Archives For bankruptcy

Posner cites Wright

Geoffrey Manne —  5 February 2010

I’m sure it’s an honor just to be nominated.

A recent opinion from Judge Posner cites our very own Josh Wright (Joshua D. Wright & Todd J. Zywicki, “Three Problematic Truths About the Consumer Financial Protection Agency Act of 2009,” Lombard Street, Sept. 14, 2009, available here) (by the way, the essay has drawn a few comments, my favorite of which is definitely the one titled, “are you stupid or scumbags[?]”).

The opinion is vaguely interesting touching as it does on the propriety of short-term, high-interest loans, but the holding rests on an analysis of the commerce clause so is pretty well beyond my ken.

At issue is an Indiana statute that purports to apply Indiana’s restrictive usury laws to consumer contracts executed outside the state, but with creditors that have advertised or solicited sales within Indiana.  The Indiana usury statute at issue constrains consumer loan interest to terms under which “the ceiling is the lower of 21 percent of the entire unpaid balance, or 36 percent on the first $300 of unpaid principal, 21 percent on the next $700, and 15 percent on the remainder,” with an exception for payday loans.  Such terms would preclude payday loans if they weren’t excepted under the statute and does preclude car title loans of the sort at issue in the case.  The court rules that the restriction on out-of-state transactions is impermissible under the constitution and strikes down the Indiana law.

The interesting part (to me) of the case, and the part where Josh (and Todd) are cited, is where Posner discusses the law and economics and related scholarship of car title and payday loans.  He doesn’t really come down on one side or another in this debate except to aver that Indiana has a colorable interest in protecting its citizens from “predatory lending,” if it so chooses.  It seems to me that he gives too much credit to the behavioral-economics-based arguments on the “predatory lending is, well, predatory” side of the debate, but he really doesn’t wade into the debate.  Nevertheless, Josh and Todd get their mention (Todd actually gets a couple of mentions) in this section, and kudos to them (and to FinReg21, where their essay appears) for drawing Posner’s attention.

I’m not generally a big fan of blogging to complain about law reviews or the way that my work has been interpreted by others.  I’m generally of the view that the risk of having my work misinterpreted within a reasonable range is my own to bear, and that if it happens, it’s probably due to my own failure to write clearly enough.  I’m not a big fan of either of those things.   With that kind of lead in, you can be pretty sure I’m going to do both in this post.

I recently opened my mail to see a reprint from Professor Alan White at Valparaiso University School of Law from his article, Behavior and Contract, published in the University of Minnesota Journal of Law and Inequality.  Unfortunately, the SSRN link above is not the finally published version to which I will refer in this post.  I read with some interest because Professor White’s article takes on a claim I make in this article that the behavioral law and economics literature has, at least as applied to the world of consumer contracts, overstated its case in terms of its predictive power relative to vanilla neoclassical economics.  My article is essentially a literature review of the real world evidence involving consumer behavior in these markets, evidence both supporting and contradicting claims in the behavioral literature, and concludes that the rational choice models outperform their behavioral counterparts.  The goal of the article was to draw attention to the existing empirical evidence, since proponents of both behavioral and traditional law and economics agree that predictive power of the models is of primary importance.  I attempted to do so carefully and thoroughly.

As I thumbed through the article, I was struck by the following passage in n. 143 referring to my article:

Wright relies on industry-sponsored research to contend that behavioral theories are not sufficiently predictive of credit card consumers’ choices, because a majority of credit card consumers are observed to make the “rational” (i.e., wealth-maximizing) choice based on the given data. See id.

I was really surprised and disappointed to read this.  My article is a literature survey.  As such, I cite and “rely” on dozens of studies in the field.  Professor White is referring to just one of these studies, a well known study in the credit card literature by Tom Brown & Lacey Plache, Paying with Plastic: Maybe Not so Crazy, 73 U. CHI. L. REV. 63 (2006) which uses a unique dataset (the VISA Payment System Panel Study) provided by VISA (Brown is affiliated with Visa, as is made obvious in the paper).   No doubt, the Brown & Plache article is “industry sponsored” in some sense or another.   It should be noted that I cite to, and discuss in detail, the findings of a number of studies.  To my knowledge, the overwhelming majority of these studies do not involve any industry funding.  Nor do I see anywhere else in Professor White’s article where he makes this special designation regarding funding sources for other articles he either critiques or cites.

But that is a bit beside the point, which is that the natural interpretation of the footnote is misleading at best.  White implies that I either (1) relied exclusively on industry funded research to support my conclusion that credit card consumers appear to be acting rationally, or (2) tried to mislead readers of my article by emphasizing industry-sponsored research to the exclusion of “unbiased” studies.   I note, for the record, that Professor White does not address the merits of Brown & Plache in the slightest nor even acknowledge the other studies coming to similar conclusions (and there have been several more since the publication of my paper back in 2007).  The larger point is that I find the first sentence entirely misleading and suggesting something intellectually dishonest about my scholarship.  As such, I wanted to clear the record here.

It is literally true that I cite to Brown & Plache and rely on their empirical findings in supporting my conclusion that the rational choice models maintain predictive superiority in credit card markets.  But the message of the footnote is, in my view, pretty clearly that “one should dismiss Wright’s critique generally because he relies on industry-sponsored research and is biased”; it is NOT that “Wright cites to a bunch of studies and you should ignore one of them because it is co-authored by a VISA employee and uses VISA data.”  As such, I view the reference as misleading and calling for the clarification made here with the request that readers interested in taking a look at the evidence please just read my paper.

Finally, this raises several other tangential but I think interesting points.

One is that I think that, as the title of the post suggests, law review editors should be catching things like this and not letting them slide.  This is something that law review editors can and should be doing.  It does not require special technical skill in statistics or econometrics, just a basic cite check.

A second is that this raises interesting issues about the probative value of industry-sponsored research in law and economics.  Many have written about this.  And I do think it can be rational to apply some discount to funded work in appropriate circumstances.  But the larger point is that I view it as wholly insufficient to simply point to an article with serious empirical analysis (Brown & Plache in this instance) and dismiss it–as well as papers relying on it–simply because it is industry-sponsored and without taking on the methods, the data, results or anything of substance.

Third, there are other quibbles I have with Professor White’s article.  For instance, the rest of n. 143 reads:

On the other hand, he concedes that based on the evidence, consumer behavior is neither 100% rational nor 100% irrational. See id. at 509-10. Wright contends that behavioral economists “assume consistent irrationality,” and thereby set up a straw man. See id. at n.31. Rather than asserting that consumer behavior is always and predictably non-utilitarian, as Wright implies of behavioralists, behavioral economics is better understood as saying that consumer behavior is not entirely predictable by rational choice theory. What behavioralism loses in predictive certainty, it gains in descriptive depth.

White apparently does not understand the behavioral literature he is hoping will inform legal debates involving consumer contracts.   Of course behaviorists and the “new” paternalists assume consistent irrationality!  If errors from cognitive biases were randomly distributed around some central tendency towards rationality then the average consumer would be acting quite rationally despite there being a distribution that included both rational and irrational individuals.  We’d be back to a logical concession that the rational actor model predicted average consumer behavior incredibly well.  To make the claim that the insights of behavioral economics can help us do “better,” it must be the case that (and by the way, Sunstein, Thaler, Jolls and just about every behavioralist that I’ve read proudly claims that behavioral economics can do exactly this …) behavioral law and economics can identify systematic, consistent and predictable deviations from rationality.  The point of the behavioral literature is not simply to say that the rational choice model doesn’t entirely predict consumer behavior.  Its to offer a better alternative.  White’s denial on this point is not only puzzling, but undermines the intellectual basis for his reliance on behavioral economics in the first place.

There has been a lot of talk recently about the possibility that lax antitrust gave rise to the financial crisis or that antitrust could be used as a proactive weapon to prevent mergers and acquisitions that would create entities “too big to fail.”    George Priest recently took AAG Varney to task for suggesting that there was a consensus amongst economists that lax antitrust contributed to the current financial situation.  Simon Johnson has been pushing the idea that antitrust is an appropriate tool for dealing with the type of financial risk imposed by businesses that become so large that their failure would cause substantial damage throughout the economy.  The idea might be catching on.  Frank Pasquale recently cited to Johnson’s work favorably.  The idea has also been favorably cited by Commissioner Rosch.

FWIW, I’m skeptical about the utility of introducing “too big to fail” as an antitrust concept.  Antitrust has come a long way since its economically unprincipled approach several decades ago to its current state.  It has done so largely by staying relatively hinged to microeconomics.  This approach has done antitrust well as evidenced by the evolution of the doctrine over the past 30 or so years.  We now have a substantial body of economic theory and empirical evidence that tells us quite a bit about sensible approaches to at least cartel and merger enforcement that are likely to help rather than harm consumers on net.  Injecting “too big to fail” as an antitrust concept whether under the Clayton Act or otherwise is not a minor tweak to the system.  Too big to fail is not an antitrust concept and attempts to operationalize it within the antitrust framework are likely to cause more harm than good by undermining the progress that has been made by sticking to a disciplined economic approach.  As I commented for a related story in The Deal, and consistent with some of my own research on economic education and complexity in antitrust cases,  “Consumer welfare is complicated enough” for judges and enforcement agencies as is.  But the threat is not just increasing the risk of errors associated with introducing this factor into the antitrust calculus, but also allowing it to substitute for and gradually subsume the economic approach which has served us well.

Obviously, the types of social costs associated with the risks of firms becoming “too big to fail” are real.  The argument is simply that antitrust is an inappropriate vehicle for addressing those problems and its use here would introduce problems of its own that I have not frequently seen discussed in this context.

My colleague Todd Zywicki has a must read op-ed in the WSJ.  Here’s an excerpt:

The Obama administration’s behavior in the Chrysler bankruptcy is a profound challenge to the rule of law. Secured creditors — entitled to first priority payment under the “absolute priority rule” — have been browbeaten by an American president into accepting only 30 cents on the dollar of their claims. Meanwhile, the United Auto Workers union, holding junior creditor claims, will get about 50 cents on the dollar.

The absolute priority rule is a linchpin of bankruptcy law. By preserving the substantive property and contract rights of creditors, it ensures that bankruptcy is used primarily as a procedural mechanism for the efficient resolution of financial distress. Chapter 11 promotes economic efficiency by reorganizing viable but financially distressed firms, i.e., firms that are worth more alive than dead.

Violating absolute priority undermines this commitment by introducing questions of redistribution into the process. It enables the rights of senior creditors to be plundered in order to benefit the rights of junior creditors.

Go read the whole thing.

So says Lucian Bebchuk in the WSJ:

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses must be recognized. AIG recently stated that it still has about $1.6 trillion in “notional derivatives exposure.” Suppose, for example, that AIG ends up with losses equal to, say, 20% of this exposure — that is, $320 billion. Suppose also that the value of AIG’s current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario, the government’s fully backing AIG’s obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

The alternative would be to put AIG into Chapter 11. In this case, AIG’s creditors, including its derivative counterparties, would obtain the company’s assets. They would end up with a 50% recovery on their claims, bearing those $160 billion of losses themselves.

It is important to understand that the government can also employ intermediate approaches between fully backing AIG’s derivative obligations and no backing. For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors. The government, for example, might elect not to provide such supplemental coverage to executives owed money by AIG.

At a minimum, the government should conduct “stress tests,” estimating potential losses in alternative scenarios, and formulate a policy on the magnitude and fraction of derivative losses it would be willing to cover. A policy that doesn’t fully back AIG’s obligations should be seriously considered.

Read the whole thing.

Russ Roberts interviews my George Mason colleague Todd Zywicki here.

Earlier this week, I argued that courts should resist the urge to modify what turn out to be improvident commercial contracts. An unintended consequence of rewriting such contracts, I asserted, is that negotiated agreements would become unreliable, which would raise the risks associated with, and thereby discourage, wealth-creating exchanges. And real wealth creation — not just wealth redistribution — is what we desperately need right now.

In an op-ed in today’s Wall Street Journal, Josh’s GMU colleague (and Volokh conspirator) Todd Zywicki offers a similar analysis of proposals to modify mortgage contracts. He cites the following unintended consequences of permitting judges to rewrite such contracts:

* Mortgage costs will rise, as the risk of judicial modification increases the risk of lending, resulting in higher interest rates and/or upfront costs;

* Bankruptcy filings will increase as homeowners see bankruptcy as a means of getting out of a bad mortgage without foreclosure (Todd notes that there were 800,000 bankruptcies last year and that five million homeowners are currently delinquent on their mortgages);

* Because “a bankruptcy filing sweeps in all of the filer’s other debts, including credit cards, car loans, unpaid medical bills, etc.,” the increase in bankruptcies resulting from the ability to rewrite mortgage contracts will also “destabilize the market for all other types of consumer credit”;

* At least under the leading pending proposal, homeowners could act opportunistically at the expense of lenders, filing for bankruptcy to get the mortgage principal written down and then pocketing much of the appreciation if the home eventually appreciates in excess of the written-down principal amount.

In addition, Todd notes a number of systematic adverse effects of permitting judicial modification of mortgages (e.g., effects on mortgage-backed securities, which “provided no allocation of how losses were to be assessed in the event that Congress would do something inconceivable, such as permitting modification of home mortgages in bankruptcy”). Go read the whole thing.

I’d like to share a quote on banking industry regulation:

“To restrain private people, it may be said, from receiving in payment the promissory notes of a banker for any sum, whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty, which it is the proper business of law not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty.  But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.” (emphasis added)

We all know that the banking industry is unique relative to other industries and needs unique regulation…this is not news.  But, did I mention that the aforementioned paragraph was written by one Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations all the way back in 1776?!? (see book 2, ch. 2)

Adam Smith believed that the role of government was to protect and maintain a system of private property (i.e. protect against invasion and provide an administration of justice) and to provide public goods.  There are very few circumstances in which he supported government intrusion in the market mechanism.  One of those circumstances is in the banking industry where the free market of capitalism may “endanger the security of the whole society.”  This is amazing stuff considering the lack of industrialization and the general lack of economic knowledge at that time (e.g. the labor theory of value and the lack of knowledge of what determined a price, the general view of precious metals as wealth, exports as “good,” imports as “bad,” etc.).

Fool me once: The lack of banking regulations and the Great Depression.  We learned our lesson and instituted regulations in the form of the Glass-Steagall Act of 1933.

Fool me twice: The relaxing of S&L regulations during 1979-1982 and the subsequent S&L crisis in the late 1980’s and early 1990’s.

Fool me – you can’t get fooled again: The relaxing of banking regulations in the late 1990’s repealing many Glass-Steagall elements (e.g. Gramm-Leach-Bliley Financial Services Modernization Act of 1999) and the situation we’re going through now.

Not to say that these are the only causes, but my oh my, there’s a lot of fooling going on here!  I think, in general, we have learned from Adam Smith, but we’re also working with a Congress that very much loves embracing free market principles involving lobbying dollars AND THEN sitting down to vote.  We recognize that it would be idiotic to let our judges do that but barely make a peep when our policymakers do it everyday.  Let me guess why: When elected to Congress you are forced to get a shot that miraculously makes it so that you no longer like money?

My colleague Todd Zywicki is in the Wall Street Journal today on the merits of bankruptcy along with some public choice:

General Motors looks like a financially failed rather than an economically failed enterprise — in need of reorganization not liquidation. It needs to shed labor contracts, retirement contracts, and modernize its distribution systems by closing many dealerships. This will give rise to many current and future liabilities that may be worked out in bankruptcy. It may need new management as well. Bankruptcy provides an opportunity to do all that. Consumers have little to fear. Reorganization will pare the weakest dealers while strengthening those who remain.  So why do the Detroit Three managements and the UAW insist that “bankruptcy is not an option”? Perhaps because of the pain that would be inflicted upon both. …

Those Washington politicians who repeat the mantra that “bankruptcy is not an option” probably do so because they want to use free taxpayer money to bribe Detroit into manufacturing the green cars favored by Nancy Pelosi and Harry Reid, rather than those cars American consumers want to buy. A Chapter 11 filing would remove these politicians’ leverage, thus explaining their desperation to avoid a bankruptcy.  In short, Detroit and the public has little to fear from a bankruptcy filing, but much to fear from the corrupt bargain that is emerging among incumbent management, the UAW and Capitol Hill to spend our money to avoid their reality check.

Go read the whole thing.

Questions on the Bailout

Josh Wright —  29 September 2008

From Peter Klein:

Over and over during the last week we’ve been told that unless Congress, the Treasury, and the Fed “take”bold action,” credit markets will freeze, equity values will plummet, small businesses and homeowners will be wiped out, and, ultimately, the entire economy will crash. Such pronouncements are issued boldly, with a sort of Gnostic certainty, a little sadness for dramatic effect, and only minor caveats and qualifications.

And yet, details are never provided. The analysis is conducted entirely at a superficial, almost literary, level. “If the government doesn’t act then banks will be afraid to lend, and people can’t get credit to buy a house or expand their business, and the economy will tank.” Unless we rescue these particular financial institution, in other words, a massive contagion effect will swamp the entire economy. But how do we know this? We don’t. First, we don’t even know if there is a “credit crunch.” Nobody has bothered to provide any empirical evidence. Second, even if credit markets are tight, how much does it matter? Any predictions about the long-term effects are, of course, purely speculative. Sure, borrowers like cheap and easy credit and tighter credit markets will leave some borrowers worse off. But what are the magnitudes? What are the likely aggregate effects? What are the possible scenarios, what is the likelihood of each, and how large are the expected effects? Where is the cost-benefit analysis? After all, the seizure of Fannie and Freddie, the takeovers of AIG and WaMu, the modified Paulson plan — the effective nationalization of the US financial sector, in other words — ain’t exactly costless. There are direct costs, of course, to be borne by taxpayers, but the possible long-term effects brought about by increased moral hazard, regime and policy uncertainty, and the like are enormous. Even on purely utilitarian grounds, the arguments offered so far are tissue-paper thin.


Keith Sharfman —  14 November 2007

Yet another major airline merger appears to be in the works: United and Delta. This calls for some antitrust analysis. A few months ago, Thom did a thorough job analyzing the antitrust aspects of AirTran’s proposed takeover of Midwest. The key point in Thom’s analysis was that assessment of an airline merger’s economic effects properly centers not on the merging parties’ overall market shares but rather on the extent to which the two firms compete head-to-head.

United and Delta are large carriers, the second and third largest in the industry. If one uses overall industry market shares to calculate HHI in the merger analysis, the transaction would seem presumptively unlawful. But if one looks at the actual routes on which the two airlines compete and the level of competition currently present on those routes from other carriers, the picture may look very different. If it is the case that the two firms now compete head-to-head only (or largely) on routes that are are served by a large number of carriers, then the firms’ high overall market shares may not matter very much.

That said, a note of caution. In a major airline asset acquisition some years ago, American/TWA, the firms argued that the transaction should be permitted on the ground that TWA (then in bankruptcy) was a “failing firm” and that therefore the transaction’s effect on HHI was not dispositive. The enforcement authorities (wrongly) bought into this argument and permitted the transaction, even though TWA’s airplanes would not have “left the industry” (the relevant standard under a failing firm theory) if they had been sold to the second highest bidder rather than to American. Commercial airplanes are a long term, durable capital good that can’t easily be converted into other uses. Sure TWA’s creditors wanted to maximize the value of TWA’s assets. But that’s not a reason to relax the requirements of antitrust law any more than it would be to permit a bankruptcy debtor to violate the Clean Water Act.

As with TWA, neither United’s nor Delta’s planes will disappear from the market if the deal is blocked, nothwithstanding the firms’ recent bankruptcies and the financial woes that chronically plague the industry. The United/Delta deal should be assessed solely on the basis of its competitive effects. The failing firm argument has no place here, and the parties should not assume that the enforcement authorities will treat them as generously as they treated American and TWA.

My colleague Todd Zywicki offers an empirical rebuttal to the Warren-Tyagi “Two Income Trap” hypothesis which asserts that families with two incomes end up more leveraged than families with single incomes and more susceptible to negative economic shocks than otherwise for a number of reasons, including, e.g. counterproductive bidding for housing, child care expenses, etc. The hypothesis is designed, in part, to explain the increase in bankruptcy filings in the US during the 1980s and 90s. After a bit of number crunching, Zywicki concludes that the largest difference between the typical family in 1970 and 2000 is the tax burden not the mortgage expenses:

expenses for health insurance, mortgage, and automobile, have actually declined as a percentage of the household budget. Child care is a new expense. But even this new expenditure is about a quarter less than the increase in taxes. Moreover, unlike new taxes and the child care expenses incurred to pay them, increases in the cost of housing and automobiles are offset by increases in the value of real and personal property as household assets that are acquired in exchange.

Overall, the typical family in the 2000s pays substantially more in taxes than in their mortgage, automobile expenses, and health insurance costs combined. And the growth in the tax obligation between the two periods is substantially greater the growth in mortgage, automobile expenses, and health insurance costs combined.

Interesting stuff.