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Shiller: Bankruptcy Law Risks Meltdown

Friday, 29 Aug 2008 08:23 AM

Robert Shiller, the Yale economist who correctly called the real estate bust, says bankruptcy law needs to be reformed to avoid a meltdown of the financial system.

If a major financial institution fails, bankruptcy law as it now stands may not be powerful enough to prevent a systemic crash, he argued in a New York Times opinion piece.

“Current bankruptcy law was not written with the perspective of systemic risk in mind,” wrotes Shiller, who also accurately predicted the stock market crash of 2000 to 2003.

“There is a big problem … when large financial institutions are at the margin between solvency and insolvency. The formal declaration that an important financial institution is insolvent could threaten the whole economy.”

That’s why the Federal Reserve had to save Bear Stearns in March, Shiller says.

But, since then, “the policies instituted by the Treasury and the Fed to deal with financial crises seem improvised, rather than part of a consistent, well-articulated policy,” he says.

As a result, “There is still a risk that financial dominoes will begin to fall,” according to Shiller.

“If the Bear Stearns crisis had such a potential for disaster, what will we do if a major hedge fund fails or if several crises happen at once?

Shiller points out that the government already has seen a need to aid Fannie Mae and Freddie Mac. “What if the next case is worse?” he asks rhetorically.

“No one in the government seems to feel a responsibility for warning about such possibilities and formulating a detailed policy for dealing with them.”

And why begin with bankruptcy law reform? Because “the dreaded financial meltdown would amount to a wave of bankruptcies,” explains Shiller.

“Preventing Bear Stearns from becoming the responsibility of the bankruptcy courts was one reason the Fed felt that it had to act so quickly,” he says.

Bankruptcy laws are too narrowly aimed at dealing with the woes of a single company and might force it to shut down, when doing so would trigger a financial crisis, Shiller argues.

He says that Jay Westbrook, a bankruptcy scholar at the University of Texas, has a good suggestion for repairing the bankruptcy code.

“He (Westbrook) said the law might be changed in innovative ways so that in times of financial crisis, when more is at stake than the fate of individual companies and their stakeholders, troubled companies could be kept functioning longer,” Shiller writes.

“A subsidized system of triage would be needed to identify which companies should be saved, with the main criterion being the possible economic impact of their liquidation.”

Flexibility represents the paramount issue, Shiller maintains. “In this country, we seem to get things right eventually,” he says.

“But the problem seems to be that the narrow specialties that develop to deal with economic crises tend to be effective in specific settings. And then they become dated as soon as the settings change.”

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Robert Shiller, the Yale economist who correctly called the real estate bust, says bankruptcy law needs to be reformed to avoid a meltdown of the financial system.If a major financial institution fails, bankruptcy law as it now stands may not be powerful enough to prevent a...
robert,shiller
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2008-23-29
Friday, 29 Aug 2008 08:23 AM
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