After financial firms collapse: Bankruptcy or bailouts?

 

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After the 2008 collapse of Lehman Brothers, two reasons are often cited for bailing out banks. First, it is assumed that bankruptcy greatly reduces the value of a firm’s assets. Second, such an action would have negative effects on the firm’s lenders that would ripple outward.  If a company is sufficiently large, it’s seen as “too big to fail,” and thus must be bailed out.

A 2009 University of Pennsylvania Law School paper, “Bankruptcy or Bailouts?” looked at the trade-offs between the two options. Historical context is provided by the cases of Drexel Burnham, American Home Mortgage, Countrywide Financial and Long Term Capital Management, as well as that of Lehman Brothers itself. The evidence presented indicates that:

  • A rescue of Lehman Brothers would not necessarily have prevented the crisis that followed.
  • A well-managed bankruptcy can distribute assets in a timely and efficient manner.
  • Ad-hoc rescue can cause serious distortions in corporate governance.
  • Systemic risks can be much greater today, but do not preclude consideration of bankruptcy as an option.

Tags: economy, financial crisis

    Writer: | Last updated: July 11, 2009

    Citation: Ayotte, Kenneth M., Skeel Jr. David A., " Bankruptcy or Bailouts?", Scholarship at Penn Law, March, 2009, Paper 268.
     

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