Repo Regret?

By Rohan Ganduri (Goizueta Business School, Emory University)

In April 2005 Congress expanded the range of bankruptcy safe-harbored repurchase agreements (repos) to include mortgage-related securities with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). The rationale behind this provision was to prevent a chain of failures among financial institutions by granting derivative counterparties an exemption to the automatic stay, thereby allowing them to close out their positions.

In “Repo Regret?” I show that there were unanticipated adverse consequences of BAPCPA, which exacerbated the growth of risky mortgage credit in the U.S. economy. BAPCPA affected the funding of non-bank mortgage originators, which fund their mortgage origination business primarily through short-term revolving lines of credit, typically secured by the originated mortgages. However, after BAPCPA, short-term secured loans were cloaked in repurchase agreement (repo) terms consistent with the bankruptcy code. This was because a repo lender has greater protection in bankruptcy, although a secured loan and a repo are economically equivalent.

Furthermore, safe harboring eliminated any long-term risk associated with a drop in the collateral’s value at liquidation. Lower exposure to the collateral’s risk drove down funding costs for non-bank originators and also reduced the incentives of short-term funding intermediaries to screen the mortgages that the non-banks placed as collateral to obtain funding. This increase in funding and lax screening led to the growth of risky mortgage credit.

Conferring seniority on derivative counterparties does not eliminate risk, however; it transfers the risk to other investors. In the case of BAPCPA and the mortgage market, the seniority accorded to repo lenders transferred the long-term credit risk associated with the holding of mortgage-related collateral entirely to the end mortgage-backed security (MBS) investors.

To the extent that greater defaults, due to increased origination of riskier mortgages, have externalities and spillover effects that cannot be internalized by the MBS investors by demanding higher yields, the cost of awarding seniority to derivative counterparties may outweigh its expected benefits.

The full article is available here.

For previous Roundtable posts on the safe harbors, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Janger & Pottow, “Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution“; and Lubben, “Lehman’s Derivatives Portfolio.”

We at the Bankruptcy Roundtable will take a break from posting this August and hope that you too will be able to get away from your desk at work. We’ll be back on September 5th.

Did Bankruptcy Reform Contribute to the Rise in Structured Finance?

By Kandarp Srinivasan

Financial contracts such as repurchase agreements (“repos”) have effective “super-priority” in a bankruptcy situation—they are safe harbored from the automatic stay provision. The common justification for this special treatment is the threat of cascade effects (systemic risk). The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) expanded safe harbor provisions for repos collateralized by mortgage-related securities.

This paper highlights an unintended consequence of preferential treatment: Safe harbor exemptions increased incentives for financial institutions to issue complex securitized products. From an economic standpoint, an increase in demand for collateral in repo markets can cause securitized products to become more attractive to issue (Gorton and Metrick (2012)). This theoretical premise has remained untested so far.

Using data from bank holding companies and underwriters of structured mortgage products, this paper finds an increase in mortgage securitization activity in years preceding the financial crisis. Hand-collected data on repo collateral in the tri-party repo market reveals underwriters of securitized products increased use of mortgage-backed repos in the quarters following the law change.

Understanding the securitization “flash flood” is important because regulatory responses during the financial crisis (for example, TARP) were primarily targeted at buying securitized assets. Yet, the Dodd-Frank Act directs little attention to repurchase markets (Acharya (2010)). If safe harbor contributed to the proliferation of securitized products, it renews the debate (Roe (2011), Duffie and Skeel (2012)) on the costs and benefits of preferential treatment of financial contracts in bankruptcy.

For the full article, please click here. The Roundtable has posted work on this topic previously. See Morrison, Roe, and Sontchi, “Rolling Back the Repo Safe Harbors.”

Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts

By Benjamin Iverson, Kellogg School of Management at Northwestern University

On average, total bankruptcy filings rise by 32% during economic recessions, leaving bankruptcy judges with far less time per case exactly when financial distress is worst.  The inflexible nature of the bankruptcy system coupled with the varying demands placed upon it, leads to the concern that time constraints might limit the effectiveness of bankruptcy when economic conditions deteriorate.

In my paper, “Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts,” I test whether Chapter 11 restructuring outcomes are affected by time constraints in busy bankruptcy courts.  Using the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005 as a shock that decreased caseloads dramatically, I show that as bankruptcy judges become busier they tend to allow more firms to reorganize and liquidate fewer firms.  I interpret this as evidence that busy bankruptcy judges defer to the debtor in possession more often, scrutinizing each case less and thereby allowing reorganization more often.  In addition, I find that firms that reorganize in busy courts tend to spend longer in bankruptcy, while firms that are dismissed from busy courts are more likely to re-file for bankruptcy within three years of their original filing.

Perhaps most striking, I also show that busy courts impose costs on local banks, which report higher charge-offs on business lending when caseload increases.  If time constraints create higher costs of financial distress, it appears that these costs are typically passed on to the creditors of the bankrupt firms in the form of higher losses on distressed loans.

The full-length article can be found here.