The following is Part I of a two-part excerpt from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph Stiglitz ( W.W. Norton & Co., 2010). Read AlterNet's recent interview with Stiglitz by Zach Carter.
Bankruptcy is a key feature of capitalism. Firms sometimes are unable to repay what they owe creditors. Financial reorganization has become a fact of life in many industries. The United States is lucky in having a particularly effective way of giving firms a fresh start—Chapter 11 of the bankruptcy code, which has been used repeatedly, for example, by the airlines. Airplanes keep flying; jobs and assets are preserved. Shareholders typically lose everything, and bondholders become the new shareholders. Under new management, and without the burden of debt, the airline can go on. The government plays a limited role in these restructurings: bankruptcy courts make sure that all creditors are treated fairly and that management doesn't steal the assets of the firm for its own benefits.
Banks differ in one respect: the government has a stake because it insures deposits....The reason the government insures deposits is to preserve the stability of the financial system, which is important to preserving the stability of the economy. But if a bank gets into trouble, the basic procedure should be the same: shareholders lose everything; bondholders become the new shareholders. Often, the value of the bonds is sufficiently great that that is all that needs to be done. For instance, at the time of the bailout, Citibank, the largest American bank, with assets of $2 trillion, had some $350 billion of long-term bonds. Because there are no obligatory payments with equity, if there had been a debt-to-equity conversion, the bank wouldn’t have had to pay the billions and billions of dollars of interest on these bonds. Not having to pay out the billions of dollars of interest puts the bank in much better stead. In such an instance, the role of the government is little different from the oversight role the government plays in the bankruptcy of an ordinary firm.
Sometimes, though, the bank has been so badly managed that what is owed to depositors is greater than the assets of the bank. (This was the case for many of the banks in the savings and loan debacle in the late 1980s and in the current crisis.) Then the government has to come in to honor its commitments to depositors. The government becomes, in effect, the (possibly partial) owner, though typically it tries to sell the bank as soon as it can or find someone to take it over. Because the bankrupt bank has liabilities greater than its assets, the government typically has to pay the acquiring bank to do this, in effect filling the hole in the balance sheet. This process is called conservatorship. Usually the switch in ownership is so seamless that depositors and other customers wouldn't even know that something had happened unless they read about it in the press. Occasionally, when an appropriate suitor can’t be found quickly, the government runs the bank for a while. (The opponents of conservatorship tried to tarnish this traditional approach by calling it nationalization. Obama suggested that this wasn’t the American way. But he was wrong: conservatorship, including the possibility of temporary government ownership when all else failed, was the traditional approach; the massive government gifts to banks were what was unprecedented. Since even the banks that were taken over by the government were always eventually sold, some suggested that the process be called preprivatization.)
Long experience has taught that when banks are at risk of failure, their managers engage in behaviors that risk taxpayers losing even more money. The banks may, for instance, undertake big bets: if they win, they keep the proceeds; if they lose, so what? They would have died anyway. That's why there are laws saying that when a bank’s capital is low, it should be shut down or put under conservatorship. Bank regulators don't wait until all of the money is gone. They want to be sure that when a depositor puts his debit card into the ATM and it says, "insufficient funds," it's because there are insufficient funds in the account, not insufficient funds in the bank. When the regulators see that a bank has too little money, they put the bank on notice to get more capital, and if it can't, they take further action of the kind just described.
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