A Bankruptcy History of Manias and Panics (in 80 pages)

By Mark Perelman (Yale School of Management)

Mark Perelman

Fraud and irrationality are often blamed for financial manias and panics. Investor euphoria can unleash social and technological breakthroughs, but the subsequent collapse can destroy value and radicalize the political sphere. Are these events random, idiosyncratic, or driven by some force? The ex-post answers—be they monetary, criminal, or international contagion—have a profound impact on the role of government in society, but have questionable predictive power.

The historical narrative in this article does not argue that overvaluation, changes in money market rates, and fraud play no part in financial panics. However, the instigating events that lead creditors to become sensitive to information which might impair contractual protections suggests that financial panics are reactive to changes in jurisdictional bankruptcy processes. The history of bankruptcy law is intertwined with that of crises and banking law, and—as argued using over 50 case studies spanning the Dutch Tulipomania of 1637 to the Great Recession of 2008—consistently causes and accelerates financial manias and panics.

This narrative can be illustrated by the most recent case study in this article: The Great Recession. Following the earlier Asian Financial Crisis, international investors demanded safe debt. Whereas home mortgages were sensitive to information regarding borrower bankruptcy, these mortgages could become safe debt if default risk were reduced. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) restricted access to bankruptcy in favor of insolvency debt management plans and gave home mortgage lenders priority over other creditors. BAPCPA—along with the Bankruptcy Amendments and Federal Judgeship Act of 1984’s safe harbor around negotiable derivatives, which gave counterparties priority over other creditors—purposely reduced incentives to monitor counterparties and gave markets a (false) sense of security about the mortgages underlying the repo market. The low default risk increased liquidity and allowed lenders to remove risky assets from their balance sheet and expand mortgage financing.

While it’s not possible to quantify the effect of the bankruptcy process relative to all of the other effects, the case studies in this article hope to illustrate how these mechanisms operate to develop more resilient economies. Without appropriate legal technology to solve collective action problems in the presence of asymmetric information, market failures arise in the form of systemic runs on credit extended to banks and other intermediaries. In the wake of financial panics, these technologies are developed by the government, courts, and the private market to improve access to financing, alleviate failures, and reset the cycle.

The full article can be found here.