Operational creditors yet again

When the Bankruptcy Law Reforms Committee (BLRC) submitted its report nearly two years ago, one of my major concerns was the dubious and unwarranted distinction that it made between operational and financial creditors (see my blog posts here and here). This invidious distinction has come back to haunt us today as home buyers find themselves in the lurch when bankruptcy proceedings are initiated against the developer. Pratik Datta tells the full story of this mess in her blog post at Ajay Shah’s blog.

This is symptomatic of a deeper problem with how bankruptcy reform in India has developed as a bailout of the financial sector rather than as a reform of the real economy. From the Debt Recovery Tribunal to SARFAESI to the Bankruptcy Code, banks were privileged over other creditors and financial creditors over operational creditors. It would appear that the dominant goal has been to save the banks. Jason Kilborn articulates the problem very elegantly in his blog post at Credit Slips:

It seems to me a sign of serious regulatory dysfunction when a government expressly uses bankruptcy law as a means of collection, rather than rescue or at least collective redress, with an aim to treating economic stagnation.

It is particularly telling that there has been a profound unwillingness to apply bankruptcy principles to the financial sector itself: Global Trust Bank was merged instead of being left to die; Unit 64 was bailed out; even today, there is no willingness to liquidate even the worst public sector banks. One has to go back half a century to Palai Central Bank for an example of a bank of any significance being allowed to die (though only after a lot of dilly dallying).

Are bonds both a liability and an asset of the borrower?

I have a special interest in this question because that was the topic of the first post on my blog way back in 2005. Five centuries after Luca Pacioli wrote the first text book on double entry accounting, this issue remains unresolved, and smart litigants are still seeking to attach the bonds issued by the debtor to recover their claims. In 2005, it was Argentina; in 2017, it is Venezuela (hat tip Credit Slips).

Twelve years ago, Argentina was exchanging its old bonds for new bonds as part of its infamous debt restructuring. Some hedge funds moved to seize the old bonds that Argentina had accepted for the exchange on the ground that the surrendered bonds were assets of Argentina which could be sold in the market to satisfy the claims of the hedge funds. Argentina of course argued that the bonds belonged to the tendering holders, and that they could not be Argentina’s assets and liabilities at the same time. The federal appeals court in New York did not decide the legal question, but simply upheld the trial court’s ruling in favour of Argentina on the ground that the trial judge overseeing the overall debt exchange had broad discretion in the matter. Anna Gelpern provides more details in this paper (page 4).

If Argentina’s debt restructuring was a mess, Venezuela promises to be even messier if and when that country gets to that stage. What is happening now are merely some skirmishes before Venezuela defaults and the serious litigation begins. Buchheit and Gulati wrote in a recent paper:

Napoleon’s invasion of Russia in 1812 was a large undertaking. Restructuring Venezuela’s public sector debt will be a very large undertaking.

Early this year, Venezuela issued $5 billion in new bonds to a state owned entity to help raise cash needed for essential imports (“Venezuela issues $5bn in bonds as it seeks cash to ease shortages”, Financial Times, January 3, 2017). In June, Venezuela engaged a Chinese securities firm, Haitong, to resell these bonds reportedly at a steep discount of more than 70% (“Venezuela Discounts $5 Billion in Bonds”, Wall Street Journal, June 6, 2017). Soon, a Canadian firm, Crystallex, obtained a restraining order against Haitong, as a first step towards attaching the bonds. (“Crystallex Moves Closer To Collecting $1.2B Venezuela Award”, Law360, July 17, 2017). Perhaps, this time, the courts will actually decide this question as to whether a debtor’s bonds can be treated as its assets and attached by the creditors.

Markets that are Too Big To Fail (TBTF)

We hear a lot about TBTF banks, but I think in the post crisis world, policy makers are beginning to view some markets as being TBTF. The IMF published a working paper last month by Darryl King et al. on Central Bank Emergency Support to Securities Markets. This paper appears to me to formalize and legitimize this idea. My unease about this paper is that it not only endorse almost everything that the central banks did during the crisis, but also elevates these to the level of best practices. The paper ignores the fact that while these might have helped in the crisis, they would also have unintended effects on the functioning of markets during normal times.

Markets that are highly likely to be bailed out during a future crisis will be perceived as safer even during normal times. Bonds that trade in these markets will therefore command lower yields. The result is a subsidy to the borrowers issuing these bonds. The subsidy to TBTF banks is partially alleviated through more stringent regulation of these banks (SIFIs), but there is no such regulatory pressure on corporate borrowers benefiting from the subsidization of TBTF markets.

I am fond of Kindleberger’s statement that a lender of last resort must exist but his existence should be doubted. In their eagerness to legitimize whatever was done during the crisis, policy makers are removing this doubt and making the TBTF subsidy more certain and more significant. They are picking winners and losers, and since the winners that they choose are the mature companies, they are penalizing the more innovative dynamic firms that are crucial for long term economic growth.

In the sister blog and on Twitter during January-July 2017

The following posts appeared on the sister blog (on Computing) during January-July 2017.

• Running LaTeX, Python and more in an Android Phone
  

• Why Aadhaar transaction authentication is like signing a blank paper
  (Cross-posted on this blog as well)

• The menace of link rot

• Predicting human behaviour is legal, predicting machines is not? (Cross-posted on this blog as well)

• Setting up a Raspberry Pi as a home file server

• The blockchain as an ERP for a whole industry (Cross-posted on this blog as well)

Tweets during January-July 2017 (other than blog post tweets):

• 16 June 2017
  • Madoff exposer Markopolos’ description of typical auditors: “22-year olds who catch more colds than frauds.” https://www.advisorperspectives.com/articles/2017/06/11/harry-markopolos-who-exposed-madoff-has-uncovered-a-new-fraud
• 14 June 2017
  • Philosophy in front of a bank headquarters building: “some deep contradictory energies are swirling around” https://aeon.co/essays/do-we-all-need-a-little-time-simply-to-sit-and-think
• 12 June 2017
  • The Banco Poplar rescue has been generally praised, but Regulation Asia has a convincing argument that ECB failed http://www.regulationasia.com/article/banco-popular-rescue-%E2%80%93-illiquid-isn%E2%80%99t-insolvent
• 23 March 2017
  • “Everything radiated professionalism … [the hackers] probably knew better than the banks.” https://www.wired.com/2017/03/russian-hacker-spy-botnet/
• 16 March 2017
  • South African central bank selling its shares to the public http://www.bis.org/review/r170316b.pdf. Similar to Switzerland http://www.snb.ch/en/iabout/snb/id/qas_unternehmen_1
• March 9 2017
  • Bloomberg’s euro scenario probabilities add up to 205% (breakup=95%, saved=110%) https://www.bloomberg.com/graphics/2017-euro-breakup-or-saved/?cmpid=BBD030817_BIZ
• 13 February 2017
  • Very relevant today: political biases can lead to poor investment performance: http://www.allaboutalpha.com/blog/2017/02/12/moszoro-and-bykhovsky-on-political-cognitive-biases/ … or https://ssrn.com/abstract=2811350
• 24 January 2017
  • David Birch: “the key innovations in technology in banking do not originate in banks” http://www.chyp.com/payments-and-passports/
• 15 January 2017
  • CHRIS DILLOW: “Everything you need to know about finance can fit onto a single sheet of A4” http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2017/01/work-capitalism-retirement.html