Where the Credit Freeze is Really Freezing

Bankruptcy is clearly a desperate act, but there are levels of desperation. A full liquidation – Chapter 7 for companies – is a clear farewell; all assets are sold for the benefit of creditors. But for those companies that think that they can continue operating, preserving corporate assets and keeping as many jobs going as possible, there is a different kind of bankruptcy – “reorganization” under Chapter 11 of the Bankruptcy Code.

But even in such reorganizations, in most circumstances, common shareholders are left with nothing, unsecured creditors negotiate a supervised “best case” repayment plan (usually pennies on the dollar), contracts that have future obligations by the company (like collective bargaining agreements with unions) can be terminated, and the company shaves off the unnecessary, keeps as much as it can to continue operations and usually goes out for a new credit facility (the ability to borrow) to jump-start operations that, if not continued immediately, will force the company into that total sell-off – the Chapter 7 liquidation scenario – where the company just dies and stops operating.

We hear a lot about “reorganizations” these days, whether it is about a possible solution for the big three Detroit automakers or major retailers that tanked with the horrible sales over the holidays – January 2 stock market gains notwithstanding. January 2 CNNMoney.com: “Michael Burden, principal with industry adviser Excess Space Retail Services, expects as many as 14,000 stores will close in 2009. ‘We could see among the highest ever number of closures,’ he said.” Every closure is a pile of jobs lost and some more homes foreclosed.

We hear about a “pre-packaged” Chapter 11 – where creditors and the company agree on how the restructure will work before the bankruptcy papers are filed – but most of these reorganizations, prepackaged and garden variety, are predicated on securing those new credit lines, which would be senior to the rest of the bankrupt company’s obligations (meaning they get paid first, so they are the safest loans).

However, these “reorganization” credit lines, especially for the larger companies, are based on banks’ ability to put together groups of banks (syndication) to share the risk. And right now, interbank lending is almost non-existent; there’s no trust. Banks that are stepping into this credit line business are using their own assets, their own depositors’ money, which makes them very, very timid. This could explain why U.S. banks seem to be hoarding around $1 trillion, while name brand companies face extinction without what was once just a common post-Chapter 11 credit line.

With reorganization, there is the hope of keeping a reasonable number of people employed; in liquidation, that hope is lost. We don’t see much reorganization in financial companies, since their financial assets are their business, so when they fall under water, there is little reason to continue. But in manufacturing, retail, commercial real estate, etc., there is something to continue in many circumstances. And right now, America needs jobs!

It would seem obvious that, at least for a while, either the Federal Reserve or Treasury should insure interbank lending (which should loosen some of that hoarded cash) sooner rather than later, or we can watch the job loss numbers accelerate. It’s a complicated world, right now, but we need some much more vigorous action to bring this ship around.

I’m Peter Dekom, and I approve this message.