I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. ...
The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps.
The last paragraph is very misleading. An exemption for derivatives was first enacted in the United States when the bankruptcy code was rewritten in 1978. The exemption was put in place so that counterparties to regulated, exchange traded futures contracts were guaranteed the right to foreclose on collateral and terminate the account of an entity that declared bankruptcy. The reason for this is that daily marking-to-market and margining (i.e. posting collateral) of positions is the mechanism exchanges use to ensure that market participants can honor their obligations. The capacity for the receiver in a bankruptcy to void margin transactions could potentially create a risk of insolvency for the exchange itself. In other words, there is indeed a genuine role for carefully constructed exceptions for certain derivatives to standard bankruptcy procedures.
What happened in 1982, 1984 and 1990 is that the financial industry argued that preferential bankruptcy treatment for exchange traded derivatives created a competitive disadvantage for over-the-counter derivatives and slowly but surely additional derivative contracts were granted safe harbor against standard provisions of the bankruptcy code too. The zeitgeist that viewed unregulated financial innovation as a purely beneficial outcome of free markets undoubtedly contributed to the steady relaxation of the law.
The argument that the 2005 bankruptcy act was just a minor adjustment to derivatives laws is simply false. The most extraordinary change took place in the area of repo contracts, but there is also a strong argument that credit default swaps were not in fact covered by earlier amendments. (A repo contract is sale and repurchase agreement, which functions just like a short-term collateralized loan.) For a thorough discussion of changes due to the 2005 bankruptcy act, see Shmuel Vasser.
The 2005 Bankruptcy Act and the repo market
According to Vasser:
Prior to the 2005 amendments, only a narrow set of securities could have been used for the repo to qualify as a safe harbor transaction. (footnote 33: These were certificates of deposit, eligible bankers' acceptances, or securities representing direct obligations of, or that are fully guaranteed by the U.S. or a U.S. agency.)
In 2005 Congress expanded the definition of a repurchase agreement eligible for safe harbor to include residential mortgage backed securities (RMBS) and derivatives on RMBS. In case you're wondering how that worked out, take a look at the table on page 11 of this paper by Gary Gorton. By July 2007 financial firms were regularly getting 100% financing against investment grade CDO collateral. One inevitable aspect of the financial crisis was the movement to more realistic haircuts on repos.
Unfortunately one of the terms used when expanding repurchase agreements to include MBS in the 2005 law was "mortgage related security." I suspect that any member of Congress who read this passage did not understand that a mortgage related security may be synthetic, that is, it may be a CDO that sells credit default swap "insurance" on a MBS and establishes some value for the CDO by positing a payout likelihood for the swap and netting this against the value of the insurance premiums. Thus a financial firm that writes an insurance policy (via a special purpose entity) was able to borrow 100% of the putative value of that "asset".
Guess what firm thought that CDO repos were a good way to finance its business: Bear Stearns. In their April 2008 congressional testimony Cox and Bernanke express absolute bewilderment about how the repo market completely dried up for Bear. Hmm, I wonder whether CDO repo markets would have grown as big and unstable as they did, if the 2005 bankruptcy act hadn't been passed and if only government and agency paper were eligible for safe harbor under the bankruptcy code.
The 2005 Bankruptcy Act and credit default swaps
Now let's talk about the extension of the derivative safe harbor provisions in the Bankruptcy code to include credit default swaps. The 1980s law that exempted interest rate swap contracts from the standard provisions of the bankruptcy code included the phrase "or any other similar agreement." The problem for financiers was that the only similarity between interest rate swaps and credit default swaps is that they both are financial contracts with the term "swap" in their names. Since common law requires courts to look at the economic substance of a transaction, there was always a strong possibility that some judge would fail to see the "similarity" between a contract that involved a repeated exchange of variable payments and a contract that was in substance an insurance contract, where the payments made by the two parties were separated over time. Thus, it was only with the passage of the 2005 bankruptcy act that a financial market participant could be confident that credit default swaps were exempt from the standard provisions of the bankruptcy code.
The 2005 Bankruptcy Act and systemic risk
Needless to say, plenty of people realized that giving special privileges under bankruptcy law to over the counter derivatives is just as likely to increase systemic risk as to reduce it.
Economists Robert Bliss and George Kaufman:
We conclude that the systemic risk reduction claims often made for close-out
netting and collateral protection appear at a minimum to have been over stated. Systemic risk is in part made more likely as a result of these protections, but then so also are the benefits obtained from a more efficient market that is based on these same protections. The combined use of these three provisions represent a two-edged sword that cuts both ways.
Bliss and Kaufman make the point that should have been obvious to everybody: When you reduce the likelihood that an individual firm will face the costs of counterparty risk, you may find that you increase the size of the market so much that there is no reduction in counterparty risk in the aggregate.
Law professors Franklin Edwards and Edward Morrison had a different concern:
as the LTCM experience demonstrates, permitting the immediate liquidation of a large financial institution counterparty such as LTCM can generate another form of systemic risk, namely the risk that a a run by derivatives counterparties on the debtor will itself destabilize financial markets.
This appears to describe precisely what happened when Lehman Brothers failed.
Finally, we have Shmuel Vasser again:
[I]n many derivative transactions the bankruptcy filing merely subjects the non-debtor counterparty ... to a risk of loss, not an uncommon situation for parties with business relationships with a failed enterprise. The safe harbor provisions change all of that.
Assume that a debtor uses large amounts of metal in its manufacturing process and to protect itself from price fluctuations has entered into a long term forward for its metal requirements. At the time of its bankruptcy, metal prices are significantly higher thus making the forward a highly valuable estate asset, and potentially making its reorganization more likely. Not so; upon bankruptcy the seller can terminate the forward allowing it to obtain market prices for the metal. If, however, at the time of bankruptcy metal prices are lower than the contract price, the non-debtor counterparty has the option not to terminate the forward, and file rejection damage claim should the debtor decide to reject the forward. As this example makes clear, only the non-debtor counterparty obtains the upside of a derivative in a bankruptcy, not the debtor.
... Now assume, however, that the debtor in the example above is a major corporation with tens of thousands of employees, tens of billions of dollars in debt securities outstanding, millions of public shareholders including pension funds and billions of dollars of notional amount of derivatives -- will the application of the safe harbor provisions in such a case serve to protect financial markets from systemic risk or stress them even further? Time will tell.
Vasser points out that the "safe harbor" provisions for derivatives in the bankruptcy code will result in a bankrupt firm being stripped by counterparties of its hedges and thus preclude a Chapter 11 reorganization of the firm. The fact that a financial firm will be forced to declare Chapter 7 bankruptcy (that is to liquidate) is common knowledge. What is not common knowledge is the fact that stripping a financial firm of all its hedges before liquidation is very likely to leave the firm with almost no value for bondholders to recover.
Thus, the derivative related revisions to the bankruptcy code of 1982, 1984, 1990 and their final apotheosis in 2005 created a huge class of secured creditors which has priority in bankruptcy over unsecured creditors (i.e. bondholders). Effectively bonds in financial institutions (and other firms with significant derivative exposure) were converted by revisions to the bankruptcy law into a senior form of equity. When this fact is fully understood, it is very likely financial firms will no longer be able to raise money on commercial paper and bond markets.
In short, those who argue that the government needs to take action X, Y or Z in order for financial firms to fund themselves on private capital or debt markets are ignoring the underlying problem. Until the special privileges granted to over the counter derivatives contracts are repealed by Congress, there is no reason to believe that financial firms will ever be able to raise money on capital or debt markets again in the absence of a government guarantee – for the simple reason that once derivative counterparties are done with a bankrupt financial firm there is not likely to be much left for residual claimants.
This is the true lesson to be drawn from the failure of Lehman Brothers and the constant refrain “No More Lehmans”: It may be time to repeal some of the special privileges granted to over the counter derivatives in the 1982, 1984, 1990 and 2005 bankruptcy law amendments.
No comments:
Post a Comment