When Banks Go Bankrupt

Currently, the House of Representatives is considering changes to the bankruptcy code that would prevent a repeat of the 2008 sting of investment bank bankruptcies and how they affected the global economy. This act, known as the Financial Institutions Bankruptcy Act would add a new section to the Chapter 11 bankruptcy code for large financial firms. It would allow bankruptcy judges and regulators alike to have more power to delegate liabilities of banks that fail, and help avoid the need for a taxpayer bailout.

 

The biggest bankruptcy in the world: The collapse of Lehman brothers

In September of 2008, Lehman Brothers holdings announced a Chapter 11 bankruptcy filing. With $691 billion in pre-bankruptcy assets, this was the Titanic of all bankruptcies, taking the number one spot for the largest bankruptcy in the entire world. This event, as we all are aware of, sent shock waves throughout the US economy and lead to the great Wall Street Panic of 2008. With the subprime housing crisis that took place, many individuals were too preoccupied to ask how a bank could go bankrupt or what happens in the Chapter 11 process. When this occurred, several other banks and financial institutions followed suite such as: Wachovia Bank, Washington Mutual, Fannie Mae, and Freddie Mac, leaving tax payers holding a large bill and coining the term “to big to fail”.

 

What about the FDIC?

In the US, unlike many countries that treat banks the same as companies, the Federal Deposit Insurance Corporation (FDIC) acts as the claimant and sole creditor of an insolvent bank and has nearly complete control after the bank has been deemed insolvent. Promoters of this type of arrangement mention two main reasons that justify this type of FDIC control: First it allows for a faster disposal in assets after failure, and secondly it makes the FDIC the major creditor.

 

What happens when banks file bankruptcy?

With large “mega-banks” and bank holding companies such as Washington Mutual and Wachovia, the capital structures can get complicated quickly. These types of organizations have different, more complex capital structures, often with significant subordinate debt, owned by other interests. In a Chapter 11 bankruptcy case, an organization can either recapitalize or liquidate its remaining assets. Either way, by the time a bank holding company files for bankruptcy, the FDIC has already taken way it’s subsidiary and there is nothing left but to divide the assets including a tax pay out to pay back the creditors.

 

Recent legislations changes affecting bankruptcy of banks

Should you be worried about your bank account disappearing if your bank declares bankruptcy? The answer is an astounding no, not if it’s FDIC insured. The main focus of the new legislation that was approved unanimously by the House Judiciary Committee is to “protect taxpayers” according to the bill’s primary sponsor Rep. David Trott (R., Mich.). These proposed changes to the bankruptcy code would have a positive effect that could prevent future bailouts in the event a bank holding company fails.