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.

Financial Scholars Submit Letter to Congress Opposing Repeal of Title II

On May 23, bankruptcy and financial scholars submitted a letter to members of Congress opposing the Financial CHOICE Act’s proposed replacement of the Dodd-Frank Act’s Orderly Liquidation Authority (“OLA”) with a new subchapter of the Bankruptcy Code as the exclusive method for resolving failed financial institutions. Like the Financial Institution Bankruptcy Act (“FIBA”), which passed the House earlier this year, the CHOICE Act would add a subchapter V to chapter 11, amending the Bankruptcy Code to facilitate a single point of entry (“SPOE”) resolution strategy for financial institutions. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, making subchapter V the only method for resolving a large, failed financial institution.

The letter noted that a bankruptcy proceeding could provide a useful addition to the financial crisis toolbox but expressed several concerns about FIBA’s capacity to deal effectively with an economy-wide financial crisis. For example, the bankruptcy court’s lack of familiarity with failed institutions could undermine the chances of success for the lightning-fast, 48-hour bankruptcy proceedings envisioned in proposed subchapter V. In contrast, in a proceeding under the OLA, the FDIC would have in-depth knowledge of the financial institution’s operations based on the “living wills” resolution planning process. Moreover, the SPOE resolution strategy at the heart of proposed subchapter V requires a specific kind of capital structure; regulators can verify that this structure is in place in advance, but the bankruptcy courts cannot. In addition, the letter voiced concerns about the lack of international coordination for a subchapter V proceeding, the absence of assured liquidity facilities in bankruptcy, and the general inability of bankruptcy courts to provide a coordinated response to the simultaneous failure of several financial institutions. Based on these weaknesses, the letter emphasized the need to retain the OLA as a backstop for resolving financial institutions in the event of a large-scale economic crisis, as well as the need to plan in advance for a subchapter V SPOE-style bankruptcy.

The letter also enumerated concerns specific to subchapter V itself as included in both FIBA and the Financial CHOICE Act. First, the letter pointed to FIBA’s weakness in giving financial institutions and their executives exclusive control over the initiation of the bankruptcy proceeding. Second, it noted that subchapter V does not provide a backup plan for a resolution that fails to be completed within 48 hours. Finally, it emphasized that existing limits on bankruptcy courts’ legal authority could result in challenges to any proceeding under subchapter V, potentially undermining its efficacy by creating uncertainty.

The full letter is available here.

(By Rebecca F. Green, Harvard Law School, J.D. 2017.)

For previous posts on this topic, see “White House Releases Memorandum on Orderly Liquidation Authority“; Jackson & Massman, “The Resolution of Distressed Financial Conglomerates“; and “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”

Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution

By Edward J. Janger (Brooklyn Law School) and John A.E. Pottow (University of Michigan Law School)

Financial contracts, such as swaps, repos, and options, are excepted from the Bankruptcy Code’s automatic stay by so-called “derivative safe harbors.” The Lehman Brothers bankruptcy provides a graphic illustration of how this device makes it almost impossible for non-bank financial firms, or other firms with significant derivative exposure, to restructure in chapter 11. Without a stay, non-debtor counterparties may run for the exits by exercising early termination rights, demanding payment, and offsetting obligations, thereby draining assets from the struggling debtor in a destructive rush.

The resolution regime for banks takes a different approach. It imposes a short stay on financial contract termination to permit the orderly transfer of a failed bank’s derivative portfolio intact to a solvent bank. This approach has been used for decades to preserve the value of financial contracts and to minimize the systemic disruption occasioned by bank failures. It has been extended contractually to cover many non-bank SIFIs through the relatively recent ISDA Resolution Stay Protocol. There are, however, significant gaps in the contractual regime. Non-SIFI financial institutions are not covered, and neither are non-financial firms that may have significant derivatives exposure, and may also be systemically important.

Our article offers a road-map for translating and generalizing the “short-stay” regime used for banks into chapter 11. The key to this synthesis is the bankruptcy concept of “adequate assurance of future performance,” provided through a commonplace bankruptcy device—debtor-in-possession financing. This financing can backstop the debtor’s timely performance of its financial obligations. We note that our approach would facilitate use of the “Single Point of Entry” strategy for restructuring financial firms in bankruptcy. Our approach also would, we contend, bring greater stability to financial markets, preserve otherwise evaporating value for insolvent debtors with a significant book of derivatives, and ultimately make it possible for many more firms to restructure in bankruptcy.

The full article, published in 10 Brooklyn Journal of Corporate, Financial and Commercial Law 155 (2015), is available here.


This article was recently published in the Brooklyn Journal of Corporate, Financial and Commercial Law as part of a symposium volume entitled: The Treatment of Financial Contracts in Bankruptcy and Bank ResolutionThe volume includes papers by Riz Mokal, Anna Gelpern and Eric Gerding, Adam Levitin, and Irit Mevorach.

The Roundtable has also posted on this topic previously. See Morrison, Roe, and Sontchi, “Rolling Back the Repo Safe Harbors” and Murphy and Smith, “Bankruptcy Code with No Repo Safe Harbor—An Evaluation.”

Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?

Stephen J. Lubben

Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall University School of Law.

Clearinghouses reduce risk by acting as a central hub for trades. Each party to a trade faces only the risk of the clearinghouse’s non-performance, rather than the doubtlessly greater risk that the counterparty to the trade will fail to perform.

But the concentration of derivatives trades into a very small number of clearinghouses or central counterparties (CCPs) makes the clearinghouse’s own failure a matter of systemic concern. As such, the recovery and resolution of CCPs becomes vital in the post-crisis financial system.

Given that important context, I argue in my paper—recently published in the Virginia Law & Business Review—that the lack of any obvious resolution mechanism for clearinghouses represents a major flaw in the Dodd-Frank regulatory fabric.

I explain why Dodd-Frank’s new orderly liquidation authority was probably not intended to apply to clearinghouses and would provide little help in the case of a distressed CCP in any event. The Bankruptcy Code is equally unhelpful, in that clearinghouses are forced into Chapter 7 liquidation proceedings, and the “safe harbors” for derivative contracts would make such a filing an exercise in futility.

I also argue that the CCP’s own, internal resolution mechanisms will be unworkable in times of systemic crisis. Most clearinghouse rules state that upon exhaustion of their default fund and any assessment rights they have against members, all contracts will be closed and member positions netted. Given the concentration of certain trades in one or two clearinghouses, the sudden termination of more than half of the index CDS trades—to take but one example—could not help but have systemic effects.

In the paper, I propose that the government should nationalize the clearinghouses upon failure, and that the intention to do so should be made clear ex ante. That is, the government should expressly state clearinghouses that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with stronger incentives to oversee the clearinghouse’s management, and avoid such a fate.

In essence, what I propose is a system of precommitment or “structured bailouts.” Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and to facilitate an organized response in the event of an essential bailout.

Lehman’s Derivative Portfolio

By Stephen Lubben, Seton Hall University School of Law

Derivatives themselves were likely at most a secondary cause of the Lehman’s collapse, and played a more central role in other firms caught up in the financial crisis, like AIG. But the late Harvey Miller suggested that derivatives were responsible for a massive loss in value suffered by Lehman post-bankruptcy. Bryan P. Marsal, the Lehman estate administrator, likewise asserted that as much as $75 billion in value was destroyed, largely as a result of the sudden termination of Lehman’s derivatives book.

The singular losses caused by Lehman’s derivative portfolio to Lehman’s bankruptcy estate come from these safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future.

In particular, the largest part of Lehman’s derivative portfolio shows how financial institutions will suffer when resolution is attempted in the traditional bankruptcy system, despite the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”

And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, especially given Dodd-Frank’s strong preference for central clearing going forward.

My paper Lehman’s Derivative Portfolio, written as a chapter for a forthcoming book, looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

The Roundtable has previously posted multiple items on the derivatives safe harbors: on selling Lehman’s derivatives portfolio, systemic risk issues, the safe harbors’ history, two posts on the ISDA derivatives stay protocols (here and here), and on congressional testimony.

Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

By Mark J. Roe, Harvard Law School, and Stephen D. Adams, Ropes & Gray LLP

adams-stephen-200 Roe 124Lehman Brothers’ failure and bankruptcy led to the deepest part of the 2008 financial crisis. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules, such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost perhaps tens of billions of dollars of further value when its contracting counterparties terminated their financial contracts with Lehman.

Bankruptcy must be able to market salable parts of the failed institution’s financial contracts portfolio at other-than-fire-sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio intact (currently impossible in bankruptcy and only narrowly viable under Dodd-Frank) or allow for the liquidation of each contract, one-by-one (which worked poorly in Lehman). Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell along product lines a very large portfolio that is too large to sell intact.

Congress and the regulators favor bankruptcy for financial resolution. Yet, bankruptcy law has neither been fixed nor even updated here since the financial crisis. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of a Lehman-style close-out of each contract, one-by-one.

This article is forthcoming in 32 Yale Journal on Regulation. A full draft of the article can be found here.

For related pieces discussing safe harbors, see here and here.

Derivatives and Collateral: Balancing Remedies and Systemic Risk

By Steven L. Schwarcz, Duke University School of Law

schwarczProfessor Schwarcz examines whether the bankruptcy “safe harbor” for derivatives is necessary or even appropriate to protect against systemic risk—such protection being the safe harbor’s articulated justification. The article examines the most important function of the safe harbor: allowing derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property notwithstanding bankruptcy law’s stay of enforcement actions. A threshold question is whether there is anything inherently risky about derivatives that might cause a systemic failure.

The standard answer is volatility. But, the article observes, regulation could reduce that potential for systemic risk in a more limited fashion. The article next addresses the safe harbor from the standpoint of its impact on avoiding contagion. The safe harbor is supposed to enable large derivatives dealers to enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chance of collapse. There are, however, several flaws in the safe harbor’s design to accomplish that. First, the safe harbor incentivizes systemically risky market concentration by enabling dealers and other parties to virtually ignore counterparty risk. Second, the safe harbor operates independently of the size of the counterparty or its portfolio. The article then examines how the Lehman bankruptcy might inform the safe harbor debate. The article offers a final caution: To the extent the safe harbor might amplify, rather than protect against, systemic risk, its negative impact would transcend the traditional derivatives market.

The full version of this article is forthcoming from the University of Illinois Law Review and is available in draft form here.

Practitioners, Academics, and a Judge Testify about Safe Harbors before Congress

Author: Stephen D. Adams

The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.

This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.

Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter.  Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out.  Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.

Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008.  Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms.  Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.

The written testimonies are linked above, and the video of the oral testimonies for the March 26th hearing will be found here once it has been posted, and is here for the December 3rd hearing.

For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.

The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis

Authors: Steven L. Schwarcz and Ori Sharon

Bankruptcy law gives creditors in derivatives transactions a “safe harbor” in the form of special rights and immunities. In The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, available on SSRN here, we argue that this safe harbor grew incrementally from industry lobbying, without a rigorous vetting of its consequences. This type of legislative accretion is path dependent, in that its outcome is shaped by its historical path.

Path-dependent legislation is not necessarily bad; but if it’s not fully vetted, its significance and utility should not be taken for granted. For example, advocates of the safe harbor contend that the collapse of a highly connected derivatives counterparty might systemically disrupt the derivatives market, impacting the broader financial system. But there’s little evidence to support this.

Scholars also seriously question the safe harbor, estimating that the net exposure of the major derivatives dealers to their counterparties is small. They also argue that the safe harbor may not be focused on the right parties because it operates independently of the size of the counterparty and applies to non-financial firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, but an ordinary company can enforce its collateral against a bankrupt derivatives counterparty. The safe harbor is also overly broad, tempting parties to try to document ordinary financial transactions as derivatives transactions.

Because the derivatives safe harbor has important consequences for systemic risk, there should be a more fully informed discussion of its merits.

[Editor’s note: Please stay tuned for a special post later this week on hearings on bankruptcy reform, financial institution insolvency, and derivatives in front of the U.S. House of Representatives Subcommittee on Regulatory Reform, Commercial, and Antitrust Law.]

Lehman Bankruptcy Court Issues Safe Harbor Decision

Authors: Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, John Thompson

On December 19, 2013, Judge James M. Peck of the United States Bankruptcy Court for the Southern District of New York issued his latest decision in the Lehman Brothers cases addressing the scope of the safe harbor provisions of the Bankruptcy Code.  Michigan State Housing Development Authority v. Lehman Brothers Derivatives Products Inc. and Lehman Brothers Holdings Inc. (In re Lehman Brothers Holdings Inc.).  Judge Peck’s decision confirms that the contractual provisions specifying the method of calculating the settlement amount under a swap agreement are protected by the Bankruptcy Code’s safe harbors.  The decision follows the reasoning of the amicus brief filed by the International Swaps and Derivatives Association (“ISDA”), which was prepared by Cadwalader.  For a full discussion of the case and argument, please continue reading here.