"Subject to the provisions herein-after mentioned, and to the prescribed rules, any court may commit to prison for a term not exceeding six weeks, or until payment of the sum due, any person who makes default in payment of any debt or installment of any debt due from him in pursuance of any order or judgment of that or any other competent court."
That such jurisdiction shall only be exercised where it is proved to the satisfaction of the court that the person making default either has or has had since the date of the order or judgment the means to pay the sum in respect of which he has made default, and has refused or neglected, or refuses or neglects, to pay the same.
This language, in the United Kingdom's Debtor's Act of 1869, effectively limited sentences committing debtors to prison to cases where the debtor was able to pay his creditors but refused to do so. This in contrast to the more "strict liability" approach historically used and that simply asked, "did you pay your debts," responding to "no," with an order of incarceration.
I am unaware of any study that weighs in on the effects on collections of looming prison sentences, (might make for a good thesis in behavioral economics?) but I suspect that creditors like such provisions. And, of course, if it had no effect then why are modern debtor's prisons (child support debtors and alimony debtors still face incarceration in many states, of course) still the law of the land? The typically well educated Going Private reader will understand this assumption to be an extension of the supremely radical concept that behavior actually tends to follow incentives. To the extent debtor's prisons were comfortable (marriages, aptly named "Fleet Marriages," were actually allowed in Fleet prison, one of the United Kingdom's most famous correctional institutions for debtors), or easy to escape, they provide little negative incentive and have little impact on behavior.
Still, baring a return to actual strict liability debtor's prisons, defaults and credit woes will plague the modern financial system, and though our attitude about debt is still a very conflicted one (witness the arbitrage opportunities presented in Going Private transactions and their subsequent IPOs) debt has its purpose, as do debt losses and bad loans. Signs of the puritan (Germanic?) distaste for debt abound however, as do signs that it is poorly understood both by novice and sophisticate alike. Making bad investments in sub-prime loans should actually be painful. Yes, we might be sympathetic to the "victim," but their fate was in their hands when they made the investments. Let us not cloud these fairly effective incentives of the financial system in the name of "fairness." (You might already be aware of my thoughts on this topic).
To listen to the gaggle of voices presently honking on the topic, one might be led to believe that defaults are a de facto evil, totally avoidable, that loan losses exist solely become some kind of simple policy oversight is lacking and that extending credit is (or should be) somehow a risk-less endeavor. I find it interesting (but unsurprising) that these self-same voices also would like to impose regulatory burdens on "sub-prime" lending that would certainly have the effect of eliminating debt as an option to the "credit unworthy." Of course, much of the "credit unworthy" definition is hung up on the most recent series of battles in the latest campaign of class warfare in the United States, and it is the hallmark of the modern "progressive" that their well-meaning (but poorly thought out) plans have a habit of substantially harming precisely those they want to help.
On that note, one can only hope that the pathetically low approval rating currently commanded by the Democratically-led Congress is a reflection of the distaste in the public over a battle strategy that includes massive tax increases, regulatory "progress," and steps towards socialized medicine of the sort that cause major political candidates to claim that healthcare quality can be maintained, costs decreased and everyone given free insurance all at the same time, but I suspect that would be hoping for quite a lot and attributing a collective intelligence to the sort of people who respond to these surveys that might well be excessive. For now, it seems, we must deal with the cycles of "sub-prime" lending.
The political yammering aside, one wonders if the modern debtor's prison isn't being long an undesirable asset you probably never should have hoarded without better risk-controls in the first place. Today, those assets may well be collateralized debt instruments. (Natural gas futures are so last year).
If this is the case, it may be far easier than one might think to escape the horrors of a modern debtor's prison. Just write a popular play, make some fool's gold, or, maybe, repackage your debts and get someone(s) to buy them. Very Hogarthian, really. (See art credit note, below).
Bear Stearns may be the prisoner of the day, having, as the case may be taken it on the chin (subscription required) for some time now (subscription required) over the bath they have been taking in sub-prime investments. Says the Journal:
Hard hit by turmoil in the market for risky mortgages, a big Bear Stearns Cos. hedge fund has fallen 23% from the start of the year through late April, according to people familiar with the matter. The performance was disclosed late last week in a letter to investors from executives at the Wall Street firm's asset-management division, these people say. The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is widely exposed to sub-prime mortgages, or home loans to borrowers with weak credit histories, these people add. It has $600 million under management, but as the fund's name suggests, it borrows heavily to make bigger bets. A spokeswoman for Bear Stearns wouldn't comment on the fund's performance.
But the damage is limited, according to the Journal:
While the year-to-date performance of the leveraged fund is a blow for its managers, Ralph Cioffi and Matthew Tannin, the paper losses will have a limited impact on Bear, two people close to the situation say. The brokerage and a group of individual executives have invested about $40 million in the fund, according to someone familiar with the matter. The majority of the $600 million under management comes from outside investors such as hedge funds and wealthy individuals.
A senior executive of a large hedge fund currently short sub-prime "across the board," (and good friend to Going Private) disagrees with the soft-landing view of Bear (and similar banks with sub-prime holdings of note):
The Journal piece is just the tip of the iceberg. Some of these banks are so long Collateralized Debt Obligation sludge, and many of these securities have at their root asset base sub-prime mortgages, that their internal hedge funds are choking on the stuff, especially their super-levered ones. When these things blow, the losses are not only going to kill the equity in the hedge funds, but the collateral will go back to the bank as the leverage provider, and their practice is to immediately sell all collateral upon margin calls.
When that much product hits the market, the prices get driven down, leading other funds to realize losses on comparable stuff, leading them to sell. It could well be the end of the credit bubble.
Bear is trying to dump this sludge so hard they're repackaging these equity and subordinated securities, which can only be bought by QIBs, into corporations which will probably just IPO over to mom and pop, and this is dangerous.
Some of us wonder whether Bear's talking about using these things to manipulate the CDS market wasn't a real threat, but merely an attempt to market them to third-party hedge funds (i.e. to get them off Bear's books) as options on market manipulation profits.
It is interesting to note that all the sub-prime lenders changing hands in M&A deals to hedge funds in the last few months have Bear as an adviser, and the merger agreements are bizarre.
It would be ironic, nay, if hedge funds were the only active means in the economy right now to keep negative incentives of the modern debt prisons working as they should? Is Going Private's colleague right?
A quick look around does expose some rather unusual break-up clauses on deals of late. Lone Star's purchase of Accredited Home Lending lets the buyer walk for $10 million plus another $2 million at closing for no real reason at all.
Reverse break-up fees have been around awhile, but, when these become a 3% option to walk on a 20%-25% equity investment in the absence of a material adverse change, the term "no financing condition" becomes meaningless. Private equity firms increasingly have easy outs should they even get "bad vibes." 3% looks pretty cheap comparatively when you consider this option in a credit market this volatile.
Looking over at the recent McBusiness article on the topic we get this:
The situation is so bleak that Bear Stearns' asset management group is suspending redemptions at the onetime $642 million fund—meaning investors have no choice but to sit on their losses.
Even the vast amounts of liquidity, a favorite tool of astute Going Private readers in times of crisis, might not stave off the recent and rather ominous signs of credit tightening. While large swaths of hedge fund and private equity money are a good thing, many liquidity providers are very "mark to market" conscious and cannot sit on deteriorating debt investments which could be held more or less indefinitely and still show up at or near acquisition cost on the books of their more traditional holders (banks). This does make me think, however, that the safety valve of mark to market in this situation might actually avoid the kind of delayed response that helped gut Japan's banking system.
It is easy to be of the opinion that risk has been underpriced for a long while. Might this be a wake-up call?
In the meantime, it appears this morning that a certain financial institution is working to dump several billion dollars of debt laden securities on the market. They might well escape debtors prison, unless certain warden-hedge funds have anything to say about it. We'll see how that works out for everyone.
Art Credit: "The Prison," painting number 7 in the series of 8 works entitled "A Rake's Progress," by William Hogarth (1733) and telling "...the story of Tom Rakewell, a young man who follows a path of vice and self-destruction after inheriting a fortune from his miserly father." The painting is set thus: "Tom is now an inmate of the Fleet, London's celebrated debtors' prison. Beside him lies the rejected script of a play he has written in the hope of securing his freedom. Other prisoners in the cell are trying similarly hopeless schemes. One man has written a treatise on how to pay 'ye Debts of ye Nation', and another is attempting to make 'fools' gold." (One wonders if anyone in the picture is drafting Collateralized Debt Obligation IPO documents).
The series "A Harlot's Progress," (1730) was the highly successful prequel (its popularity likely driven by the more sexual subject matter). An outstanding Hogarth exhibit was on display at the Tate through April of this year (an amazing show, I might add) with these pieces on loan, but the works have now returned to Sir John Soane's Museum.