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.

Rolling Back the Repo Safe Harbors

Authors: Edward R. Morrison, Mark J. Roe, and Hon. Christopher S. Sontchi

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Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to some creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007–2009, leading to a bailout of the repo market and the institutions supporting mortgage-backed securities. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed.

This article is forthcoming in The Business Lawyer, and a draft is available here.