Creditor rights, collateral reuse, and credit supply

Brittany Lewis is an Assistant Professor of Finance at Olin Business School, Washington University in St. Louis. This post is based on her recent article forthcoming in the Journal of Financial Economics.

According to Griffin, Kruger, and Maturana (JFE, 2021), “ten years after the financial crisis, the central question of what explains the rise and fall in house prices remains unresolved.” In “Creditor Rights, Collateral Reuse, and Credit Supply” (JFE, 2024), I seek to address this central question by critically analyzing the contribution of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) 2005 in the build up to and unfolding of the Global Financial Crisis (GFC) of 2008.

In addressing this question, the paper combines micro hand-collected data, an innovative research design, and a quasi-random experiment. The research design causally links BAPCPA to an expansion of credit supply that directly funded the mortgages most exposed to default in the GFC.  BAPCPA expanded the sale and repurchase, or “repo,” market’s “safe harbors” in the Bankruptcy Code to include mortgages loans, mortgage related securities and interest on mortgage loans and mortgage related securities. This change granted mortgage collateral preferred bankruptcy treatment and only affected private-label or risky mortgage collateral, since agency mortgage collateral had been granted this status in 1984.

The paper documents that Congress’s strengthening of creditor rights for private-label mortgages created a money multiplier in the repo market. This repo money multiplier expanded credit supply first in the repo market and then ultimately in the housing market. The paper illustrates how this legal change first increased large systemic dealers’ leverage in the form of short-term runnable collateral on both dealers’ asset and liability side of their balance sheets. It then documents that large dealer-banks – for example Credit Suisse, Lehman Brothers, and Bear Stearns – passed the resulting credit supply increase on to mortgage companies. I estimate that the mortgages originated as a result of BAPCPA accounted for a 9.1% increase in mortgage originations and made up 38% of defaults among all mortgages originated during 2005-2006. The paper provides insight into how the legal change led to an increase in dealer-bank leverage by allowing them to repledge collateral. The legal change also deteriorated the collateral quality and set the stage for repo runs via cross default clauses in the repo contracts.

The paper is directly related to Morrison, Roe, and Sontchi (2014), Duffie and Skeel (2012), and Bebchuk (2002). Morrison et al argue that the BAPCPA 2005 Bankruptcy Code’s repo safe harbors aggressively and unwisely sought to regulate market liquidity and systemic risk. They state that the Bankruptcy Code should be returned to where it stood in 1984, a change which has not yet been made. The paper states that while the safe harbors exist for one articulated purpose: to promote stability in financial markets, there is little evidence that they serve this purpose. Duffie and Skeel propose four risks associated with granting repo collateral preferred bankruptcy status: lowering repo lenders’ incentive to monitor collateral; increasing their ability to become too interlinked to fail; increasing inefficient substitution toward short-term repo funding; and increasing risk of fire sales. Bebchuk shows that the structure of bankruptcy proceedings has ex-ante effects on the leverage and risk that firms take on.

These papers make the prescient point that assigning assets priority in bankruptcy can incentivize agents to take excessive risk, build up systemic positions, and facilitate bank runs. However, they lack the micro-level empirical data to systematically document the role that a change in bankruptcy safe harbors played in the lead up to the GFC. My paper provides the first direct causal empirical evidence that the repo safe harbors in BAPCPA led to a massive increase in credit supply and set the stage for the four risks proposed by Duffie and Skeel: decreasing the quality of underlying mortgage collateral, increasing dealer-bank interlinkages, increasing the use of short-term repo debt, and increasing the risk of fire sales.

I trace the transmission of the credit increase caused by BAPCPA, using micro level data, through the mortgage lending sector and ultimately to households. I thus provide clean evidence that the warnings that Morrison, Roe, and Sontchi and Duffie and Skeep were in fact warranted: changing the bankruptcy law indeed increased credit supply in the economy, which was funded by short-term runnable repo contracts. My paper illustrates that the bankruptcy law change increased leverage and interconnections between systemic financial intermediaries by allowing large dealer-banks to repledge repo collateral. I explain that since BAPCPA affected private-label (rather than agency) mortgage collateral and since the repo contracts all carried cross default clauses, the policy change set the stage for the price of the underlying collateral to plumet when cross default clauses were called. This is because the bankruptcy law change led to a buildup of repo positions, which were written to include cross default clauses. These cross default clauses allowed systemic players to liquidate their positions en masse when one counterparty missed a margin call. As we saw in the GFC, this led private-label mortgage-backed securities’ (MBS) market prices to fall much more than agency MBS, which received government backing.

Thus, my paper provides an important link between the expansion of repo safe harbors in 2005 and the increasing financial fragility leading up to the GFC. It documents that important legal consequences of the bankruptcy law change were borne out in financial markets and illustrates how these consequences set the stage for the Global Financial Crisis. My paper also supports Morrison, Roe, Sontchi’s policy implication that before repo contracts are granted “safe harbor” in the future, the underlying asset’s ability to maintain its price in a crisis should be a major consideration. It is important to understand the role that BAPCPA played in increasing the fragility of the financial system prior to the GFE to understand which factors are and are not at play, and thus the proper policy response, in current bank runs such as the one on SVB in early 2023.

Congress expanded the bankruptcy code to include additional repo safe harbors in 1984 and 2005. If Congress voted to expand repo safe harbors to additional collateral classes such as Commercial Real Estate or Collateralized Loan Obligations for example, my paper illustrates the mechanisms through which we should expect to see a similar build up in credit and deterioration in lending in these asset classes. These outcomes would unfold in a similar way to what we experienced during the GFC in the repo and housing market.

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