The Reasoning Behind the Safe Harbor Protections #1-6

In every case when a law was passed granting derivatives safe harbor from the Bankruptcy Code, the stated goal of the law was to protect the financial system from systemic risk.  The basic concern is that when collateral is locked up in a bankruptcy court, it cannot be sold.  This generates a major problem for financial firms, because the collateral pledged in derivatives contracts is not held in trust, but is treated as the temporary property of the recipient.[1] The recipient has the right to lend or sell the collateral and the obligation to replace the item with its equivalent.  Thus in financial markets collateral is a liquid asset.   For this reason the firm with a claim on collateral that is tied up in bankruptcy court will face not only the market risk that the collateral falls in value before it is sold, but also a decline in liquid assets while the collateral is tied up in bankruptcy.  The decline in liquid assets can cause a counterparty to be unable to pay its bills and thus the first bankruptcy may cause one or more subsequent bankruptcies.  Furthermore, there is some possibility that the decline in value of collateral while it is tied up in bankruptcy could cause losses that would bankrupt a firm.  In short, there is concern that standard bankruptcy procedure can cause a chain of failures in derivative and repo markets.

To understand why the repo amendment was passed in 1984, recall that in the early 1980s the banking system was not in robust health:  the high short-term interest rates of the previous years had decimated bank profitability, competition with new financial products like money market funds and junk bonds further reduced profits and the Latin American debt crisis left some of the largest banks with crippling losses.  Under the circumstances the Fed had a strong interest in avoiding any further stresses on the system.

Repurchase agreements were an important tool used by the banks to adjust to the new competitive environment where funds that had once flowed directly into bank deposits were going to money market funds instead.  One of the ways that the banks dealt with the funding drain was by borrowing from money market funds using repos.  Another was by issuing term deposits in the form of Certificates of Deposit (CDs).  Money market funds and firms that had tied their cash up at a bank for six months in a CD could have immediate access to the funds by using the CD as collateral in a repo.  Finally some of the larger banks earned fee income by acting as dealers in the repo market.  In short, in the absence of a growing market in repurchase agreements, the banks would have found it far more difficult to adapt to the challenge of competing with money market funds for deposits.

Thus constraining the growth of the repo trade in its early years would have undermined bank profitability at a time when banks needed profits to restore their financial health.  There was genuine concern that if a bankruptcy as large as Drysdale’s locked repo collateral up for weeks, some of the smaller dealers could be driven into default by the resulting liquidity squeeze. This could lock yet more collateral up in bankruptcy and the whole process could only hurt the banking system.  For these reasons, the Fed was the most influential advocate of safe harbor for repurchase agreements.

During the hearings on the repo amendment in 1983, an assistant secretary of the Treasury brought up the fact that safe harbor privileges are in conflict with a fundamental principle of bankruptcy law, that creditors be treated equally.[2] This concern was outweighed by Fed Chairman Paul Volcker’s testimony that the bankruptcy protections were necessary because the repo market was a critically important financial market which could be destabilized by a string of failures.[3] Volcker emphasized the importance of limiting the repo protections to those segments of the repo market that were large enough to be systemically important.[4] Thus, in 1984 a conscious decision was made to generate an injustice in the interests of protecting the greater good.  A factor that was, perhaps, overlooked at the time was that this decision set a precedent.  We find that these difficult issues are rarely raised in subsequent discussions of the bankruptcy exemptions.

While derivatives contracts also face the market and liquidity risk created by having collateral tied up in bankruptcy, the strongest argument in favor of special treatment for derivatives is that clearly defined netting procedures protect against systemic risk.  Under normal bankruptcy procedures, in theory, a judge could permit a receiver to look at the list of recent contracts between the bankrupt firm and a counterparty and choose to avoid all of the contracts on which the firm owes money and not those where the counterparty owes money.  In short, rather than netting the contracts an attempt could theoretically be made in bankruptcy to force a counterparty to honor all of its gross obligations.  Such an outcome would be highly likely to result in a chain of failures.  Thus, there can be little doubt that precise, legally enforceable netting procedures are essential to financial markets.  What is not clear, however, is that such clearly defined netting must take place beyond the supervision of a bankruptcy court.  If there is a defined procedure that every bankruptcy judge must approve, the solvent counterparty will be able to reliably calculate net exposure and market and liquidity risk will only affect this net exposure.

Recent arguments in favor of exempting swaps and other derivatives from bankruptcy leave it  far from clear that the principal concern is really systemic risk – there is a tendency to emphasize the fact that safe harbor protects the dealers from losses due to credit and market risk.  For example, Michael Krimminger, Senior Policy Advisor to the FDIC, states that, while the effects of safe harbor on systemic risk are open to debate, the real advantage of these laws is that they make it easier for financial institutions to manage risk.

Congress, regulators, and market participants have been concerned that if parties to these contracts are unable to enforce their rights to terminate financial market contracts in a timely manner despite their counterparty’s insolvency, to offset or net payment and other claims under the contracts, and to use pledged collateral to cover any amounts due, the resulting uncertainty and potential lack of liquidity could increase the risk of broader market disruption.

While these broader concerns can be debated, effective risk management of financial market contracts requires the ability to fix the credit and market risk through enforceable rights to terminate and net exposures at the time of insolvency. … [S]ince 1978 both the Bankruptcy Code and the FDI Act have gradually adopted broad protection for financial market contracts. Today the breadth of those protections provides confidence in market participants that their risk mitigation efforts can be successful to limit their risks even if insolvency of their trading partner occurs.[5]

This argument indicates that the sophisticated hedging strategies that are used by large financial institutions to manage risk would be rendered ineffective by having assets locked in bankruptcy proceedings (presumably because such hedging requires positions to be adjusted on a daily – or even hourly – basis).  On the other hand, it is not at all clear that making it easier for financial firms to manage risk is a legitimate purpose of the bankruptcy code.  After all easy risk management may induce firms to feel comfortable with lower levels of equity capital, thus reducing the firm’s ability to survive adverse events.  In short, easy risk management may increase rather than decrease systemic risk.

Further evidence that safe harbor exemptions are not really focused on protecting the economy from systemic risk is to be found in the President’s Working Group’s explanation of the exemptions:

[T]he U.S. Bankruptcy Code makes an exception to the automatic stay with respect to contractual rights to net and closeout positions in certain financial contracts in the event of default.… In the event of default, these rights, in general, contribute to the stability of markets as a whole by reducing the potential size of credit exposures and thus lowering the probability that the inability of one market participant to meet their obligations will cause others to be unable meet their obligations (i.e., domino effects). [6]

Here the regulators argue that every decrease in credit risk results in a decline in systemic risk.  It’s somewhat disturbing that there is no effort to focus on the larger participants in these markets or use other means to determine more precisely the characteristics of those losses that are likely to result in systemic risk.  After all it’s hard to believe that having a few contracts tied up in the bankruptcy of a trivial player in derivatives could result in a chain of failures – and yet current law grants counterparties to these transactions safe harbor.[7] Thus, the quote above implies that exemptions to the bankruptcy code are granted for the simple reason that they serve to protect financial institutions from losses due to credit risk.[8]

The regulators justify the bankruptcy exemptions by deploying an implicit model which posits a linear relationship between credit losses at financial institutions and systemic risk – without explaining the foundations of their belief in this relationship.  Edwards and Morrison conclude that this justification must be a red herring.[9] There is very little evidence that anyone was focusing his or her attention on the key questions:  What is the nature of systemic risk and how do we mitigate it?  Instead, the regulators simply assume that if they can keep the banks from experiencing losses, they will be addressing systemic risk.

This view is disturbing given the inequities created by the bankruptcy exemptions.  Neither Michael Krimminger nor the President’s Working Group on Financial Markets’ extensive analysis of the treatment of financial contracts in bankruptcy discusses explicitly the fact that safe harbor provisions grant financial institutions privileged treatment over other creditors.  This indicates that by 1999 when the Working Group’s report was published these privileges had become so established that they were the norm and that there was no longer any need to explain the injustices associated with them.

[1] To use technical language, the collateral can be rehypothecated.  In fact, this is true only of over-the-counter derivatives.  Collateral posted for exchange-traded derivatives is held in trust.

[2] Gary Walters, 1984, “Note: Repurchase Agreements and the Bankruptcy Code,” 52 Fordham Law Rev. p. 847.

[3] Gary Walters, 1984, “Note: Repurchase Agreements and the Bankruptcy Code,” 52 Fordham Law Rev. p. 847.

[4] Quoted in Kenneth Garbade, “The Evolution of Repo Contracting Conventions,” NYFRB Economic Policy Review, May 2006, p. 36.

[5] Michael Krimminger, 2006, “The evolution of US insolvency law for financial market contracts”

[6] President’s Working Group on Fin. Mkts., Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999), p. 19.  This source is referenced to below as PWG.

[7] Franklin Edwards and Edward Morrison (2004) “Derivatives and the Bankruptcy Code:  Why the Special Treatment?” Columbia Law and Economics Paper no. 258, p. 8.
Steven Lubben, 2008, “Derivatives and Bankruptcy: The Flawed Case for Special Treatment,” also struggles to understand the reasoning behind the breadth of the Bankruptcy Code’s exceptions for derivatives, although his focus is on the distinction between contracts used for speculation and those used for hedging. In his view in a typical Chapter 11 the exceptions “represent little more than a wealth transfer to the financial institutions that stand on the other side of these swaps.”

[8] Kenneth Kettering, 2008, “Securitization and its discontents,” Cardozo Law Review, p. 1651 makes the same point.

[9] Edwards and Morrison (2004), p. 4.


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