The derivatives market's payment priorities as financial crisis accelerator.

• Author: Roe, Mark J.

INTRODUCTION I. CHAPTER 11 SUPERPRIORITIES FOR DERIVATIVES AND REPOS A. The Code B. The AIG, Bear, and Lehman Failures in Light of the Code 1. AIG 2. Bear Stearns 3. Lehman II. THE CORE BANKRUPTCY ISSUE: CODE-INDUCED DISINCENTIVES TO MARKET DISCIPLINE A. Incentives and Disincentives for Market Discipline 1. Counterparties often have needed skills, but limited incentives 2. Exposed creditors have incentives, but limited skills 3. The United States of America as missing creditor 4. The quandary of the bystander creditor B. The Code-Induced Weakening of Market-Discipline Mechanisms 1. Market discipline by counterparty monitoring 2. By raising prices 3. By dealing only with strong counterparties 4. By reducing exposure to a single counterparty 5. By substituting into stronger financing structures 6. By moving from overnight repos to longer-term financing 7. By setting better margin coverage, earlier 8. By discouraging knife's-edge, systemically dangerous financing C. Runs and Contagion 1. The analytic bidding to date 2. AIG: collateral calls, runs, and private lenders' refusal to lend 3. Credit contagion 4. Information contagion 5. Collateral contagion III. WHY CONTRACT CANNOT SOLVE COUNTERPARTY RISK A. Contractual Reaction and Its Limits 1. Financial covenants as partial solution 2. The necessary incompleteness of contract: the United States as de facto guarantor B. The Regulatory Reaction Needed 1. Reshaping the Bankruptcy Code's safe harbors 2. Justified exceptions for the derivatives and repo markets IV. COUNTERARGUMENTS FROM COUNTERPARTIES A. Would Repeal Change Derivatives Market Incentives? B. The Unnecessary Asset? C. Financial Necessity: Are Derivatives and Repos Like Banking? D. Preserving Priority E. Transition F. Extent V. WHAT THE DODD-FRANK FINANCIAL REFORMS DO AND FAIL TO DO A. Dodd-Frank: Nothing on Bankruptcy Superpriorities B. A Derivatives Exchange: Many Eggs, One Basket CONCLUSION INTRODUCTION

The AIG, Bear Stearns, and Lehman Brothers failures were at the heart of the 2008-2009 financial crisis and economic downturn. Some said their failures sparked a financial panic, others that it exacerbated the downturn. Some said their failures transmitted financial troubles emanating elsewhere in the economy in a way that brought the underlying economic damage to a head. (1) Here, I show that the Bankruptcy Code's favored treatment of these firms' massive derivatives and financial repurchase (repo) contracts facilitated the firms' failures, by undermining market discipline in those markets in the years before these firms failed.

The Bankruptcy Code did so by sapping the failed firms' counterparties' incentives to account well for counterparty risk--the risk that their financial trading partner would fail (as AIG, Bear, and Lehman eventually did). Policymakers at the highest levels expected private monitoring to substitute for public monitoring, perhaps unaware that bankruptcy rules reduced those private incentives. Alan Greenspan, who chaired the Federal Reserve, extolled the derivatives players' "strong incentives to monitor and control [counterparty risk].... [P]rudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities.... [P]rivate regulation generally is far better at constraining excessive risk-taking than is government regulation." (2) As late as 2008, Greenspan praised "counterparties' surveillance" as "the first and most effective line of defense against fraud and insolvency." "JPMorgan," he said, "thoroughly scrutinizes the balance sheet of Merrill Lynch before it lends. It does not look to the Securities and Exchange Commission to verify Merrill's solvency." (3)

We now know that such scrutiny was not thorough. Worse, in the end, the financial sector relied on the government for far more than verifying counterparty solvency, obtaining the Federal Reserve's and U.S. Treasury's cash to bail out the seriously insolvent.

I show here that bankruptcy priority perniciously weakens market discipline in the derivatives and repo markets because the stronger counterparties know that they often enough will be paid even if their derivatives or repo counterparty fails. Were the Bankruptcy Code superpriorities not so broad, the failed firms' financial trading partners would have anticipated that they might not be paid if they had weak counterparties that failed. Understanding this, they would have been further incentivized to lower their exposure to a potential failure of Lehman, AIG, or Bear. Were the superpriorities not in the Code, each failed firm would itself have been incentivized to substitute away from their own risky, often overnight financing and toward a stronger balance sheet to better attract trading partners. Were the superpriorities not in the Code, the three firms' counterparties would have had reason to diversify away from some trades with the failed firms into trades with other financial firms. Were the superpriorities not in the Code, the extra risk borne by counterparties would be more accurately priced and, at the higher pricing, we'd have had less systemically risky activity. Together, those incentives to market discipline should have made each of these three firms less financially central and less interconnected. They would likely have had less superpriority debt. The financial system would have been more resilient.

These bankruptcy-based problems are not small. When Bear failed, a quarter of its ca4Pital came from the repo market via short-term, often overnight, borrowings. Without the Code's priorities, such a precarious capital structure would not have been viable. When AIG failed, its excessive credit default derivatives exposure destabilized it further. Without the Code's priorities for AIG's derivatives trading partners, such a precarious position for AIG would not have been so easily viable. Without the Code's priorities, AIG's counterparties would have had reason to worry earlier about AIG's potential to fail to make good on its derivatives obligations.

That is the downside of favoring the derivatives and repo markets in bankruptcy. But risk-free investments with a very high bankruptcy priority have major efficiency potential. Superpriority investment channels can lower information and negotiation costs for lenders and borrowers, facilitating financing flows that otherwise would not occur. Such efficient flows, if they could proceed without imposing costs on other parties or on the financial system and the economy, deserve a supportive legal framework. The problem, though, is that the major superpriority vehicles come packaged with systemically dangerous consequences, because systemically central institutions disproportionately use the bankruptcy-safe package. And, while a low-risk channel is supported, some major part of that risk ends up borne by the United States as backer of major, too-big-to-fail financial institutions. If we could separate efficient flows from systemically dangerous flows--and then allow the first, while restricting the second--we could strengthen finance in two dimensions. But if we cannot separate the efficient from the dangerous, we need to choose. Given our recent experience, the best policy choice with the information at hand is to strengthen the system in the critical dimension of systemic stability. To do so, we need to sharply cut back the priority package.

Overall, these are not just local financial structures that failed: When the financial crisis began in June 2007, we had $2.5 trillion in overnight repos, while the aggregate insured bank deposits in the United States were not even twice that. (5) The overall derivatives market was backed by $4 trillion of collateral in December 2008, and just one type of derivatives market--the interest rate swap, explained below--grew to more than $400 trillion. (6)

Figure 1 illustrates the market's explosive growth in the dozen years preceding the financial crisis. In 1994, the private business debt and interest rate derivatives markets were about the same size, at $13 trillion for the former and $11 trillion for the latter. In the subsequent fifteen years, the business debt market tripled to $34 trillion, while the interest rate derivatives market increased nearly fortyfold to $430 trillion. Combine the overnight repo market with the collateralized portion of the derivatives market, and we have a financial market bigger than the government-insured banking system. If there's a failure in these markets, the initial governing rules come from the Bankruptcy Code.

[FIGURE 1 OMITTED] (7)

A roadmap for this Article: In Part I, I describe the counterparties' Code-based advantages. Although several are conceptually sound in that the Code accommodates potentially useful financial channels, most go beyond wise bankruptcy and financial policy. Several otherwise-sensible local accommodations become unsound public policy when we account for the potential systemic damage they entail.

In Part II, I show how the Code's advantages sap counterparties' incentives for market discipline when dealing with the weak debtor. The Code thereby discourages financial resiliency. Understanding how this happens adds to important prior work on the derivatives priorities. Prior work focused on the problem of financial contagion and a bank-run-style collapse of a derivatives-heavy entity, with the Code priorities facilitating a run and collapse.

Run analysis is important, and I analyze it further. But, regardless of run and contagion analysis, I seek to shift policymakers' focus from the moment just prior to the institution's collapse to the months and years well before collapse. Better bankruptcy law could create better incentives than it does now for counterparties to more efficiently structure their trillion-dollar derivatives and repo books so as to avoid an eventual counterparty collapse, rather than to mitigate the consequences of an actual collapse. This...