May 9, 2024 - Business

Why financial bankruptcies are a unique animal

Illustration of a zebra with stripes in the shape of a dollar bill sign.

Illustration: Aïda Amer/Axios

FTX has now officially joined the ranks of dramatic financial bankruptcies — including Lehman Brothers and MF Global — in which customers actually get paid back in full.

Why it matters: Such outcomes are more common than you might think, largely because financial bankruptcies are a unique animal where the ultimate losses borne by creditors are rarely a good guide to the magnitude of the damage caused.

How it works: Financial companies tend to have large balance sheets, filled with assets that can often be hard to value or sell. Their liabilities, however, are generally unambiguous: Depositors and other creditors know exactly what they are owed.

  • When the market worries that the assets are worth less than the liabilities, it tends to lose trust in the creditworthiness of the institution and a bank run results.
  • Creditors pull their deposits en masse, forcing the company into a fire sale of its assets to meet its obligations. That fire sale in turn drives the price of the assets down even further, making the company clearly insolvent. Bankruptcy tends to arrive very quickly.

Between the lines: The minute the bankruptcy filing goes into effect, the whole dynamic changes. Creditors have no choice but to sit and wait to see how much they get paid out, and it's the administrator of the estate who has a large degree of freedom in terms of when and how to sell the remaining assets.

  • By waiting until those assets rise in value and then selling them expertly, the total amount realized can often exceed the value of the liabilities.
  • That's what happened at FTX, where the rise in value of cryptocurrency Solana (SOL) in particular helped to increase the value of the company's assets by billions of dollars.
  • FTX held more than 60 million SOL, which were worth about $1 billion when the company filed for bankruptcy in November 2022. By March 2024, the value of SOL had risen tenfold.

Flashback: Something very similar happened with the bankruptcies of Lehman Brothers and MF Global. In both cases, customers ended up being paid out in full after asset prices recovered, although the process took many years.

  • During the financial crisis, Citigroup split itself into a "good bank" and a "bad bank," with the intention of selling off the assets in the bad bank, Citi Holdings, while losing as little money as possible. In the end, Citi Holdings turned out to be a surprise success.

The other side: Even when customers get paid back in full, equity holders and unsecured creditors are often wiped out. And as anybody who remembers the Lehman bankruptcy knows, financial bankruptcies tend to have huge ramifications far beyond the narrow confines of the creditor committee.

The bottom line: In most bankruptcies, creditors get zeroed so that the underlying business can end up continuing unencumbered by large debt service obligations.

  • In financial bankruptcies, the value of the assets is normally much greater than the value of the underlying business. That's why volatile market valuations become crucially important.
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