Abstract
Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties, who unlike most creditors, even most other secured creditors, can seize and immediately liquidate collateral, net out gains and losses, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor in ways that favor them over other creditors. Their right to jump to the head of the bankruptcy re-payment line, in ways that even ordinary secured creditors cannot, weakens their incentives for market discipline in managing their credits to the debtor; it reduces their concern for the risk of counterparty failure and bankruptcy, since they do well in any resulting bankruptcy. If they were made to account better for counterparty risk, they would be more likely to insist that there be stronger counterparties than otherwise on the other side of their derivatives bets, thereby insisting for their own good on strengthening the financial system. True, because they bear less risk, nonprioritized creditors bear more and thus have more incentive to monitor the debtor or to assure themselves that the debtor is a safe bet. But the repo and derivatives market’s other creditors - such as the United States of America - are poorly positioned contractually either to consistently monitor the derivatives debtors’ well or to fully replicate the needed market discipline. Bankruptcy policy should harness private incentives for counterparty market discipline by cutting back the extensive de facto priorities for these investment channels now embedded in chapter 11 and related laws. More generally, when we subsidize derivatives and repos activity via bankruptcy benefits not open to other creditors, we get more of the activity than we otherwise would. Repeal would induce the derivatives market to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG/Bear/Lehman financial meltdown, thereby helping to maintain financial stability. Repeal would lift the de facto bankruptcy subsidy. Yet the major financial reform package Congress just enacted lacked the needed cutbacks.
Highlights
Repeal would induce these burgeoning financial markets to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG, Bear Stearns, or Lehman Brothers-style financial meltdown, thereby helping to maintain systemic financial stability
Alan Greenspan, who chaired the Federal Reserve, extolled the derivatives players’ “strong incentives to monitor and control [counterparty risk] . . . . [P]rudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. . . . [P]rivate regulation generally is far better at constraining excessive risk-taking than is government regulation.”[2]. As late as 2008, Greenspan praised “counterparties’ surveillance” as “the first and most effective line of defense against fraud and insolvency.”
Their privileged capacity to jump the queue can induce a run on the failing financial institution, and such a run may have hit AIG, Bear Stearns, and Lehman, deepening and extending the recent financial crisis
Summary
This paper can be downloaded without charge from: The Harvard John M. Not so for the bankrupt’s derivatives counterparties, who, unlike most other secured creditors, can seize and immediately liquidate collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eveof-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor them over the bankrupt’s other creditors. Their right to jump to the head of the bankruptcy repayment line, in ways that even ordinary secured creditors cannot, weakens their incentives for market discipline in managing their dealings with the debtor because the rules reduce their concern for the risk of counterparty failure and bankruptcy. The major financial reform package Congress enacted in response to the financial crisis lacks the needed changes
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