Steven L. Schwarcz

Regulating Shadow Banking

Although shadow banking is said to be huge, estimated at over

Sovereign Debt Restructuring: A Bankruptcy Reorganization Approach

60 trillion, it is not well defined. This short and accessible paper attempts to define shadow banking by identifying its overall scope and its basic characteristics. Based on the definition derived, the paper also conceptually examines how shadow banking can be regulated to try to maximize its efficiencies while minimizing its risks.

The Easy Case for the Priority of Secured Claims in Bankruptcy

This article systematically examines sovereign debt restructuring in light of bankruptcy reorganization law principles. It proposes that a simple and arguably practical convention, based on just three of these principles, would encourage free market funding of troubled States, thereby avoiding reliance on the International Monetary Fund (and the moral hazard and taxpayer subsidy issues caused by such reliance). On the other hand, the article proposes a limited role for the IMF that would allow it to continue its current practice of imposing conditionality on funding, but without triggering any of the problems presently associated with IMF lending. Furthermore, the article explains why a convention is needed to solve the problem of holdout creditors undermining collective action toward a negotiated settlement. In this context, the article shows that recent proposals to contractually solve this problem by introducing special-majority voting clauses in new bond issues are doomed to failure. The article additionally explains why no international bankruptcy court or other new organization is needed.

Global Decentralization and the Subnational Debt Problem

For years, scholars have questioned the efficiency of secured debt, many suggesting that it transfers uncompensated risk to unsecured creditors. This Article argues that the most important form of secured debt, new money credit secured by collateral, tends to create value for unsecured creditors as well as for the debtor. Prior writing on the value of secured debt ignores the distinction between the use and the availability (and subsequent use only if needed) of secured credit. As a result, previous models of secured debt erroneously assumed that a debtor that can borrow on an unsecured basis may well prefer to borrow on a secured basis to reduce interest cost. The Article combines theory and experience to show that those models do not reflect an economically rational debtor. A rational debtor that can borrow unsecured has an economic incentive not to prematurely encumber its assets because doing so gives away value in an amount, which the Article calls Theta, that exceeds any interest cost saving. Perhaps the most significant component of this value is the increased liquidity in times of financial trouble that secured credit affords. The Article also shows that this increased liquidity does not generally keep debtors alive that should be allowed to fail. Bankruptcy creates market imperfections that tend to make lenders reluctant to extend credit, even on a secured basis, to debtors that are likely to go bankrupt. Furthermore, these market imperfections discourage troubled debtors from incurring secured debt unless they can thereby avoid bankruptcy. Secured credit is therefore usually extended in these circumstances only where the liquidity would help the debtor regain viability. Therefore, unsecured creditors should want a debtor to have access to secured credit.

The Future of Securitization

According to the World Bank, decentralization of government is a pivotal force that will shape global development policy in the 21st Century. Subnational debt restructuring has emerged, however, as one of decentralizations most difficult problems. Financially troubled municipalities face many of the same concerns, for example, as financially troubled nations: holdout creditors can stymie collective attempts at debt restructuring, and reliance on politically-motivated lenders of last resort (the International Monetary Fund in the case of troubled nations, the central government in the case of troubled municipalities) can foster moral hazard. In a recent article, I argued that an international convention for sovereign debt restructuring based on several fundamental principles of bankruptcy reorganization law can effectively address these concerns for nations. In this article, I argue that similar principles can even more easily be applied to the financial problems of subnational governments. To this end, I propose a model law based on these principles that might form the foundation for a national law, informed by local political and legal culture. Then, using the Japanese municipal crisis as an example, I show that countries enacting such a law can prudently and equitably resolve their subnational debt burdens.

The 'Principles' Paradox

Securitization, a process in which firms can raise low-cost financing by efficiently allocating asset risks with investor appetite for risk, has been one of the most dominant and fastest-growing means of capital formation in the United States and the world. The subprime financial crisis, however, has revealed certain defects with how securitization is sometimes utilized. This Article examines these defects and the extent they can, and should, be remedied going forward.

Keynote Address: Understanding the Subprime Financial Crisis

This essay, prepared for a University of Cambridge conference on ‘Principles Versus Rules in Financial Regulation’, posits a new issue in that debate. Although principles-based regulation is thought to more closely achieve normative goals than rules, the extent to which that occurs can depend on the enforcement regime. A person who is subject to unpredictable liability is likely to hew to the most conservative interpretation of the principle, especially where that person would be a potential deep pocket in litigation. This creates a paradox: unless protected by a regime enabling one in good faith to exercise judgment without fear of liability, such a person will effectively act as if subject to a rule and, even worse, an unintended rule.

The Inherent Irrationality of Judgment Proofing

This short and accessible paper, based on a keynote speech for a law review symposium, addresses how and why the financial crisis occurred and what should be done to avoid future crises. Among other things, the paper explains why neither the making of subprime mortgages nor the originate-and-distribute model pursuant to which these mortgages were monetized was per se evil; why the governmental regulatory structure failed to deter the crisis; and why the governmental bailout plan under the Emergency Economic Stabilization Act is critically needed and where it may be deficient. The paper also explains the difficulties in valuing mortgage-backed securities and in locating the ultimate holders of risk under credit default swaps and the relationship between financial market breakdown and counterparty risk.

Globalization, Decentralization, and the Subnational Debt Problem

In recent articles in the Yale Law Journal and the Stanford Law Review, Professor Lynn M. LoPucki has sparked much academic discussion arguing that recent developments in corporate law have led to an erosion in the system of corporate liability, such that it might one day prove impotent. LoPucki has argued that transactions such as asset securitizations, sale-leasebacks, and corporate structures in which liabilities are placed in asset-poor subsidiaries are driving this change. One early critic to the LoPucki thesis, Professor James J. White, has argued that empirical data show no evidence of increasing use of judgement proofing techniques. In this Article, Professor Steven L. Schwarcz joins this debate, arguing that an economic analysis of these transactions suggests that widespread use of these judgement proofing techniques is unlikely. A key distinction in the analysis, Schwarcz argues, is between arms length and non-arms length transactions. Arms length transactions are unlikely to lead to judgement proofing because corporations will receive value - often cash - for the assets they sell. It is only by paying out this value in dividends that a corporation begins to judgement-proof itself. The theoretical possibility to take value away from future involuntary creditors through such transactions will rarely be realized because of the costs - taxes, negative publicity, personal and criminal liability - of entering into such agreements. By contrast, in non-arms length transactions, corporate owners do have the incentive to create judgement-proof structures. However, these structures are not innovative, and they will continue to be well-regulated ex post by existing legal doctrines in bankruptcy, corporate law, tort law, and criminal law. Following this article are a response from Professor Lynn LoPucki, a comment by Professor Charles Mooney, and a breif rejoinder from Professor Schwarcz.

Securitization and Structured Finance

According to the World Bank, decentralization of government is a pivotal force that will shape global development policy in the 21st Century. Subnational debt restructuring has emerged, however, as one of decentralizations most difficult problems. Financially troubled municipalities face many of the same concerns, for example, as financially troubled nations: holdout creditors can stymie collective attempts at debt restructuring, and reliance on politically-motivated lenders of last resort (the International Monetary Fund in the case of troubled nations, the central government in the case of troubled municipalities) can foster moral hazard. In a recent article, I argued that an international convention for sovereign debt restructuring based on several fundamental principles of bankruptcy reorganization law can effectively address these concerns for nations. In this article, I argue that similar principles can even more easily be applied to the financial problems of subnational governments. To this end, I propose a model law based on these principles that might form the foundation for national laws, informed by local political and legal culture. Then, using the Japanese municipal crisis as an example, I show that countries enacting such a law can prudently and equitably resolve their subnational debt burdens.