The first unregulated financial contract to be granted safe harbor was the repurchase agreement (or repo). Two parties enter into a repurchase agreement when a security is sold and simultaneously the parties agree to reverse the transaction at a specific future date and price. Thus, a repo transaction is comparable to a secured loan; in fact, repo contracts typically include a mark-to-market clause requiring additional margin if the value of the security falls below the value of the loan. On the other hand, the repo transaction is like a sale, because the buyer-lender has complete control over the collateral including the right to sell it on to somebody else: this process is called rehypothecation. The buyer-lender’s only obligation is to replace the rehypothecated collateral with an equivalent security by the date of the repurchase contract.
Repos were used by the New York Federal Reserve Bank starting in the early years of the 20th century and also by other firms that faced restrictions on secured lending. Since the 1950s the Federal Reserve used repurchase agreements as a principal tool when implementing monetary policy. For this reason, the repo market was a crucial concern of the Fed.
The private sector repo market did not grow large until the 1970s when short-term interest rates rose to unprecedented levels. This phenomenon drove firms and local governments – which often were not authorized to lend – to place funds in the repo market as way of earning interest income.[1] The use of repos by the private sector grew from $2.8 billion of outstanding repos in 1970 to $45 billion by 1979 to hundreds of billions in 1983.[2]
The problem with repos in the 70s and early 80s was that there was a strong likelihood that they would be considered secured loans under the terms of Article 9 of the Uniform Commercial Code, which applies to “any transaction (regardless of form) which is intended to create a security interest in personal property.”[3] If repos are secured loans, then in bankruptcy they are subject to the automatic stay: in other words, the counterparties to a bankrupt firm cannot dispose of the collateral they hold as it is the property of the bankrupt estate.
In 1982 when a small government securities dealer, Lombard Wall, declared bankruptcy, the bankruptcy judge found that Lombard Wall’s repo contracts were secured loans. While the status of repos had been uncertain before, market participants in the past had held out the hope that “friend of the court” briefs from the Federal Reserve and major investment banks would convince bankruptcy judges not to risk disrupting this huge market. Lombard Wall made it clear that some judges were not swayed by these arguments. Buyer-lenders in the repo market risked finding that collateral that had been pledged by a bankrupt firm had suddenly become a frozen asset, and, if the price of the collateral moved quickly, this illiquidity could lead to losses.[4] Lombard Wall, however, was a small affair and the collateral was released within days, so it did not involve significant losses.
Whether this ruling had any quantitative effect on the repo market is very difficult to determine, because it followed less than three months after the failure of Drysdale Government Securities – a large bankruptcy which made it clear that contemporary repo market practices could be gamed and which led to major changes in the market. Thus, while there is evidence that the rate of growth of the repo market slowed between June 1982 and May 1983,[5] it is not at all clear that this slowdown can be attributed to the Lombard-Wall ruling.
In the absence of safe harbor protections for repurchase agreements, buyer-lenders were exposed to more credit risk than they would be if they controlled the collateral free and clear. The repo dealers believed that the best solution to this state of affairs was for Congress to amend the Bankruptcy Code and expand the safe harbor provisions to repo contracts. In their pursuit of a legislative solution the dealers had an impressive ally: the Federal Reserve.
In 1984 the repo amendment to the Bankruptcy Code was passed. The amendment applied only to the most common repurchase agreements, specifically those that were backed by Treasury and Agency securities, bank certificates of deposit and bankers’ acceptances. Repo traders were now permitted to seize collateral, liquidate it and net the proceeds against the bankrupt counterparty’s obligations without interference from a bankruptcy trustee, as long as the collateral fell into one of the protected categories.
Because the rules of repo were not established by a self-regulatory organization, the contractual rights that were exempt from bankruptcy had to be broader than those granted in 1982. Specifically the repo amendment states that it applies to contractual rights including any right “whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.”[6] Thus the 1984 law set a precedent for the expansion of safe harbor provisions to unregulated financial contracts.[7]
[1] Kenneth C. Kettering, March 2008, 29 Cardozo L. Rev. 1553 “Securitization and its discontents: the dynamics of financial product development”, p. 1640
[2] Norman Bowsher, “Repurchase Agreements,” Federal Reserve Bank of St Louis Review, Sept. 1979, p. 19 and for the 1983 data Kettering, 2008, note 287 quoting Peter Sternlight, Executive Vice President of the Federal Reserve Bank of New York statement for Bankruptcy Reform: Hearings Before the Senate Judiciary Comm., 98th Cong. 328 (1983).
[3] Jeanne Schroeder, “Repo Madness: The characterization of repurchase agreements under the bankruptcy code and the UCC,” 46 Syracuse Law Review, 1996, p. 1007.
[4] Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006
[5] Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006, p. 37. Raw data on repos is available here: http://fraser.stlouisfed.org/publications/frb/page/31488.
[6] Hance p. 743.
[7] Of course, the 1978 Bankruptcy Act also granted an unregulated market safe harbor, but forward contracts were exempt from regulation, because they were commercial — not financial — contracts. (Ramdhanie, p. 277).
Synthetic Assets 