more willing to file for bankruptcy in the United States than they are in other countries. As far as creditors, my guess is that creditors would adjust to either system. They might lend in a different way but you would see roughly comparable creditors in both contexts. It may be that it's different from employees' perspectives. The U.S. system tends to go hand in glove with a high velocity labor market, a labor market where people don't necessary stay with the same company for their entire career but might move from one company to another. So, there may be some differences there, although it doesn't fit intuitively with the bankruptcy system. So, I think the most obvious beneficiaries of the U.S. system are managers of a company that is financially precarious. So, the incentives for innovation are interesting, because on the one hand it says: Take chances because in the worst case scenario you probably get to keep your job and you can probably reorganize if it doesn't turn out so well. On the other hand it says, if you make a bad choice, don't worry. Complicates the innovation side because it suggests you don't just abandon one idea and move to the next one.