During my twelve years practicing before the United States Bankruptcy Court, I have learned that economic euthanasia is a great act of benevolence.  Unfortunately, dreams die hard.  Those whose lives are tied up in the venture hang on despite the obvious irrationality of doing so.  Debtors’ attorneys are happy to accept their fees in an attempt to revive an obviously dead horse, while creditors are even inclined to see an occasional spark of life in hopes of getting something more than a few pennies on the dollar from liquidation of the business.  The poor judge faces a courtroom of lawyers and interested parties pleading for another chance, promising that this time it will all work.  Judges often understand that pulling the plug instantly sends hundreds to the unemployment line.  As a result, billions of dollars are wasted each year in the United States on Chapter 11 business reorganizations, when only about 5% of these cases ever successfully complete a plan of reorganization.  Arguably, it would be economically more efficient quickly end the lives of these companies and rapidly shift their resources into more productive uses.  This same scenario is not limited to Bankruptcy Court, but seems to repeat in other areas as well.  This paper discusses three illustrations of this point: the U.S. S&L crisis during the 1980s; the Japanese banking crisis of the 1990s; and the current financial crisis involving several U.S. corporations, including WorldCom.

             The 1979 Iranian Revolution shocked Americans as they watched a new hostile regime take several Americans hostage, and turn off the oil supply from one of the world’s largest producers.  As oil hit forty dollars a barrel on the spot market, the U.S. economy was gripped by stagflation (the combination of high inflation and high unemployment rates).  To fight the inflation, Paul Volker and the Federal Reserve drastically increased interest rates.  The S&Ls, which were traditionally engaged in a from of spread banking (taking in savings deposits and lending them out in the form of home mortgages) found themselves squeezed at both ends. 

            Liberalizations in financial regulation allowed increased competition for deposits in the form of money market accounts.  Institutions such as Merrill Lynch were paying significantly higher interest rates on deposits than those traditionally paid by S&Ls.  Thus, while the S&Ls were facing a squeeze as deposits were leaving their institutions, the value of their primary asset—mortgage loans—plummeted.  As interest rates climbed, the value of these long-term low interest assets dropped as their “present values” were driven down in response to the new high interest rates.  Thus, the S&Ls faced an impossible situation, dwindling deposits to be covered by rapidly devaluing assets. 

            The logical response to this situation was “gamble.”  Financial deregulation also allowed the S&Ls to engage in other lending besides their traditional mortgage business.  In their desperate financial position the only chance for survival was to lend at high interest rates to very risky ventures.  Of course most of these ventures did not pan out, but the inclination was be to hold off the inevitable by continuing to supply funds to these risky ventures.  In the end, the losses were much bigger than they would have been, if the regulators had closed the S&Ls, once it was obvious that they could not survive.  Early intervention by regulators to conduct an orderly redistribution of the economic assets tied up in the failing S&Ls could have saved the U.S. economy hundreds of billions of dollars.

In Japan, there is a saying that “the whole world is connections.”  This is definitely true for Japanese business and financial institutions.  Large parts of the Japanese economy are organized around big banks in organizations known as “keiretsu.”  The member businesses of the keiretsu meet together and coordinate their activities.  The bank at the center of the keiretsu will function as the “main bank” for the member businesses.  It is understood that the main bank will supply needed capital to the member businesses, and if necessary, the main bank can exercise extraordinary control over a member company that is facing financial difficulties.

            In addition, large banks are affiliated with numerous leasing and financing companies.  While the bank does not have any legal responsibility for the obligations of these affiliates, it is understood that ultimately the bank is responsible for the liabilities of its leasing and financing companies.

            During the 1980s, Japan experienced two huge speculative bubbles in equities and in real estate. These bubbles were inflated by low interest rates and the easy monetary policy underlying those rates.  After a six-fold increase in equity prices during the 1980s, and inflation of land prices to the point that the value of the land under the Emperor’s Palace exceeded the value of all of the land in California, the Bank of Japan decided that the asset bubbles must be deflated.  To accomplish this, the Bank of Japan increased interest rates, and these twin bubbles burst.

            The banks had financed loans to purchase many of these assets, and the loans were secured by these assets.  On top of this, the banks were also large shareholders.  To cement together the keiretsu, the members of the keiretsu engaged in cross shareholding.  While a bank cannot own more than 5% of a company’s shares in Japan, since a keiretsu consists of hundreds of companies, the banks had vast equity holdings, which constituted a major asset of the banks.  Thus, declining share prices directly threatened the solvency of these financial institutions.

            As asset prices plummeted, the number of bad loans held by the banks and their associates skyrocketed.  Many of these loans were located in their affiliated institutions, and finally the banks began to do the previously unthinkable, they allowed many of these institutions to fail despite the social obligation that the banks had to cover the liabilities of the leasing and finance companies.

            The banks also increasingly engaged in riskier lending practices, like the S&Ls, hoping to play the odds and regain their profitability.  The result has been a multiplication of the banks’ bad loans. 

            Finally, the banks have refused to recognize their bad loans, because to do so would demonstrate that many of the banks are in fact insolvent.  Regulators have gone along with this farce, and failed to take strong action that would bring these practices to a halt, and oversee an orderly reallocation of banking resources in Japan.  As a result estimates of the amount of bad loans held by Japanese banks have continued to climb. Recent estimates are near $1 trillion.1  This lack of transparency has further compounded the problems of the system.

            WorldCom is representative of several large U.S. corporations, which have recently announced accounting irregularities.  It appears that WorldCom was willing to try accounting methods which did not accurately reflect the deteriorating state of the corporation, in order to maintain the value of its shares.  This effort was not particularly successful in the long-run, but the willingness of managers to misrepresent to true state of the corporation in an attempt to stave off the inevitable is again manifested in this case.

            This behavior does not appear to be unique to WorldCom.  Several of the corporations involved in such behaviors, including WorldCom, were proponents of the use of EBITDA as a measure of corporate performance.  EBITDA stands for “earnings before interest, taxes, dividends and amortization.  I first ran across this term a few years ago, while assisting the International Examiners with an audit.  I made a fool of myself asking if the term was something that the company’s attorneys had simply made up.  It seemed so ridiculous.  How can you know the state of a company, if you subtract out so many important expenses first?

            Apparently, several of the major accounting firms have used EBITDA as a measure of corporate performance.  In the case of WorldCom, Arthur Andersen also recommended that the company “capitalize” many items that have traditionally been expensed.  This is bad enough on its face, because it increases current reported earnings by pushing the reporting of expenses off into the future.  However, if EBITDA is the measure used, since depreciation and amortization are always subtracted, those expenses are never reflected in EBITDA.  In WorldCom, these attempts to manipulate and put off the inevitable also resulted in greater damage, and inefficient use of resources than would not have been the case, if the public was given accurate information, and the market had been allowed to properly function.  Concerning EBITDA, Warren Buffet has said: "Among those who talk about EBITDA . . . and those who don't, there are more frauds among those who do. Either they're trying to con you, or they're conning themselves."

            Extraordinary efforts to save failing enterprises are often counter productive.  Whether these efforts are in the form of Chapter 11 bankruptcies, reluctance by regulators to close failing financial institutions, or the use of misleading information to buy additional time, the longer clearly failing entities are allowed to carry on, the greater the resulting economic damage.

[1] Another serious problem in Japan has been the use of an alternative publicly owned banking system in the form of postal banking.  The Japanese postal banking system is the world’s largest bank.  As confidence in private banks declined, postal deposits grew rapidly.  However, these funds are funneled into the Japanese FILP system, which lends these funds primarily to public corporations.  Thus, the world’s largest poll of depositor’s funds is distributed based on political needs, and not market forces.  The Japanese government is currently working on privatizing this system