As economists, financiers, journalists and many others struggle to understand the financial crisis with which the 21st century opened, derivatives inevitably enter the conversation. Unfortunately derivatives – especially those that are traded only through dealers on what are called “over the counter” markets – are not well understood outside the financial industry. Perhaps, the fact that regulators and legislators permitted the development of markets that they did not understand is an important cause of the crisis.
Starting in the early 80s, the financial industry lobbied aggressively for legislation that favored youthful markets in repurchase agreements and derivatives. Initially the industry was supported by the Federal Reserve, because the financial system was already fragile and there was genuine concern that losses in these new markets could be destabilizing. In later years, the industry was careful to frame its requests for special privileges under the law in the same terms: the stability of the financial system could only be ensured if these privileges were granted. Neither regulators nor legislators were willing to challenge the expertise of the financiers.
In 1984, in 1990 and in 2005 Congress passed laws exempting certain financial contracts from the standard provisions of the bankruptcy code. In each case, the effect of the law was to protect collateral securing the contract from those provisions of the bankruptcy code that allow a judge to review the claims of secured creditors and to protect the interests of other creditors whenever necessary. By granting derivative counterparties special treatment under the law, these exceptions guarantee that no contract is more secure than a repurchase agreement or an over the counter derivative – this guarantee comes at the expense of other secured creditors and bondholders. In short, in modern bankruptcies, there is one class of claimant that doesn’t even need to show up in court to prove its claim – the counterparties to collateralized derivative contracts.
The introduction of inequitable treatment into the bankruptcy code would be acceptable, if in fact the financial contract exemptions worked to protect the stability of the financial system. Recent experience indicates, however, that the special treatment granted to repurchase agreements and over the counter derivatives tends to reduce the stability of the financial system by encouraging collateralized interbank lending and discouraging careful analysis of the credit risk of counterparties. The bankruptcy exemptions also increase the risk that creditors will run on a financial firm and bankrupt it. Thus, the bankruptcy code has been rewritten to favor financial firms and this revision of the law has had a profoundly destabilizing effect on the financial system.
Introduction to the Bankruptcy Code
The Bankruptcy Code is designed to distribute the assets of a firm that cannot meet all of its obligations as equitably as possible across the firm’s creditors. Thus, as soon as a firm files for bankruptcy, creditors are prohibited from collecting on the firm’s debts, and recent payments made by the firm may be recalled by the trustee of the estate. The principle is that the trustee needs to take the time to realize the value of the firm’s assets and evaluate the full extent of creditor claims. Only after the trustee has the whole picture of assets and liabilities can the bankrupt estate be distributed fairly to creditors. Because payments made just prior to bankruptcy can potentially have the effect of favoring one creditor over another, the trustee has broad powers to void such transactions.
The prohibition against collecting on a bankrupt firm’s debts is called the automatic stay. The trustee’s power to cancel recent transactions is called avoidance. Prior to the special exemptions enacted by Congress over the counter derivatives were subject to the same treatment in bankruptcy as all other contracts. The automatic stay ensured that netting of offsetting derivatives and termination of derivatives could only take place after receiving the approval of the bankruptcy court. Furthermore, collateral that had been posted against derivative contracts over the last 90 days was subject to avoidance – and could thus be reclaimed as the property of the estate. Collateral that had been posted over the previous year could be avoided if the transaction had an adverse effect on the equitable distribution of the estate.
In general, the purpose of the bankruptcy exemptions enacted by Congress was to ensure that participants in the markets for over the counter derivatives and repurchase agreements were not subject to the automatic stay or to the avoidance powers of the trustee. The bankruptcy exemptions guarantee that over the counter derivatives and repurchase agreements can be netted and terminated instantly when bankruptcy is declared. Any collateral can be seized and sold, free and clear of encumbrances. Effectively under current law once collateral is posted against a derivative or repurchase agreement, it cannot be touched by a bankruptcy trustee – unless the recipient of the collateral was aware that the transfer was fraudulent.
Before examining the effects of these changes to the bankruptcy code, we will outline the history of the changes and then analyze why the exemptions were put in place. Understanding the reasoning behind these bankruptcy provisions is essential to any discussion of the role that derivatives and repo markets played in destabilizing the financial system.
 There were exceptions amongst the regulators, such as Brooksley Born. They were, however, unsuccessful in their endeavors.