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E-MailMark Roe is a professor at Harvard Law School, where he teaches bankruptcy and corporate law.
Stanford Law Review recently published my article, The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator, in which I analyze the Bankruptcy Code’s role in undermining the stability of systemically-vital financial institutions.
Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors’ cash demands shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties, who, unlike most other secured creditors, can seize and immediately liquidate collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor them over the bankrupt’s other creditors.
The derivatives and repo players’ right to jump to the head of the bankruptcy repayment line, in ways that even ordinary secured creditors cannot, weakens their incentives for market discipline in managing their dealings with the debtor because the rules reduce their concern for the risk of counterparty failure and bankruptcy. If derivatives counterparties and financial repurchase creditors, who are treated similarly well in bankruptcy, were made to account better for counterparty risk, they would be more likely to insist that there be stronger counterparties on the other side of their derivatives bets, thereby insisting for their own good on strengthening the financial system. They would ration their use of such financial contracts, if they weren’t prioritized.
True, because derivatives counterparties bear less risk, nonprioritized creditors bear more and those nonprioritized creditors thus have more market-discipline incentives to assure themselves that the debtor is a safe bet. But the derivatives markets’ other creditors—such as the United States—are poorly positioned either to consistently monitor the derivatives debtors well or to fully replicate the needed market discipline. Bankruptcy policy should harness private incentives for counterparty market discipline by cutting back the extensive advantages Chapter 11 and related laws now bestow on these investment channels.
More generally, when we subsidize derivatives and similar financial activity via bankruptcy benefits unavailable to other creditors, we get more of the activity than we otherwise would. Repeal would induce these burgeoning financial markets to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG-, Bear Stearns-, or Lehman Brothers-style financial meltdown, thereby helping to maintain systemic financial stability. Repeal would end the de facto bankruptcy subsidy of these financing channels. Yet the Dodd-Frank financial reform package Congress enacted in response to the financial crisis lacks the needed changes.
The complete paper is available here.
4 Comments
Great article exposing what a rigged game it really is. Why is their legislation granting certain creditors advantage over others? Politicking thats how. All these laws, most obscure, are all about directing protection to certain industries or business groups. You all know why.
Sounds like a very good idea. Deritives were definitely a big factor in the financial crisis, so why do they continue to receive special treatment. They should have no higher priority than other secured creditors, like bondholders, and those with accounts payable.
Typical of Dodd/Frank that they pass a whole bunch of new regs, like the controls on credit cards and payday lenders, that had nothing to do with the financial crisis, but do nothing about primary causes, like derivitives, Fannie Mae, and the community redevelopment act.
Good article that makes a very strong point of why derivative counterparties have less incentive to monitor their dealings with the debtor or their financial situation of the debtor. But I would say that overall creditors have done a poor job in monitoring their dealings with debtors. I believe it is a systematic problem and although derivative counterparties may have less incentives overall, in general creditors overall did a poor job of monitoring their deals with the debtors.
Very insightful. I don’t believe there’s a rational basis to allow such bankruptcy preferences and if such checks and balances were implemented we would have definitely prevented this past financial crisis which has led to so many bankruptcies, whether individual or corporate.