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E-MailMark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an article co-authored by Professor Roe, Ed Morrison, Professor of Law at Columbia Law School, and Bankruptcy Judge Christopher Sontchi for the District of Delaware. All three are members of the Advisory Committee on Derivatives, Financial Contracts and Safe Harbors, which is working with the ABI Commission to Study the Reform of Chapter 11. The article was presented at the Federal Reserve’s recent conference on Wholesale Funding Markets.
Ed Morrison, Judge Christopher Sontchi and I recently posted to SSRN our article recommending a major narrowing of the repo safe harbors, after presenting it at the Federal Reserve’s recent conference on Wholesale Funding Markets in which the Boston Fed president warned of the dangers in the repo market. Overall, we conclude that the Bankruptcy Code has aggressively and unwisely sought to regulate market liquidity and systemic risk, with the Code’s “safe harbors” from the normal bankruptcy machinery largely backfiring during the financial crisis. The sounder policy would be to limit the repo safe harbors to U.S. Treasury repos and repos of similarly liquid government securities.
During recent decades, the so-called safe harbors from the Bankruptcy Code’s normal operation for repurchase agreements have substantially expanded. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to favored creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007–2009. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed. These safe harbors for financial contracts exist for one articulated purpose: to promote stability in financial markets.
Yet there is no evidence that they serve this purpose. Instead, considerable evidence shows that, when they matter most—in a financial crisis—the safe harbors exacerbate the crisis, weaken critical financial institutions, destabilize financial markets, and then prove costly to the real economy. Worse, the best available evidence also shows that the safe harbors distort the capital structure decisions of financial firms by subsidizing runnable short-term financing at the expense of other, safer debt channels, including longer-term financing. When financial firms favor volatile short-term over more stable long-term debt, they (and markets generally) are more likely to experience a “run” in the event of a market shock, such as the downturn in housing prices during the most recent recession.
The Bankruptcy Code is an unsuitable means to regulate financial markets and systemic risk. Other institutions—the Federal Reserve and Treasury—are better suited for this task. The Bankruptcy Code should therefore be returned to about where it stood in 1984: safe harbors should exist only for agreements involving United States Treasury securities and several other, highly-liquid assets that are unlikely to lose value in a crisis, such as other securities backed by the government’s full faith and credit). Safe harbors for these repos can be justified on grounds that have nothing to do with systemic risk management and they are at base sufficiently liquid and likely to retain fundamental value in a crisis that they pose no real systemic risk. For all other repos, such as mortgage-backed repos, the core rationale for safe harboring them—reducing systemic risk—lacks foundation. Their safe harbor should therefore be eliminated and they should be returned to ordinary bankruptcy practice.
We focus here in this Article on the safe harbors for repurchase agreements (“repos”)—even though the protections for swaps and other financial contracts should be narrowed as well—because the safe harbors for a wide array of repos are the most dangerous to financial stability. We are not the first to make this point and two of us have written on the topic and with a similar conclusion previously. In this paper we aggregate and evaluate the existing evidence, sharpen arguments made by prior scholars (including ourselves) and regulators, and examine the counter-arguments that proponents of the safe harbors commonly make.
The fundamental problem is this: The repo safe harbors exacerbated the financial crisis of 2007-2009 by encouraging the use of short-term repo financing by major American financial firms. The bulk of repo volume is overnight and the vast majority has a maturity of less than three months. This expansion of repo led that market to use securities that could not, and did not, retain their value in the crisis, thereby worsening the crisis and weakening financial firms and markets. The broad expansion of short-term repo, particularly repos of mortgage-backed securities, made major American financial firms more sensitive to financial shocks, more sensitive to disruption in the housing market, and more likely to propagate those shocks through the financial system via rapid close-outs, such as those that induced massive government backing of the financial system in 2007–2009. That government backing included a guarantee of the money market industry after the Reserve Primary Fund broke the buck in the wake of Lehman’s failure, the rescue of AIG after the Lehman failure, the bailout of government Agencies—Fannie Mae and Freddie Mae—that issue widely-repo’ed securities, and the Federal Reserve’s Primary Dealer Credit Facility—sized in the tens of billions of dollars—to support the repo market. This wide and deep governmental support makes clear that, although it is often mistakenly thought (particularly by industry representatives) that the safe harbors mitigate systemic risk, the reality is that the safe harbors both (1) make too many core financial institutions more fragile, by facilitating their relying on short-term debt that is unstable in a crisis and (2) shift the epicenter of systemic risk to other sectors of the financial market, particularly after the government buttresses the safe-harbored market.
Today, proponents of the current safe harbors sometimes argue that regulators are bringing systemic risks under control, thanks to various federal and international regulatory changes. But if systemic risks are being brought under control, what then remains of the original rationale for the safe harbors? Either systemic risk still matters in bankruptcy, or it does not. If systemic risk is relevant (as we conclude it may be), the evidence indicates that the safe harbors exacerbated systemic disturbance during the financial crisis. If systemic risk is not relevant (as proponents of the safe harbors sometimes assert), then bankruptcy should return to first principles, without the deep carve-outs (beyond U.S. Treasury securities) from the automatic stay, preference law, fraudulent conveyance law, and the limitation on ipso facto clauses.
Hence, we recommend scaling back the repo safe harbor to approximately the 1984 scope for “repurchase agreements”, namely, safe harboring only repos on U.S. Treasury and Agency securities backed by the government’s full faith and credit, certificates of deposits, and bankers acceptances. This proposal is consonant with recommendations from leading economists and legal scholars and federal regulators. The Bankruptcy Code’s safe harbors for other financial contracts should be narrowed as well, to ensure that the other safe harbors do not provide end-runs around the narrowed scope of the repo safe harbors. Equally importantly, the Bankruptcy Code’s rules governing adequate protection, setoff rights, and assumption and rejection of executory contracts should be modified to protect contracting parties better in general and to better protect financial contract counterparties in particular. The latter often face substantially greater costs from the bankruptcy process than other creditors and nonfinancial counterparties. Indeed, these costs are a driver of demand for safe-harbored financial contracts. Reducing these costs will reduce the demand for financial instruments that short-circuit the bankruptcy code.
Although we address only the Bankruptcy Code in this Article, its logic would support comparably narrowing the safe harbors in other federal statutes—e.g., the Federal Deposit Insurance Act and the Dodd-Frank Act.
The full article is available for download here.
