The derivatives market's payment priorities as financial crisis accelerator

Stanford Law Review

Volumn 63, Issue 3, 2011, Pages 539-590

  Roe, Mark J ^a  

^a HARVARD LAW SCHOOL   (United States)

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EID: 79953041216     PISSN: 00389765     EISSN: None     Source Type: Journal    
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References (130)

1. Compare Thomas Ferguson & Robert Johnson, The God that Failed: Free Market Fundamentalism and the Lehman Bankruptcy, 7 ECONOMISTS' VOICE 1, 5 (2010), with John H. Cochrane & Luigi Zingales, Lehman and the Financial Crisis, WALL ST. J., Sept. 15, 2009, at A21.
2. Alan Greenspan, Chairman, Fed. Reserve Bd., Remarks at the 2003 Conference on Bank Structure and Competition (May 8, 2003) (transcript available at http://www.federalreserve.gov/boarddocs/speeches/2003/20030508/default.h tm); see Benjamin M. Friedman, Two Roads to Our Financial Catastrophe, N.Y. REV. BOOKS, Apr. 29, 2010, at 27
3. ALAN GREENSPAN, THE AGE OF TURBULENCE 257 (2008).
4. See The Bear Stearns Cos., Quarterly Report (Form 10-Q), at 5 (Apr. 14, 2008) [hereinafter Bear Stearns Form 10-Q], available at http://www.sec.gov/Archives/edgar/data/ 777001/000091412108000345/be12550652-10q.txt.
5. For total repo, see Figure 2 and supporting sources. For total insured deposits, see FDIC, STATISTICS AT A GLANCE (2007), available at http://www.fdic.gov/bank/statistical/ stats/2007jun/FDIC.pdf.
6. INT'L SWAP & DERIVATIVES ASS'N, ISDA MARKET SURVEY (2010) [hereinafter 2010 ISDA MARKET SURVEY], available at http://www.isda.org/statistics/pdf/ISDA-Market -Survey-annual-data.pdf; INT'L SWAPS & DERIVATIVES ASS'N, ISDA MARGIN SURVEY 2009, at 3 (2009), available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf. In an interest rate swap, one party trades a floating interest rate for a fixed rate on, say, $100 million of debt that neither party has borrowed or lent. The $100 million "notional" amount is often reported as the transaction's size. At year-end 2008, that notional amount totaled $400 trillion. But it is the smaller interest payment obligation that is being swapped, with the collateral transferred even smaller. That lower collateral amount goes into the text's still-big $4 trillion number.
7. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., FLOW OF FUNDS ACCOUNTS OF THE UNITED STATES 9 (2010), available at http://federalreserve.gov/releases/z1/20100917/ z1.pdf (growth in private business debt); 2010 ISDA MARKET SURVEY, supra note 6 (growth in derivatives).
8. See 11 U.S.C. § 362(d) (2006) (automatic stay); id. § 547 (requiring return of preferences); id. § 362(a)(7) (setoffs); id. § 548 (fraudulent conveyance liability for mismatched consideration); id. §§ 365, 541(c)(1) (debtor's contract right is property of the estate); id. § 365(e)(1) (providing for unenforceability of ipso facto clauses that make the debtor's bankruptcy a default under its contract). Bankruptcy aficionados will see exceptions and qualifications, such as the need for secured-creditor "adequate protection" and the multiple steps for preference recovery. For textual brevity, I state the general rules summarily.
9. See id. §§ 362(b)(17), 362(b)(27), 560 (derivatives and repo players' ability to liquidate collateral in their possession); id. § 546(g), (j) (exemption from preference rules); id. §§ 553(a), 560 (wider option to set off); id. § 546(g), (j) (exemption from constructive fraudulent conveyance liability); id. §§ 555, 559-561 (ability to terminate repos, swaps, and master netting agreements); id. (exemption from debtor's typical § 365 option to affirm or reject). These apply in both Chapter 7 liquidations and Chapter 11 reorganizations. Not all of these favorable rules are unwise. Most, though, are too broad. See Part III.B.2 on the cutback's appropriate scope. Termination rights are quite valuable when the counterparty is secured. In that situation, the counterparty can take advantage of two derivatives exemptions from the Code, by terminating the contract and then seizing the security to satisfy any damages that the bankrupt owes it upon termination. Other creditors can neither terminate the contract nor seize the security. Two-thirds of the derivatives contracts were collateralized (that is, secured) in 2007. René M. Stulz, Financial Derivatives: Lessons from the Subprime Crisis, MILKEN INST. REV., First Quarter 2009, at 58, 65.
10. See infra Part II.C.
11. For example, there may be reason to make some basic rules more creditor friendly than they now are (I offer no view on that here), but there is little reason and much cost to doing so only for one favored group of creditors and not for others.
12. E.g., WILLIAM D. COHAN, HOUSE OF CARDS (2009); LAWRENCE G. MCDONALD WITH PATRICK ROBINSON, A COLOSSAL FAILURE OF COMMON SENSE (2009); HENRY M. PAULSON, JR., ON THE BRINK (2010); GILLIAN TETT, FOOL'S GOLD (2009).
13. See COMM. ON CAPITAL MKTS. REGULATION, THE GLOBAL FINANCIAL CRISIS (2009), available at http://www.capmktsreg.org/pdfs/TGFC-CCMR_Report_%285-26-09% 29.pdf; Ross Levine, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, 2 J. FIN. ECON. POL'Y 196 (2010); Jonathan C. Lipson, Enron Rerun: The Credit Crisis in Three Easy Pieces, in LESSONS FROM THE FINANCIAL CRISIS 43 (Robert W. Kolb ed., 2010); Michael Simkovic, Secret Liens and the Financial Crisis of 2008, 83 AM. BANKR. L.J. 253 (2009).
14. See Matthew Philips, The Monster That Ate Wall Street, NEWSWEEK, Oct. 6, 2008, at 46; Ben Levisohn, AIG's CDS Hoard: The Great Unraveling, BUSINESSWEEK (Apr. 6, 2009), http://www.businessweek.com/bwdaily/dnflash/content/apr2009/db2009044_48 8554.htm.
15. Serena Ng & Carrick Mollenkamp, Goldman Fueled AIG Gambles, WALL ST. J., Dec. 12, 2009, at B1. The AIG executive had left AIG before its mortgage-backed purchases began in earnest. Id.
16. See OFFICE OF THE SPECIAL INSPECTOR GEN. FOR THE TROUBLED ASSET RELIEF PROGRAM, FACTORS AFFECTING EFFORTS TO LIMIT PAYMENTS TO AIG COUNTERPARTIES 16- 17 (2009), available at http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_ to_Limit_Payments_to_AIG_Counterparties.pdf. But see Carrick Mollenkamp & Serena Ng, Report Rebuts Goldman's Claim on AIG, WALL ST. J., Nov. 18, 2009, at C1 (stating that Goldman's collateral would not have fully protected the firm from AIG's collapse). Other explanations are possible. Goldman might have not understood the risk early enough. Credit agencies, for example, were late in downgrading AIG.
17. Henny Sender, AIG Saga Shows Dangers of Credit Default Swaps, FIN. TIMES (London), Mar. 6, 2009, http://www.ft.com/cms/aa741ba8-0a7e-11de-95ed-0000779fd2ac .html.
18. See René M. Stulz, Credit Default Swaps and the Credit Crisis, 24 J. ECON. PERSP. 73, 83 (2010).
19. See Gretchen Morgenson & Louise Story, Testy Conflict with Goldman Helped Push A.I.G. to Precipice, N.Y. TIMES, Feb. 7, 2010, at A1.
20. See id. If ordinary preference law applied, the eve-of-bankruptcy collateral postings could have been attacked in a bankruptcy. (The relevant AIG affiliate, if in bankruptcy, could have pursued a separate contract claim if Goldman breached the contract it had with AIG via refusing to return an overposting.) Goldman insisted that it was well protected without the government's eventual $85 billion bailout of AIG. Uninvestigated is whether this self-protection claim could have been made accurately without the Code's derivatives exceptions for repayments that otherwise would have been voidable preferences. AIG's credit default swap business was largely run through a London subsidiary. In an AIG bankruptcy, presumably the United Kingdom's substantially similar priority rules would have applied. (Bankruptcy in the United Kingdom is liquidation oriented. American bankruptcy is, derivatives excepted, reorganization oriented.)
21. COHAN, supra note 12, at 5. Short-term financing can make all those concerned more alert. But that does not justify subsidy via favored bankruptcy status.
22. See Bear Stearns Form 10-Q, supra note 4, at 5. While this is the number reported in the media, Bear's net repo position is more relevant, as it also bought securities subject to sale back. Its net position parallels its liability position alone. When it failed, its net repo position was nearly 20% of total liabilities and six times its equity.
23. When Bear failed, it had been using nonprime collateral for its repo contracts. It lost access to repo financing when the market would only take government securities for repos. See Peter Hördahl & Michael R. King, Developments in Repo Markets During the Financial Turmoil, BIS Q. REV., Dec. 2008, at 37, 46. Prior to the 2005 Code amendments, only repos of treasuries and similar securities explicitly had superpriority.
24. Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007- 2008, 23 J. ECON. PERSP. 77, 80 (2009).
25. Ordinary creditors, even secured creditors, can be called on to turn over property needed by the estate to reorganize. See 11 U.S.C. §§ 541-542 (2006); United States v. Whiting Pools, Inc., 462 U.S. 198 (1983). They may be protected in Code terms, but creditors frequently think they are not made financially whole.
26. And Bear's counterparties revalued Bear subprime collateral just before Bear failed. See Jason Hsu & Max Moroz, Shadow Banks and the Financial Crisis of 2007-2008, in THE BANKING CRISIS HANDBOOK 39, 49 (Greg N. Gregoriou ed., 2010).
27. See Darrell Duffie, The Failure Mechanics of Dealer Banks, 24 J. ECON. PERSP. 51, 67-68 (2010); Susanne Craig & Robin Sidel, Crisis on Wall Street: J.P. Morgan Made Dual Cash Demands, WALL ST. J., Oct. 8, 2008, at C2; Iain Dey & Danny Fortson, JP Morgan 'Brought Down' Lehman Brothers, SUNDAY TIMES (London), Oct. 5, 2008, at 1; David Teather, Banking Crisis: Lehman Brothers: JP Morgan Accused over Bank's Downfall, GUARDIAN (London), Oct. 6, 2008, at 11.
28. See 11 U.S.C. §§ 361-362.
29. See id. §§ 362(b)(17), 362(b)(27), 560.
30. In early March 2010, the Lehman bankruptcy examiner filed a report analyzing the Code status of the transactions. Shortly after he filed the report, Lehman and J.P. Morgan settled claims from these transactions on terms favorable to J.P. Morgan. Lehman paid J.P. Morgan a cash settlement and J.P. Morgan returned some unused, unsold, difficult-to-value collateral. See Lehman Settles Collateral Claims with JPMorgan, DEALBOOK (Feb. 25, 2010), http://dealbook.nytimes.com/2010/02/25/lehman-settles-collateral-claims- with -jpmorgan; Linda Sandler, Lehman Brothers Examiner Files Sealed Report on Banks (Update2), BLOOMBERG (Feb. 9, 2010), http://www.bloomberg.com/apps/news?pid=20601103 &sid=awa8w7ZOIhbY#.
31. See 11 U.S.C. § 546(g), (j). A transfer for less than full value from a bankrupt in the two years before bankruptcy is prima facie a fraudulent conveyance, which the bankrupt estate can recover from the recipient.
32. The Reserve Fund could have faced problems just from the other creditors being secured, although the actual transfer sequence suggests a $5 billion eve-of-bankruptcy preference to J.P. Morgan that benefited from the derivatives' exemption from preference law.
33. See Press Release, The Reserve, A Statement Regarding the Primary Fund (Sept. 16, 2008), available at http://www.reservefunds.com/pdfs/Press%20Release%202008_0916 .pdf; see also Jeffrey N. Gordon & Christopher Muller, Confronting Financial Crisis: Dodd- Frank's Dangers and the Case for a Systemic Emergency Insurance Fund, 28 YALE J. ON REG. 151, 164, 181 n.80 (2011); Marcin Kacperczyk & Philipp Schnabl, When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007-2009, 24 J. ECON. PERSP. 29, 40-41 (2010).
34. See Press Release, U.S. Dep't of the Treasury, Treasury Announces Guaranty Program for Money Market Funds (Sept. 19, 2008), available at http://www.ustreas.gov/press/ releases/hp1147.html.
35. That is what Greenspan erroneously thought was happening in the derivatives and repo markets. See supra notes 2-3 and accompanying text.
36. See PHILIP MCBRIDE JOHNSON, DERIVATIVES: A MANAGER'S GUIDE TO THE WORLD'S MOST POWERFUL FINANCIAL INSTRUMENTS 47 (1999). Johnson wrote as a derivatives lawyer and former chair of the Commodity Futures Trading Commission, the market's main regulator.
37. See id. at 49.
38. See id. at 115-16.
39. Michael Johannes & Suresh Sundaresan, The Impact of Collateralization on Swap Rates, 62 J. FIN. 383, 383 (2007); accord BRUCE TUCKMAN, FIXED INCOME SECURITIES: TOOLS FOR TODAY'S MARKETS 388-90 (2d ed. 2002).
40. See MICHAEL LEWIS, THE BIG SHORT 48 n., 49 (2010).
41. JOHNSON, supra note 36, at 56.
42. Modigliani and Miller showed that a firm's risks emanated from its underlying operations,
43. not from how it sliced up its capital structure, absent transaction costs and benefits. Here, the risk of counterparty failure emanates from the counterparty's underlying business; if one creditor bears less risk, another takes on more. See Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261 (1958).
44. Lehman Bros. Holdings Inc., Quarterly Report (Form 10-Q), at 24 (July 10, 2008) [hereinafter Lehman Form 10-Q], available at http://www.secinfo.com/d11MXs.t1C1k.htm #1stPage.
45. See INT'L MONETARY FUND ET AL., GUIDANCE TO ASSESS THE SYSTEMIC IMPORTANCE OF FINANCIAL INSTITUTIONS, MARKETS AND INSTRUMENTS 19-22 (2009), available at http://www.imf.org/external/np/g20/pdf/100109a.pdf. Lehman lost access to other financing sources as well, and the coup de grâce came when "its clearing bank, JPMorgan, cut its credit line." Id. at 19.
46. See Kacperczyk & Schnabl, supra note 33, at 36; Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market Before the 2010 Reforms 25, 37 (Fed. Reserve Bank of N.Y., Staff Report No. 477, 2010), available at http://www.ny.frb.org/ research/staff_reports/sr477.pdf.
47. On opacity, see Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1036 (2007); and Simkovic, supra note 13, at 271-75. Although better disclosure is the usual cure, the derivatives book may be inherently opaque. See Robert P. Bartlett, III, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis (Berkeley Cent. for Law, Bus. & the Econ., Paper No. 1585953, 2010), available at http://www.ssrn.com/abstract=1585953.
48. See Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 HARV. L. REV. 1151, 1187-89 (2010). The insurer would not reorganize under Chapter 11, but its holding company and affiliates typically would.
49. Commercial banks do not reorganize in Chapter 11, but their affiliates traditionally do. FDIC resolution procedures today would have treated the derivatives contracts of a failed Citibank similarly to the way they're treated for other counterparties under the Bankruptcy Code.
50. See supra Part II.A.4 (describing the quandary of the traditional lender).
51. See, e.g., Bear Stearns Form 10-Q, supra note 4, at 5; Lehman Form 10-Q, supra note 43, at 5.
52. "It is now much more common [post-Lehman], according to [the head of asset servicing at Société Générale Securities Services], for a specialist provider to monitor the collateral and provide full support to investors on the collateral process." Heather Dale, Institutions Focus on Counterparty Risk, FIN. TIMES (London), Oct. 17, 2010, http://www.ft.com/ cms/s/0/7853d582-d877-11df-8e05-00144feabdc0.html#axzz1EHxX6CSV.
53. OFFICE OF THE COMPTROLLER OF THE CURRENCY, OCC'S QUARTERLY REPORT ON BANK TRADING AND DERIVATIVES ACTIVITIES (2009), available at http://www.occ.gov/ topics/capital-markets/financial-markets/trading/derivatives/dq209.pdf.
54. See Bear Stearns Form 10-Q, supra note 4, at 5.
55. Because time is money, if the interest rate paid for the delay is not the market rate, the ordinary secured creditor is hurt. The Code requires that the court adequately protect the secured creditor, but what courts consider adequate, financial markets can consider inadequate. Bear is said to have used collateral of decreasing quality over time, starting with treasury securities and trading down to mortgage-backed securities, such as those famous from subprime lending. When the lower-quality securities were recognized as such, Bear's counterparties asked for higher-quality collateral, which Bear could only provide for a time.
56. A good way to handle the inevitable valuation problems for eve-of-bankruptcy collateral enhancements in the repo and derivatives markets is to analogize to inventory financing, which faces similar problems. The solution is to ignore changes in inventory levels in the ninety days prior to bankruptcy and to just assess whether the creditor was favored by an overall increase in inventory collateral over that period. See 11 U.S.C. § 547(c)(5) (2006); Thomas H. Jackson & David A. Skeel, Jr., Bankruptcy, Banks, and Non-Bank Financial Institutions (Feb. 8, 2010) (unpublished manuscript) (on file with author).
57. See Bear Stearns Form 10-Q, supra note 4, at 5; The Bear Stearns Cos., Annual Report (Form 10-K), at 181 (Sept. 28, 1994); THE BEAR STEARNS COS., 1989 SUMMARY ANNUAL REPORT 21 (1989). The numbers are net numbers, subtracting Bear's repo assets from its repo liabilities. One macro impact must be mentioned. Wall Street firms increasingly used mortgagebacked securities to back up their prioritized repos, especially after the 2005 Code amendments explicitly allowed them to do so and obtain the superpriorities. See Hördahl & King, supra note 23, at 37, 46. They were borrowing short term, often overnight, to finance what were, when one dug down deep enough, long-term, illiquid assets (housing and real estate). The Code thereby made it easier to borrow short term to invest long term, which is an unwise financial combination. When widespread, it makes the financial system riskier and potentially less liquid.
58. E.g., Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE J. ON REG. 91, 101 (2005); Partnoy & Skeel, supra note 46, at 1049; David A. Skeel, Jr., Bankruptcy Boundary Games, 4 BROOK. J. CORP. FIN. & COM. L. 1, 10-11 (2010).
59. A similar bankruptcy problem arises when higher-ranking creditors seek immediate repayment in ways that can stop an otherwise viable firm from reorganizing. See THOMAS H. JACKSON, THE LOGIC AND LIMITS OF BANKRUPTCY LAW 7-19, 125 (1986).
60. See Stephen J. Lubben, Repeal the Safe Harbors, 18 AM. BANKR. INST. L. REV. 319 (2010); see also Duffie, supra note 27, at 68-69; Stephen J. Lubben, Derivatives and Bankruptcy: The Flawed Case for Special Treatment, 12 U. PA. J. BUS. L. 61 (2009).
61. Edwards & Morrison, supra note 57, at 101; see also Partnoy & Skeel, supra note 46, at 1049.
62. See Stulz, supra note 9, at 64.
63. See JACKSON, supra note 58, at 125.
64. See Barry E. Adler, A Re-Examination of Near-Bankruptcy Investment Incentives, 62 U. CHI. L. REV. 575, 576 (1995).
65. And for traditional lenders, actively seeking preferential payment can shade into conduct that induces courts to equitably subordinate not just the preferred payment, but the entire loan. See In re Am. Lumber Co., 7 B.R. 519 (Bankr. D. Minn. 1979). Presumably derivatives players who position themselves to get the Code's benefits will not be subordinated for doing so. See In re Clark Pipe & Supply Co., 893 F.2d 693 (5th Cir. 1990); In re W.T. Grant Co., 699 F.2d 599, 610 (2d Cir. 1983).
66. See H.R. REP. NO. 109-31, pt. 1, at 20 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 105 ("These provisions are intended to reduce 'systemic risk' in the banking system and financial marketplace."); 128 CONG. REC. 15,981 (1982) (statement of Sen. Dole) ("It is essential that stockbrokers . . . be protected from the issuance of a court . . . order which would stay the prompt litigation of an insolvent's positions, because . . . the insolvency of one party could trigger a chain reaction of insolvencies . . . ."). Fear of contagion also motivated Congress to expand the safe harbors. See H.R. REP. NO. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583; 135 CONG. REC. S1414-15 (daily ed. Feb. 9, 1989) (statement of Sen. DeConcini); Philippe Jorion & Gaiyan Zhang, Credit Contagion from Counterparty Risk, 64 J. FIN. 2053 (2009).
67. Compare Letter from Paul A. Volcker, Chairman, Bd. of Governors of the Fed. Reserve Sys., to Senator Robert J. Dole, Chairman, Subcomm. on Courts, Comm. on the Judiciary (Sept. 29, 1982) (on file with author) (asserting that the automatic stay on repos would undermine systemic liquidity), with Letter from Roger W. Mehle, Assistant Sec'y of Domestic Fin., Dep't of the Treasury, to Senator Robert J. Dole (Mar. 16, 1983), available at http://www.sechistorical.org/collection/papers/1980/1982_0929_VolckerDol eT.pdf (stating to Congress that an automatic stay on repos posed no such threat).
68. Letter from Roger W. Mehle to Robert J. Dole, supra note 66.
69. See Edwards & Morrison, supra note 57, at 94; Squire, supra note 47, at 1200.
70. See GARY B. GORTON, SLAPPED BY THE INVISIBLE HAND 16-17, 48-49 (2010). For more on information contagion, see FRANKLIN ALLEN & DOUGLAS GALE, UNDERSTANDING FINANCIAL CRISES 260-95 (2007); Franklin Allen & Douglas Gale, Financial Contagion, 108 J. POL. ECON. 1 (2000); Brunnermeier, supra note 24; and Douglas W. Diamond & Raghuram G. Rajan, Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking, 109 J. POL. ECON. 287 (2001).
71. GORTON, supra note 69, at 51.
72. See Gary B. Gorton & Andrew Metrick, Securitized Banking and the Run on Repo (Yale Int'l Ctr. for Fin. Working Paper No. 09-14, 2010), available at http://www.ssrn.com/ abstract=1440752; Antoine Martin, David Skeie & Ernst-Ludwig von Thadden, Repo Runs (Eur. Banking Ctr., Discussion Paper No. 2010-13S, 2010), available at http://arno.uvt.nl/show.cgi?fid=103635; cf. Samuel G. Hanson, Anil K. Kashyap & Jeremy C. Stein, A Macroprudential Approach to Financial Regulation, 25 J. ECON. PERSP. 3, 6 (2011) ("[W]hen Bank A takes on more [short-term] debt, it does not account for the fact that by doing so, it degrades the collateral value of any assets it holds in common with another Bank B-since in a crisis state of the world, A's fire-selling of its assets lowers the liquidation value that B can realize for these same assets."). The Dodd-Frank rules do better than bankruptcy in reducing collateral contagion. They do allow a brief stay, of one business day. That will not reduce collateral contagion much in itself. But during that time, the banking authorities can transfer the failed firm's derivatives book elsewhere, thereby reducing rapid collateral liquidation.
73. See Edwards & Morrison, supra note 57, at 94; Squire, supra note 47, at 1200.
74. See supra Part II.A.2-4.
75. While the conventional wisdom was that credit derivatives were central in bringing down AIG and others, some analysts show the centrality of the riskiness of AIG's core portfolio. See Squire, supra note 47, at 1183-87, 1203-04; cf. Viral V. Acharya et al., Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007-2009, 4 FOUND. & TRENDS FIN. 247 (2009) (describing excessive risk taking in large financial institutions). This view would extend the monitoring story: superpriorities reduced the incentives to monitor counterparty risk, with that counterparty risk emanating from both the immediate derivatives trades and from the firm's overall portfolio.
76. Modigliani & Miller, supra note 42.
77. Alan Schwartz, Security Interests and Bankruptcy Priorities: A Review of Current Theories, 10 J. LEGAL STUD. 1, 1, 3, 7-8, 11 n.28 (1981). Schwartz indicates that a normative solution to the tort risk transfer mismatch is to make the tort claimants prior in payment to the previously benefited creditors. The analogue for derivatives and repos would be to make the United States senior in all settings.
78. See Lucian Ayre Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of
79. Secured Claims in Bankruptcy, 105 YALE L.J. 857 (1996).
80. On monitoring incentives and disincentives in general, compare Richard Squire, The
81. Case for Symmetry in Creditors' Rights, 118 YALE L.J. 806, 818-19 (2009), with Saul Levmore,
82. Monitors and Freeriders in Commercial and Corporate Settings, 92 YALE L.J. 49, 56
83. (1982).
84. See AM. BAR FOUND., COMMENTARIES ON INDENTURES 368-400 (1971)
85. See Chris Flood, Demand Rises for Collateral Solutions, FIN. TIMES (London), May 30, 2010, http://www.ft.com/cms/s/0/57ca84ee-6a83-11df-b282-00144feab49a.html# axzz1DmcmVSVD ("Rapid growth in the use of derivatives has been matched by a 'significant increase' in the demand for collateral management solutions, says Robert Coates of Viteos Fund Services. But the extreme volatility of asset prices during the financial crisis and heightened concerns about counterparty risk means collateral management has become an operationally intensive task . . . .")
86. Could disfavored counterparties grab collateral earlier and thereby put themselves outside the bankruptcy preference recovery period? Not really. While Goldman, if lacking a safe harbor, might try to grab collateral ninety-one days before it initially expects a bankruptcy, cf. supra text accompanying notes 15-19, it cannot assuredly keep it. If the debtor filed more quickly, or were forced to file, Goldman's prebankruptcy take would be recoverable for the benefit of the bankrupt's other creditors. The early seizing of collateral is typi fraucally a public event, warning other creditors, who can demand repayment or force an early bankruptcy. This turns the seizure of collateral into day seven before the debtor's bankruptcy instead of day ninety-one. Goldman (if it lost its favored status) would be advised that creditors would react thus to early seizure of collateral, and so would have less reason to seize an insolvent counterparty's collateral and more reason to seek a collective remedy among creditors. See JACKSON, supra note 58, at 7-19, 122-50. If the preference rules induce the creditor to act early when the debtor is solvent (when everyone can then be paid), they induce an efficient early restructuring before the debtor deteriorates. See George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CALIF. L. REV. 1073 (1995). Superpriorities undermine this beneficial impact
87. For banks-AIG, Bear, and Lehman were not banks-FDIC resolution can treat failed commercial banks' derivatives counterparties roughly as favorably as the Code does. See Michael H. Krimminger, Adjusting the Rules: What Bankruptcy Reform Will Mean for Financial Market Contracts, FDIC (Oct. 11, 2005), http://fdic.gov/bank/analytical/fyi/2005/ 101105fyi.html
88. See 11 U.S.C. § 546(e) (2006)
89. COHAN, supra note 12, at 30. As before, this is fair when the priority rule only affects the two immediate players. But the risks keep moving and eventually reach the United States. Cutting back setoff will not be transactionally easy. Parties can rewrite unrelated contracts into a single contract that blends otherwise unrelated bets into a single net amount due. To some extent, the standard master derivatives contract does this
90. The debtor's option also affected commercial lease markets. To reduce the debtor's optionality impact on lessors, Congress required that the debtor decide whether to assume or reject within 120 days of the filing of the bankruptcy petition. See H.R. REP. NO. 109-31, pt. 1, at 86 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 153. The time frame could be tighter for financial contracts
91. Thomas Jackson and David Skeel indicate that a properly drafted contract could readily reduce debtor cherry-picking under ordinary bankruptcy rules. Jackson & Skeel, supra note 55, at 36-37. The derivatives lobby's characterization of the threat may have been overblown
92. See CHARLES P. KINDLEBERGER & ROBERT Z. ALIBER, MANIAS, PANICS, AND CRASHES: A HISTORY OF FINANCIAL CRISES 20 (5th ed. 2005)
93. See Jeanne L. Schroeder, A Repo Opera: How Criimi Mae Got Repos Backwards, 76 AM. BANKR. L.J. 565, 567-68 (2002) ("[Prior to the 2005 amendments, a court's suggestion that repos might be recharacterized as secured loans] sent shockwaves through the financial industry . . . [because it placed] [b]illions of dollars in notional amounts of outstanding repos . . . in danger of being labeled as security interests . . . ."); Simkovic, supra note 13, at 282
94. Total financial sector debt was twenty times larger at the end of 2006 than it was in 1981, the first year available for repo data. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 7, at 9. But the repo market grew more, to more than fifty times its 1981 size. Much of the relatively greater growth was in the 2000-2007 period. Repo market information is from Statistical Supplement to the Federal Reserve Bulletin, BOARD GOVERNORS FED. RES. SYS., http://www.federalreserve.gov/pubs/supplement/default.htm (last updated Jan. 28, 2011) (data available in Table 1.43 of each month's bulletin); and U.S. Government Securities Dealers-Positions and Financing, FED. RES. ARCHIVAL SYS. FOR ECON. RES., http://fraser.stlouisfed.org/publications/frb/page/31488 (last visited Feb. 17, 2011). A slowing of repo growth in the 1980s is consistent with the view that court decisions unfavorable to priority affected the market, but this is hardly dispositive
95. Financial sector debt information is from BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 7, at 9. Repo market information is from Statistical Supplement to the Federal Reserve Bulletin, supra note 88; and U.S. Government Securities Dealers-Positions and Financing, supra note 88
96. Michael Mackenzie & Helen Thomas, Repo Dealers Fear Legislation Will Drain Liquidity, FIN. TIMES (London), Dec. 7, 2009, http://www.ft.com/cms/s/0/c26678c2-e35a -11de-8d36-00144feab49a.html#axzz153BhFB1C
97. Tom Braithwaite & Michael Mackenzie, Creditors to Foot Bill in U.S. Risk Regulation, FIN. TIMES (London), Dec. 2, 2009, http://www.ft.com/cms/s/0/558799be-df9c-11de -98ca-00144feab49a.html
98. Id note note note
99. Id note note.; accord Cheyenne Hopkins, Creditors Fear New Resolution Process, AM. BANKER, Dec. 7, 2009, at 1
100. David L. Mengle, Close-Out Netting and Risk Management in Over-the-Counter Derivatives 1 (June 1, 2010) (unpublished manuscript), available at http://www.ssrn.com/ abstract=1619480
101. See Gary Gorton & Andrew Metrick, Regulating the Shadow Banking System 3 (Oct. 18, 2010) (unpublished manuscript), available at http://www.ssrn.com/abstract= 1676947 ("[T]he bankruptcy 'safe harbor' for repo has been a crucial feature in the growth of shadow banking . . . .")
102. Mackenzie & Thomas, supra note 90
103. Braithwaite & Mackenzie, supra note 91 (omission in original). Ex post haircuts are not a good way to strengthen market discipline
104. In re Lombard-Wall Inc. v. Bankers Trust Co., 23 B.R. 165 (Bankr. S.D.N.Y. 1982)
105. See Kenneth D. Garbade, The Evolution of Repo Contracting Conventions in the 1980s, FRBNY ECON. POL'Y REV., May 2006, at 27, 35-37; Carolyn Sissoko, The Legal Foundations of Financial Collapse 5-6 (Oct. 6, 2009) (unpublished manuscript), available at http://www.ssrn.com/abstract=1525120. Of course, extracting a trend from one event, especially one corresponding to a weak economy, is an interpretive indication, not proof
106. See Jennifer S. Taub, A Whiff of Repo 105, BASELINE SCENARIO (Mar. 16, 2010), http://www.baselinescenario.com/2010/03/16/a-whiff-of-repo-105 (former Fidelity legal official tying priority structure to repo market growth)
107. Creditors often conclude that they are not getting full financial value, but the theory is clear: keep the asset in the firm, reorganize, and then pay the affected creditor in full
108. See Edwards & Morrison, supra note 57, at 114
109. See 11 U.S.C. § 364 (2006)
110. Cf. Mark Carey & René M. Stulz, Introduction to THE RISKS OF FINANCIAL INSTITUTIONS 1, 6 (Mark Carey & René M. Stulz eds., 2006) ("[R]isk management is uniquely important for financial institutions because, in contrast to firms in other industries, their liabilities are a source of wealth creation for their shareholders. For instance, a financial institution that writes long-dated derivatives would usually be shut out of the market if the credit rating of the vehicle it uses to write such derivatives fell below an A rating. . . . [A financial institution's] franchise value depends on the risk of its insolvency . . . .")
111. See sources cited supra note 71
112. Ben S. Bernanke, Chairman, Fed. Reserve Bd., Remarks to the Risk Transfer Mechanisms and Financial Stability Workshop (May 29, 2008) (transcript available at http://www.federalreserve.gov/newsevents/speech/bernanke20080513.htm)
113. Solely focusing on the safe harbor's extra benefits to the derivatives and repo players is itself not logically entailed here. If serious systemic costs emanated from ordinary treatment of derivatives, and did so without offsetting benefits, then the logic of incentives and systemic risk would point us to considering cutting back ordinary treatment
114. Cf. Morgan Ricks, Shadow Banking and Financial Regulation 1, 27 (Aug. 30, 2010) (unpublished manuscript), available at http://www.ssrn.com/paper=1571290
115. A special purpose vehicle is a separately incorporated firm, structured to be difficult to enter Chapter 11 (hence, they're often called "bankruptcy remote"), into which a firm moves assets for the purpose of financing itself
116. See Kenneth Ayotte & Stav Gaon, Asset-Backed Securities: Costs and Benefits of "Bankruptcy Remoteness," REV. FIN. STUD. (forthcoming) (manuscript at 1-2), available at http://rfs.oxfordjournals.org/content/early/2010/09/13/rfs.hhq059.full
117. Again, bankruptcy-remote affiliates are companies that hold the target assets and are kept separate from the core company. Even if the core company goes bankrupt, the affiliate should not. It would thereby pay its debts outside of the core firm's bankruptcy
118. See Wall Street Transparency & Accountability Act of 2010, S. 3217, 111th Cong. (as reported by S. Comm. on Agric., Nutrition, & Forestry, 2010), available at http://ag.senate.gov/site/legislation.html; Scott Patterson & Robin Sidel, Finance-Bill Proposal Worries Banks, WALL ST. J., Apr. 27, 2010, at A4; Edward Wyatt, Veto Threat Raised over Derivatives, N.Y. TIMES, Apr. 17, 2010, at B1 ("The measure would . . . require banks and Wall Street firms to spin off much of their derivatives operations into a separate subsidiary . . . . Financial institutions will fight that provision vigorously.")
119. A third and further analytic issue is the application of differing rules: the Federal Deposit Insurance Act applies to commercial banks, while the Code applies to investment banks. But the FDIC priority and safe harbor rules are analogous to the Code rules, as the derivatives industry sought and obtained parallel safe harbors in the Code and under banking regulation. Changes should occur in parallel fashion
120. See, e.g., Mark J. Roe, Chaos and Evolution in Law and Economics, 109 HARV. L. REV. 641, 652 (1996); Enrico Perotti & Paolo Volpin, Lobbying on Entry (Eur. Fin. Ass'n 2004 Maastricht Meetings, Paper No. 2277, 2004), available at http://www.ssrn.com/ abstract=558588
121. See Lucian Arye Bebchuk & Mark J. Roe, A Theory of Path Dependence in Corporate Ownership and Governance, 52 STAN. L. REV. 127 (1999)
122. Cf. A Financial Reform Reprieve, WALL ST. J., Mar. 12, 2010, at A18 (identifying companies such as Alcoa, Boeing, Caterpillar, Disney, and Procter & Gamble that lobbied to be exempt from derivatives regulation)
123. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111- 203, 124 Stat. 1376 (2010)
124. Whether it will succeed is disputed. See Nelson D. Schwartz & Eric Dash, Despite Reform, Banks Have Room for Risky Deals, N.Y. TIMES, Aug. 26, 2010, at A1 (describing loopholes)
125. See Dodd-Frank Act §§ 201-217, 124 Stat. at 1442-520 (to be codified at 12 U.S.C. §§ 5381-5394)
126. See Dodd-Frank Act § 210(b)(4)(B), 124 Stat. at 1477 (to be codified at 12 U.S.C. § 5390(b)(4)(B)). Dodd-Frank affirms the Federal Deposit Insurance Corporation's power to repudiate contracts, including derivatives contracts, as long as it does so in a reasonable period of time and pays damages
127. See Dodd-Frank Act § 725, 124 Stat. at 1685 (to be codified at 7 U.S.C. § 7a-1)
128. On Washington's postcrisis infatuation with clearinghouses, see COMM. ON CAPITAL MKTS. REGULATION, supra note 13, at iii-iv; U.S. DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM 7 (2009); Gary Gensler, How to Stop Another Derivatives Inferno, FIN. TIMES (London), Feb. 24, 2010, http://www.ft.com/cms/s/0/3b52b642-217c- 11df-830e-00144feab49a.html (chair of the derivatives market's primary regulator touting capital requirements, transparency, and clearinghouses); and Michael Mackenzie, Aline Van Duyn & Hal Weitzman, Derivatives Dealers Brace for Clearing Shake-Up, FIN. TIMES (London), July 13, 2010, http://www.ft.com/cms/s/0/019f8048-8e9a-11df-8a67-00144feab49a .html ("After Bear Stearns and then Lehman in 2008, clearing became a priority for regulators.")
129. See ROBERT E. LITAN, THE DERIVATIVES DEALERS' CLUB AND DERIVATIVES MARKETS REFORM 9, 11, 28-29 (2010), available at http://www.brookings.edu/~/media/ Files/rc/papers/2010/0407_derivatives_litan/0407_derivatives_litan.pdf
130. See Craig Pirrong, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty (Jan. 8, 2009) (unpublished manuscript), available at http://www.ssrn.com/abstract/paper= 1340660; see also Stulz, supra note 18, at 82, 88-89; Mark J. Roe, Derivatives Clearinghouses Are No Magic Bullet, WALL ST. J., May 6, 2010, at A19; Jeremy C. Kress, Credit Default Swap Clearinghouses and Systemic Risk (Apr. 3, 2010) (unpublished manuscript), available at http://ssrn.com/paper=1583912. The clearinghouse also does not address the knife's-edge financing issues for repos. (Repos do not go through a clearinghouse, although triparty repo, which inserts a dealer between buyer and seller, has similarities. See Garbade, supra note 99, at 38-39.) The clearinghouse, however, has one undiscussed systemic advantage if superpriorities persist. The superpriorities' wide setoff right supports a concentrated derivatives market, because concentrated counterparties with many offsetting trades between them better capture the value of extended setoff than do decentralized traders with many counterparties. See supra Part II.B.4. The clearinghouse internalizes this setoff advantage in the clearinghouse, allowing for smaller players to indirectly get some of the Code-bestowed setoff benefit. However, the clearinghouse may itself then also pick up much, or all, of the systemic toobig- to-fail quality now adhering to major derivatives players.