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Sunday, May 07, 2006

New Bankruptcy Law & Game Theory

Originally Posted: October 16, 2005 -- 7:56pm
Fool Boards Link: http://boards.fool.com/Message.asp?mid=23172927

A "think piece" on the differences between personal and corporate bankruptcies and their macroeconomic impacts.

=================

There were four stories this week in the news that have an interesting common thread, though it's not obvious at first glance:

Delphi Files for Bankruptcy / $4B in Pensions At Risk (see #1 and #2)
Nobel Prize In Economics for Game Theory (see #3)
Weekly Filings Quadruple Ahead of New Bankruptcy Law (see #4)
Refco Uncovers $300M Fraud / Company Unravels Positions (see #5)

First the basic events...

DELPHI --- Delphi was spun off from GM six years ago in an attempt by GM to push debt off its own books and subject one of the most inefficient parts of its manufacturing chain to external competition to help cut wages and expenses. Delphi now has about $22 billion in debt but has assets of around $17 billion and is losing money. After its spin-off, Delphi failed to materially reduce labor and pension expenses while foreign competition and slowing demand for GM cars has hurt revenues. GM is also losing close to a billion per year and provided some guarantees of pension benefits of GM employees who followed their jobs to Delphi in the spin-off, meaning GM is holding the bag for some of Delphi's nearly $4 billion in pension obligations.

GAME THEORY --- Two economists won the Nobel Prize in economics for their research on game theory, which analyzes the impact of incentives and imperfect information on human decision making in economic, social and military situations. Game theory is often used to explain behavior in so called "prisoners' dilemma" scenarios. The classic example is interrogation of two murder suspects by a prosecutor who lacks any evidence. If the prosecutor separates the two prisoners and offers each a bargain to go free if they rat the other out, the possible outcomes are:

| B silent | B talks |
---------+---------------------+-------------------------+
A silent | A jailed / B jailed | A executed / B free |
---------+---------------------+-------------------------+
A talks | A free / B executed | A executed / B executed |
---------+---------------------+-------------------------+

Of course, each prisoner, looking at his own self-interest with imperfect information (did the other guy talk?) will try to improve his own plight, talk, and doom the other. Of course, BOTH are thinking the same way, dooming both of them.

In short, game theory states individuals faced with a simple set of rules and a straightforward situation in which the decisions that produce the best overall result for all parties are obvious will STILL often select non-optimal outcomes when making those decisions based upon their individual incentives and perceptions of reality.

SKYROCKETING INDIVIDUAL BANKRUPTCY FILINGS --- The new personal bankruptcy law goes into affect Monday, October 17, 2005 with drastically tighter rules that limit how much debt individuals can erase by filing bankruptcy. Normal weekly filings were around 30,000 for the past few years. Filings in the past two weeks have numbered around 120,000 and 200,000. Undoubtedly, some of the spike in filings could be due to residents of Louisiana and Mississippi who lost everything and have no insurance to cover damage caused by water. However, many of the filings are by individuals who realize their obligations will be far greater after 10/17, making it more difficult to start over after getting swamped by unforeseen medical expenses or (yes...) flat out poor finanancial management and over-consumption financed by credit cards and home equity loans.

REFCO UNCOVERS $545 MILLION FRAUD --- Refco found loans on its books previously thought to involve actual customers were in fact loans to its CEO, who has now been arrested. As a securities firm, the company's day to day viability is directly dependent upon its reputation and quality of its financial books. Standard and Poors has opined Refco is likely to default on its debt, forcing the company to begin trying to restructure positions in other investments to preserve cash to avoid triggering any covenants on those obligations.

Ok, what's the tie-in between these stories?

The new bankruptcy law taking effect 10/17/2005 was promoted as a "bankruptcy abuse prevention" act by Bush himself. Here's an excerpt from his comments (see #6) at the bill's signing (emphasis added):

Our bankruptcy laws are an important part of the safety net of America. They give those who cannot pay their debts a fresh start. Yet bankruptcy should always be a last resort in our legal system. If someone does not pay his or her debts, the rest of society ends up paying them. In recent years, too many people have abused the bankruptcy laws. They've walked away from debts even when they had the ability to repay them. This has made credit less affordable and less accessible, especially for low-income workers who already face financial obstacles.

Who are the real deadbeats here? An individual hit with a $200,000 medical expense that was only partially covered by medical insurance and cannot afford the remainder? Or companies that

  1. transferred money from "over-funded" pension funds to other boondoggles or to executive pockets during good times

  2. failed to properly manage their long term cost structures

  3. delayed the day of reckoning through pointless acquisitions or divestitures

  4. in many cases, cooked books or turned a blind eye to flagrant abuses by executives

  5. further looted the company treasury prior to filing bankruptcy to provide executives additional cash

  6. walked away from BILLIONS in pension obligations, saddling US taxpayers with the difference


The Pension Benefit Guarantee Corporation (PBGC), the government equivalent of the FDIC for pension plans, is already $22 billion underfunded for current obligations that have been abandoned by US corporations (see #7). Think about what that REALLY says. The actual amount of abandoned pension obligations in America is $22 BILLION + X, where X is the current funding level for the PBGC. That's a lot of at-risk retirees. Add another $4.7 billion for Delphi. The GAO estimates the total shortfall will reach $87 billion in another ten years.

A more useful analysis involves approximating the actual amount of bad debt associated with business and individual bankruptcies. A report from the US Courts (see #8) shows for the year ending 12/31/2004, business and personal filings broke down as follows:

Business Individual TOTAL
Chapter 7 20,192 1,117,766 1,137,958
Chapter 11 9,186 946 10,132
Chapter 12 108 NA 108
Chapter 13 4,701 444,428 449,129
TOTAL 34,317 1,563,145 1,597,462


Using information about per capital income from the St. Louis Fed (see #9) and information from BNA about average debt per filing as a percentage of income (see #10), I've estimated roughly $46 billion in individual debt was wiped clean by 2004 filings. (See notes below if you want the details.)

Compare that figure with numbers from recent corporate bankruptcy filings in 2005 (see #11):

LARGEST U.S. BANKRUPTCY FILINGS IN 2005
COMPANY/DATE TOTAL ASSETS
Delta Air Lines Inc. (Sept. 14) $ 21,801,000,000
Delphi Corp. (Oct. 8) $ 16,593,000,000
Northwest Airlines (Sept. 14) $ 14,042,000,000
Collins & Aikman Corp. (May 17) $ 3,196,700,000
Tower Automotive Inc. (Feb. 2) $ 2,846,406,000
Winn-Dixie Stores Inc.(Feb. 21) $ 2,618,891,000


That's over $60 BILLION for just six corporate filings.

As was the case with Ronald Reagan's plan to pay for his 1980s tax cuts by eliminating fraud and abuse by "welfare queens" wearing mink coats and driving Cadillacs, the new bankruptcy law is clearly aiming at the wrong target. Corporate bankruptcy numbers clearly indicate the pain facing corporate filers is not sufficient to prevent them from taking big gambles and undue risk since any downside in the form of abandoned pension plans or lost jobs isn't born by those benefiting from the gambles at the top.

More perversely, much of the rise in consumer debt has resulted from the banking industry making the same types of "swing for the fences" gambles. In the past 25 years, banking laws regarding usury (unduly high interest rates) were scuttled, limits on fees and penalties banks can charge were relaxed and hundreds of failed savings and loans were rescued at taxpayer expense in the late 80s. Banks looking at that legal and political landscape all reach the same conclusion:

"Heads I win, tails I win."

If consumers keep saddling themselves with more debt, I make tons of money. If they get to the point of treading water, I make more money every time they miss a payment, bounce a check, etc. If they continue to tread water, I sell them a home equity loan, further locking them into more interest payments. If they go under, the government bails me out.

Of course, shortly after reaching this conclusion, they reached another:

"I'm a genius. I deserve a bigger salary."

Bankers KNOW most Americans are WAY over their head in both home and credit card debt. Yet they keep on lending. Why? What's the incentive to cut back? All of the downside squeeze gets applied to the consumers, one at a time, who lack the resources and political influence to fight for more equitable terms on a typical $35,000 to $100,000 obligation. In contrast, as a company, if you wind up BILLIONS short, you're in the driver's seat and other big companies will come try to help you out, if only in fear of your problems triggering a run on their assets and melting them down with you. That model cannot work forever, either. As companies keep backing each other up with government protection behind them, they'll keep making bigger and bigger gambles and at some point, a collapse is inevitable.

The facts are all out there. The theory behind the behavior is well understood. We are seeing billion dollar dominoes starting to fall. Why isn't government changing the rules of the game being played by corporate America to drive more responsible behavior? The ongoing failure to correct the incentives facing corporate America is leading to major economic problems in the not-so-distant future.


WTH

=======================================

References:

#1 = http://www.msnbc.msn.com/id/9644882/
#2 = http://quote.bloomberg.com/apps/news?pid=10000039
&refer=columnist_gilbert&sid=afqGNUNI2dR0

#3 = http://www.msnbc.msn.com/id/9649575/
#4 = http://news.yahoo.com/s/ap/20051014/ap_on_bi_ge/
bankruptcy_filings

#5 = http://news.yahoo.com/s/ap/20051014/ap_on_bi_ge/refco
#6 = http://www.whitehouse.gov/news/releases/2005/
04/20050420-5.html

#7 = http://www.pbgc.gov/docs/2004_annual_report.pdf
#8 = http://www.uscourts.gov/bnkrpctystats/
bankrupt_f2table_dec2004.pdf

#9 = http://www.stlouisfed.org/publications/re/2005/
d/pages/bankruptcy.html

#10 = http://www.bna.com/webwatch/bankruptcycrs3.pdf
#11 = http://72.14.207.104/search?q=cache:m8N9itTUrngJ:
sg.biz.yahoo.com/051008/3/3vii8.html+kmart+bankruptcy+
delphi+UAL+Northwest&hl=en



Estimating Individual Debt for Bankruptcy Filings

According to a paper published by the St. Louis Fed (see #9), in 2004, the average per capita income was about $32,937. According to a report published by BNA (see #10), the average debt of those filing for bankruptcy was 105.1 percent of their disposable income. Not wanting to split hairs about gross versus disposable income, let's just assume that means the average debt owed by a filer is 1.05 x 32937 or $34, 583. Let's assume for ease of math that Chapter 13 filers are stuck with 50% of their debt.. That would amount to $46 billion in total debt eliminated.




We all have gotten into some trouble in our lives, but a law that makes it a $1000 or less mistake to get out of, is utterly ridiculous.

I don't care if you are Republican or Democrat, the law needed reformation and I get sick of tired of people whining about it, blaming about it, while never, ever, putting forth their own solutions.


=========================

Absolutely agree. However, current law makes it RIDICULOUSLY easy for a corporation to spend a few million dollars in legal fees to walk away from BILLIONS of dollars in debt that gets dumped on US taxpayers. A key point of my post is that corporations understand the game and the incentives and have behaved accordingly throughout the 90s and 00s. Pension overfunded? Count it as earnings, skim some off to pay million dollar bonuses to executives, blow some more on overexpansion or other executive pipe dreams and enjoy the good times. Pension suddenly short? I guess we'll declare bankruptcy, tear up the union contracts and start over, and toss the (now) underfunded pension obligations to PBGC and let Uncle Sam take care of that. We have a business to run.

Why the double standard?

A single corporate bankruptcy costing $1 billion produces much greater damage to the economy than 20,000 individuals going bankrupt costing the same amount. A single corporate bankruptcy usually produces instant job loss for hundreds (thousands?) of workers, instant loses for suppliers left holding the bag and a pretty concentrated hit to major banks and creditors. Think about all of the tax abatements large companies get from local governments to keep them from relocating. The governments gamble the loss of direct tax revenue will be made up for in local jobs, individual income taxes, property taxes, etc. When the company and its jobs vanish, local governments get left short. (I'm dead set against TIFs and tax abatements for this exact reason, but the existing deals are out there and it is the BIG corporations getting most of the benefits.)

In other words, the secondary effects of a single $1 billion bankruptcy are greater than those of 20,000 small individual bankruptcies involving the same amount. If we're going pass laws discouraging bankruptcy abuse, we need to pass laws that discourage ALL bankruptcy abuse, including the kind the government encourages by doing the bidding of big business.


WTH

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