Thursday, March 18, 2010

Bankruptcy's Financial Crisis Accelerator: The Derivatives Players' Priorities in Chapter 11

By Mark J. Roe:

Abstract: Chapter 11 bars bankrupts from immediately repaying their creditors, so that the court can reorganize the debtor without creditors shredding the bankrupt firm’s business. Not so for the bankrupt’s derivatives counterparties, who can seize and 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 repayment line, ahead of even ordinary secured creditors, warps their pre-bankruptcy incentives both to monitor the pre-bankruptcy debtor and to adjust their investments to better account for counterparty risk, since they do well in any resulting bankruptcy. If they bear less risk, other creditors bear more risk and have more incentives to monitor the debtor or to assure themselves that the debtor is a safe bet. But the other creditors — such as the United States of America — are poorly positioned to provide that monitoring. Moreover, the policy justification for the super-priorities — reducing financial contagion risk — is difficult to maintain today: contagion is as likely to be propagated by the priorities as it is to be stifled, the priorities did not prevent contagion in the 2007-2008 financial melt-down and may have spread it, and we use alternate resolution mechanisms anyway for systemically vital failing financial institutions. Bankruptcy policy was made in the erroneous belief that it could contain contagion and that there was no other way to do so. The best regulatory reaction to these monitoring and regulatory disconnects is for Congress to cut back the extensive de facto priorities embedded now in chapter 11 for these derivatives counterparties. 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 melt-down, thereby helping to maintain financial stability. Yet the major financial reform packages now in Congress do not contemplate the needed cutbacks.

Download paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1567075

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