Don't Call It Bankruptcy

The phenomenon we now know as Chapter 11 bankruptcy was born during the financial panics that regularly pummeled the U.S. economy in the 1800s. Railroads had emerged as the country's first large industrial corporations, and every time the markets crashed and the economy slumped, many found themselves unable to pay their bills.

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These railroads were worth more alive than dead, so inventive people figured out ways to reorganize them rather than shut them down. "The investment banks and lawyers and managers would negotiate a deal and get the courts to bless it," says David Skeel, a law professor at the University of Pennsylvania and author of Debt's Dominion: A History of Bankruptcy Law in America. "It was a very flexible reorganization process." It was also a uniquely American answer to business failure. The private sector took the lead. Reinvention--and rebirth--was the goal. (See pictures of the global financial crisis.)

The reorganization option faded after William O. Douglas (then SEC chairman, later a Supreme Court Justice) persuaded Congress in 1938 to approve more punitive bankruptcy laws, but it was resurrected by Congress in 1978 as Chapter 11 of the bankruptcy code. Since then Chapter 11 has been used to reorganize airlines, steelmakers and countless other companies in trouble.

Now, though, something curious is happening. We've been hit by a financial crisis eerily reminiscent of those 19th century panics. But instead of going to bankruptcy court, troubled firms are lining up at the Federal Reserve, the Treasury Department and Congress.

First came the financial sector. Bankruptcy has never really worked for banks, because mere rumors that a bank is headed for failure can drive it under. That's why Congress long ago created a separate regulatory system and reorganization process for banks, with the Fed and the fdic at the center. Over the past quarter-century, though, a "shadow banking system" of investment firms, hedge funds and derivatives dealers grew up that was subject to the same risks as banks but not the same rules. In September, Lehman Brothers, a major cog in this system, filed for Chapter 11. In one sense the process worked as designed--much of Lehman lives on under the names Barclays and Nomura. But the resulting run on the financial system sent Ben Bernanke and Hank Paulson scurrying in panic to Capitol Hill to ask for a $700 billion bailout.

That was why, when the CEOs of the Detroit Three auto companies showed up on Capitol Hill in mid-November to beg for $25 billion in emergency loans, the committees they went to were Senate Banking and House Financial Services--which have jurisdiction over the financial-bailout pot.

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