Tuesday, April 13, 2010

Collateral and Derivatives

Original posted on Credit Slips by Stephen Lubben

One of the arguments I've been seeing a lot of lately is that industry X needs an exemption from the financial reform legislation, because the new requirements that most swaps be collateralized -- that is, backed up with collateral to support the "out of the money" party's ability to perform -- would drain capital out of said industry.

But never mentioned is the simple fact that many of these industries did not transact under derivative agreements until after the 2005 amendments to the Bankruptcy Code massively expanded the safe harbors that exempt derivatives from key provisions of the Code. After 2005, many ordinary commodity supply agreements suddenly became swaps. Warehouse loans to mortgage originators suddenly became repo agreements. The economic terms of the deals were essentially the same as before, but now the agreements were exempt from the automatic stay and the normal rule that you can't terminate a contract simply because the other side is in bankruptcy.

So I suspect that many of these industries that claim that they would be hurt by having so much money tied up in posted collateral could easily avoid this fate by simply returning to normal, non-derivative contracts. But then they'd have to give up their special bankruptcy exemption . . . of course, they shouldn't have that in the first place.

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