Did Bankruptcy Reform Contribute to the Rise in Structured Finance?
by | posted in: Financial Firms and Safe Harbors | 0

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.”

Bankruptcy Code With No Repo Safe Harbor — An Evaluation
by | posted in: Financial Firms and Safe Harbors | 0

By Jeffrey Murphy and Lee Smith of Dentons

The ABI Reform Commission recommended that the safe harbors under Section 555 and 559 of the Code be revised to return to their pre-2005 contours and, specifically, that the safe harbors exclude mortgage warehousing, which is a short-term revolving credit facility extended by a financial institution to the loan originator. We believe that excluding mortgage warehousing transactions from the safe harbors will increase “contagion risk” and also reject the Commission’s assertion that mortgages, in comparison with other safe-harbored asset types, are “illiquid” investments based upon our experience with mortgage loan trading.  The largest banks, and ever increasingly, the largest investment funds, are major participants in the mortgage markets as originators, buyers, and market makers (the same cannot be said of, say, municipal bonds), and the financial crisis started with a subset of the mortgage markets: subprime mortgages.

We are not persuaded that repo financing contributed to the excesses of the credit boom of the mid-2000s, nor do we believe that the Bankruptcy Code safe harbors for the liquidation, termination or acceleration of repurchase agreements are to be indicted for causing “runs” on debtors that knowledgeable market actors will not restructure.  To the contrary, mortgage repos are a crucial component of healthy housing markets, and fairness requires that debtors relieved of their margin call obligations by a bankruptcy filing not have options to satisfy their obligations while the repo buyers are exposed to all the market risk.

For our full analysis of the ABI recommendation, please see here.

Rolling Back the Repo Safe Harbors
by | posted in: Financial Firms and Safe Harbors | 0

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

Morrison PicMarkRoeSontchi, Christopher resized_1

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.

Practitioners, Academics, and a Judge Testify about Safe Harbors before Congress
by | posted in: Financial Firms and Safe Harbors | 0

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.