Derivatives markets in bankruptcy.

Roe, Mark J.

INTRODUCTION

Chapter 11 of the Bankruptcy Code bars bankrupt debtors from immediately repaying most of their creditors, including their secured creditors, so that the bankrupt firm can reorganize without creditors forcing an otherwise viable business to liquidate. However, there are exceptions to Chapter 11's reorganization orientation, with one of the most important being that accorded to the bankrupt's derivatives and financial repurchase (known to all involved as 'repo') counterparties. They, unlike typical creditors, can seize and liquidate collateral, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, which other creditors would have to return to the bankrupt. The impact of this favorable treatment is to graft a fast liquidation-oriented system onto a traditionally reorganization-oriented Chapter 11, but only for repos and derivatives.

Derivatives' and repos' power under bankruptcy law to leap-frog other creditors, including other secured creditors, reduces their pre-bankruptcy incentives for market discipline in dealing with counterparties. Because the derivatives and repo players need not be as concerned about a counterparty's failure as with an ordinary debtor's failure, they have less incentive to ration their dealings with derivatives and repo debtors as carefully. If they were made to account for counterparty risk in ways similar to how most creditors must, they would be more likely to insist that there be stronger counterparties than otherwise on the other side of their derivatives bets and they would substitute at the margin away from short-term derivatives and repo financing into more stable financing, thereby insisting for their own good on strengthening the financial system. Without the strong bankruptcy protection they have for derivatives and repo contracts, they would substitute some of their investments away into alternatives. Bankruptcy rules thereby affect financial markets' stability and discipline. Here they do so unfavorably for financial stability, as they encourage more short-term financing than would otherwise be the case.

True, if derivatives and repo counterparties bear less risk, as they do, due to the Bankruptcy Code's favoritism, then other creditors that are poorly prioritized in relation to repos and derivatives bear more risk and thus have more incentive for market discipline. This is a basic application of the well-known Modigliani-Miller framework. But the other creditors--such as the United States of America as guarantor of too-big-to-fail institutions--are poorly positioned contractually to consistently anticipate problems and to react quickly and well when problems arise anyway. A worthwhile policy agenda to consider is for bankruptcy institutions to harness private incentives for market discipline by cutting back on the large advantages that Chapter 11 and related insolvency legislation, such as Dodd-Frank's resolution regime, bestow on these derivatives and repo investment channels.

When we subsidize derivatives and repo via bankruptcy benefits unavailable to other creditors, we get more of that subsidized activity than we otherwise would. Bringing these bankruptcy benefits back down toward the level accorded most creditors would induce the derivatives and repo markets to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG/Bear/Lehman financial meltdown, such as that which occurred in 2007 and 2008. American and worldwide financial stability would be enhanced. Moreover, quick liquidation by counterparties of an excessively large portion of a financial firm's portfolio, which the safe harbors allow, makes it harder to quickly reposition a weakened financial firm's divisions and product lines without large losses. Regulatory action could move the system in that direction, but has not yet strongly or persistently done so.

DERIVATIVES PRIORITIES AND THE FINANCIAL CRISIS

The AIG, Bear Stearns, and Lehman Brothers failures were at the heart of the 2008-2009 financial crisis and economic downturn. Some said their failure fueled a financial panic and exacerbated the consequent economic downturn. Some said they transmitted financial troubles emanating from elsewhere in the economy--largely in the subprime mortgage market--in a way that exacerbated financial damage. (2) Quite plausibly, the latter scenario was not peripheral, with financial weakness in the housing and mortgage markets then affecting financial institutions that, due to their derivatives and repo market exposures, were less able to sail through the financial storm than they otherwise would have been.

The Bankruptcy Code's favored treatment of these firms' massive derivatives and financial repurchase contracts facilitated these firms' failures by undermining market discipline in the derivatives and repurchase markets in the years before these firms failed. It 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, apparently unaware that bankruptcy rules reduced those private incentives. Alan Greenspan (2003), 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.... Private regulation generally has proved far better
 at constraining excessive risk-taking than has government
 regulation.

As late as 2008, Greenspan praised 'counterparties' surveillance' as 'the first and most effective line of defense against fraud and insolvency'. 'JP Morgan', he said, 'thoroughly scrutinizes the balance sheet of Merrill Lynch before it lends. It does not look to the SEC to verify Merrill's solvency' (Greenspan 2008, p. 257). It appears though that such scrutiny was less thorough than Greenspan expected and, in the end, the financial sector relied on the government for more than just verifying counterparty solvency, obtaining the Federal Reserve's and US Treasury's cash to bail out the seriously insolvent. An alternative view to Greenspan's is that bankruptcy priority discourages such counterparty surveillance in the derivatives and repo markets, because counterparties know that they typically will be paid even if their derivatives or repo counterparty fails. Greenspan's judgment that market discipline could help in these markets is appropriate, but the Code's priorities for derivatives and repo contracts disincentivize market discipline.

Were the Bankruptcy Code priorities narrower, the failed firms' financial trading partners would have anticipated that they might not be fully paid if weak counterparties failed. Understanding this--or more realistically, raising their estimate of the chance of bearing major losses if a counterparty failed--they would have been more incentivized to lower their exposure to a potential failure of Lehman, AIG, or Bear. Were these safe harbor priorities not in the Code, each failed firm would itself have been incentivized to substitute away from risky, often overnight, financing and toward a stronger balance sheet, to better attract trading partners. Were the priorities not in the Code, the three firms' counterparties would have had reason to substitute away from some trades with the failed firms, into trades with the next tier of financial firms. Together, those results would have made each of these three firms less financially central and less interconnected. They would likely have had less highly prioritized debt (that is paid before other creditors are paid). The financial system should accordingly have been more resilient.

These bankruptcy-based problems are not small. When Bear failed, a quarter of its capital came from the "repo" market via short-term, often overnight borrowings, amounting to eight times its capital at risk. (3) The proportion of its funding coming from short-term repo had been increasing in the years and decades before its failure. Without the Code's priorities, such a precarious capital structure would not have been viable. And, the failure of AIG was largely due to its excessive credit default derivatives exposure. Without the Code's priorities for AIG's derivatives-trading partners, such a precarious position for AIG would not have been so easily viable. They would have had reason to worry earlier about AIG's potential precariousness and potential to fail to make good on its derivatives obligations.

That is one major downside of favoring the derivatives and repo markets in bankruptcy. Another is the difficulty of repositioning the failed firm's portfolio when its counterparties can immediately liquidate parts of that portfolio. But risk-free investments with super-high bankruptcy priorities have major efficiency potential. Highly prioritized 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 the financial system, deserve a supportive legal framework.

The problem, though, is that this lower risk for derivatives traders and repo investors comes at the expense not just of other financial creditors who price and monitor the debtor. The advantages are embedded in systemically vital businesses, institutions, and markets. As such, their failure will call forth a government bailout, or will degrade financial and economic results generally. Hence, the cost of this risk-free (or, better, lower-risk) environment for derivatives traders and repo investors is not fully borne, and not fully priced, by those doing the trading and investing.

If we could separate efficient flows from systemically dangerous flows and then allow the first, while restricting and pricing the second--we could strengthen finance in two dimensions. But if we cannot separate the efficient from the dangerous, and if we cannot price either, then we need to choose which policy package makes most sense: better bankruptcy treatment for derivatives and repo creditors, which gives them trading efficiencies, or equal treatment for them as compared to other secured creditors, to foster systemic stability. Given our recent poor experience in 2007 and 2008, the best choice may well be to strengthen the system in the more important dimension of systemic stability. To do so, policymakers would need to cut back the priority package for derivatives and repos.

Overall, these are policy issues that reflect not just the problems of local, minor financial structures that unfortunately failed: When the financial crisis began in June 2007, the United States had $2.5 trillion in overnight repos, while the aggregate insured bank deposits in the United States were only twice as much. Just one type of derivative market--the interest rate swap--grew to more than $400 trillion by December 2008, with $4 trillion of collateral backing up the derivatives market overall (ISDA, 2009a, b). (4)

[FIGURE 1 OMITTED]

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 first and $11 trillion for the second. In the subsequent 15 years, the business debt market tripled in size to $34 trillion, while the interest rate derivatives markets increased nearly 40-fold to $430 trillion. Combine the overnight repo market with the collateralized portion of the derivatives markets and we have a financial market bigger than the FDIC-insured banking system. If there is a failure in these markets, the first set of governing rules comes from the Bankruptcy Code. (For some financial institutions, like the banks embedded in bank holding companies, the reorganization rules emanate from laws other than the Bankruptcy Code, such as the banking laws most recently updated via Dodd-Frank; but the treatment under the other laws is substantially similar to the treatment under the Bankruptcy Code.) Academic supporters of the derivatives and repo markets indicate that these markets' growth would not have been possible without the bankruptcy safe harbors (Gorton and Metrick, 2010, p. 3). Those safe harbors can be viewed less neutrally, as I do here, as subsidies to the derivatives and repo markets, coming at the expense of other creditors.

In the next few pages, I describe the counterparties' Code-based advantages. Although several are conceptually sound, most go far beyond wise bankruptcy and financial policy. After that, I show how the Code's advantages weaken counterparties' incentives for market discipline. The Code thereby discourages financial resiliency. 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 avoid the consequences of an actual collapse. This lost potential for enhanced market discipline is where, I argue, central bankruptcy priority costs of the derivatives and repo markets lie.

Then, in the subsequent section, I apply Modigliani-Miller's irrelevance hypothesis to show how the bankruptcy rules shift risks from inside the derivatives and repo markets to outside it. Although creditors' lawyers here often like to think of the structure as reducing risk, and it does reduce it for the immediate parties, it does not necessarily reduce it system-wide. Rather, Code priorities that reduce the derivatives counterparties' risks and monitoring incentives thereby raise risks that the financial firm's other creditors face. Risk is transferred, not eliminated.

Conceptually, those other creditors can reduce their exposure to a risky debtor, raise their prices, or monitor more closely. But the relevant players here are not always the best informed and best skilled at reducing resulting risks because they often are not themselves derivatives and repo professionals. The largest affected creditor is the United States as de facto guarantor of weak, too-big-to-fail financial debtors. But the United States has no contract, unless we conceptualize the Bankruptcy Code rules as its de facto contract. If we do so, that contract needs to be revised going forward.

In the penultimate section, I examine the core arguments favoring derivatives and repo priorities, as well as glance at some of the major recent regulatory reactions. Although several bankruptcy advantages for each instrument are functional and ought to be kept, the full range is far too broad. In particular, I examine the contagion argument again, and point to two negative, perhaps serious, macro economic implications of derivatives priorities.

Overall, the Bankruptcy Code's safe harbor provisions prioritize derivatives and repurchase agreements over a bankrupt's other creditors in ways that are unwise for sound policy governing major, systemically important financial institutions. Not only do the provisions facilitate runs on financial institutions during financial crises, they also seriously weaken counterparties' ex ante incentives for financial stability. The Code priorities decrease the derivatives players' ex ante monitoring incentives and decrease their incentives to use stronger financing channels. If these markets lacked their safe harbor priorities, one should ordinarily expect the market players to substitute into other financing channels. Moreover, safe harbor priorities make the quick repositioning of ongoing bundles of a failed financial firm's portfolio difficult or impossible, because the counterparties can, unlike secured creditors generally, immediately liquidate their safe-harbored positions.

The Code thereby encourages risky, knife's edge financing, which, when pursued in financially central firms, transfers risk to the United States as the ultimate guarantor of the key firms' solvency. Financial resiliency is thereby drained; market discipline forgone.

THE PROBLEM: SHORT-RUN SUPERPRIORITY IN THE DERIVATIVES AND REPO MARKETS

Under American bankruptcy law, a bankruptcy filing strips creditors of contractual rights that they would otherwise have in three major ways. First, bankruptcy law bars the bankrupt's creditors from suing the debtor for repayment, bars them from trying otherwise to collect debts due from the bankrupt, and bars secured creditors from immediately seizing and liquidating their security. Inventory financiers, for example, cannot seize the inventory they have financed, but must ask the court for permission to do so and typically must wait, while the business is reorganized. Later on, they all collect their security, if it is still available, or what is due them (equal to the amount of their security), oftentimes when a plan of reorganization is completed. The purpose of this bar on collection is to do the best the bankruptcy system can to reorganize the failed firm into a viable enterprise, on the theory that many bankrupt firms remain viable, albeit in a reduced state.

Second, bankruptcy law treats safe harbored creditors more favorably in other dimensions. A bedrock principle for bankruptcy is preference law, designed to reduce an eve-of-bankruptcy rush by creditors to grab the failing firm's assets. Preference law requires that creditors who were repaid within 90 days of the bankruptcy filing be made to return their repayments under wide conditions, thereby allowing all creditors to share in that value.

Third, creditors and suppliers generally cannot terminate an open contract with the bankrupt.

For creditors of the bankrupt that are derivatives or repo players, these rules are reversed to favor the derivatives and repo creditors, who are 'safe-harbored' from basic bankruptcy institutions. The safe harbors in effect pull these favored creditors out from the bankruptcy process. First, they can immediately collect on their debts. Second, they do not need to return preferential payments they received within the 90 days prior to bankruptcy as do regular creditors. Third, the safe-harbored derivatives and repo players can decide to terminate their contracts with the debtor, as opposed to the usual bankruptcy rule that gives this option to the bankrupt debtor. Collectively, these rules highly prioritize derivatives and repo creditors over other creditors.

Several of these baseline American bankruptcy rules that the safe harbors reverse are, in the view of bankruptcy analysts (including this author), unwise. But, unwise or not, it is arguably poor policy to have some rules favor contracts that are derivatives or repo contracts over all other kinds of pre-bankruptcy credit contracts. The impact of favoring one class of credits is to drive more credit transactions into such shorter-term financial contracts, like repo, and away from other credit channels. Moreover, at the moment of failure, safe harbor priorities disrupt the reorganization-based nature of American bankruptcy by motivating creditors owning core credit positions in the derivatives and repo markets to liquidate their positions quickly to pull as much cash out of failing financial firms as they can, thereby hastening the firms' demise. The rules thereby enhance run potential.

UNDERMINING MARKET DISCIPLINE

The major damage done by the Bankruptcy Code's safe harbors (and similar provisions in banking law) is that they weaken the derivatives and repo markets' incentives for market discipline. The priorities' systemic impact is important at two different times. The first is when the economy is suffering an ongoing crisis. At that time one question is whether the safe harbor priorities facilitate or impede the repositioning of a failed financial firm and its portfolio. The second question at that time is whether the priorities dampen or exacerbate a financial crisis. The answer is that it is hard to tell. Although most commentary says that the priorities help reduce contagion, there are strong reasons why they do not dampen runs and that they in fact exacerbate a crisis by propelling more runs.

The second time the priorities have an important impact is well before the crisis hits, during ordinary financial times. During that period, these safe harbor priorities sap market discipline and thereby increase the chance that when a financial crisis occurs, it will be worse than it otherwise would have been.

There are multiple channels for market discipline and each deserves more analysis than it will get here. (5) But the persistent overall impact of the Code's priorities' channels for derivatives and repos is to weaken discipline in each channel. The most obvious weakening of market discipline comes from the safe harbor priorities' weakening of the counterparties' incentives to monitor one another--the kind of market discipline Greenspan was looking for. True, the derivatives book for a counterparty is opaque and difficult to monitor. But if the counterparties were made to bear more of the risk of counterparty failure, some would raise prices and some would seek better collective monitoring channels. Others would deal only with the strongest counterparties. Still others would reduce their exposure to a single counterparty or require that its counterparties substitute into a stronger financial structure. Weaker counterparties, if faced with higher prices or reluctant counterparties, would have incentives to strengthen their own balance sheet, such as by substituting more long-term financing for the short-term derivatives and repo financing.

The systemic justification usually given for the safe harbor priorities is again that they reduce contagion during a crisis. This may be true, but it is more than counterbalanced conceptually by two heavy counterweights. Even if the safe harbor priorities reduce contagion during a crisis, they also induce runs during that crisis. And even if they reduce contagion more than they induce runs (which is by no means proven), they also have the large ex ante systemic costs of sapping market discipline.

The contagion idea is that if one institution is weakening and its counterparties cannot take their derivatives and repo investments out, then these counterparties will also fail. Then, like a row of dominoes, the financial system will topple. A difficulty with this view is that it is unclear why only derivatives and repo counterparties need to be protected from financial contagion. That is, one must ask whether all financial counterparties should get that protection, in order to stop runs. And by permitting safe-harbored, prioritized derivatives and repo creditors to take their money out immediately from a weakening financial institution, but not permitting any other creditor to do so, does that safe-harboring not increase contagion potential when the other, non-prioritized creditors bear the losses that the favored creditors do not bear? Will the non-prioritized creditors--themselves financial institutions--thereby weaken and, perhaps, fail?

The other difficulty with the contagion analytic is that the same process that reduces contagion also creates runs: the strong counterparty who sees its trading counterparty weakening then considers that, via the superpriorities and bankruptcy exemptions, it has the incentives and means to pull its cash out of the weakening financial institution, like AIG, Lehman, and Bear Stearns. This strength that the strong safe-harbored creditors have, but the other creditors lack, can induce a run on the weakening institution, bringing about the weakened financial firm's failure when, if financial heads were made to cool down, they might have survived or been disposed of in a more systemically sound way. (6)

MODIGLIANI-MILLER APPLIED

Applying one of finance theory's central insights helps us to better understand the mixed impact of the safe harbor priorities for derivatives and repo contracts.

The risks that bankruptcy law's safe harbors lift off of the shoulders of the derivatives and repo players do not disappear. Rather, they shift to other shoulders. Hence, priority proponents' arguments that derivatives and repo priorities reduce risk must be qualified: Although the safe harbors do indeed reduce the risk for derivatives and repo players, they do so in the first instance by transferring those risks to other financial players. In the first instance, risk is not directly reduced by financial manipulation, but only shifted from shoulder to shoulder. For such insights and development, Modigliani and Miller (1958) won their Nobel Prizes.

But the Modigliani and Miller (M-M) risk transfer analysis also rebuts some of the market discipline analytics I have thus far offered. By transferring the risk, the bankruptcy rules do not reduce overall risk. They reduce the derivatives and repo players' incentives for market discipline, as I have indicated. But they concomitantly raise the incentives of other creditors to seek more market discipline.

The reason this M-M-style rebuttal fails--that is, the reason that the risk transfer is not a simple wash for market discipline--is that a major creditor of systemically central financial firms affected by American bankruptcy law is the United States government as contingent guarantor. The United States does not ordinarily react like a contract creditor. It could, in principle, regulate the financial institutions more tightly and effectively, and the M-M analysis indicates why it should and why leaving the results to marketplace monitoring, as so enamored Alan Greenspan, is mistaken if the monitors are bankruptcy-favored.

The better next step in the analysis is not to rely on governmental prudential regulation. Rather, the better step is to hybridize by using bankruptcy rules to better harness market discipline than before, because governments will often be late to realize the risks that are emanating from one market or another to threaten financial stability.

FURTHER CONSIDERATIONS

Reducing and increasing contagion

Consider ordinary contagion first. The Code's superpriorities were first justified as measures to reduce ordinary contagion. One institution fails and another, unable to get its cash out of the failed firm, is rendered illiquid and fails itself. This scenario is possible, but on an ex ante basis is offset by the possibility that the first institution, although weak, would not have failed were it not for the second institution's bankruptcy rights to pull cash out of the weak but potentially survivable firm. Hence, we have reason to believe that the bankruptcy safe harbor priorities are as likely conceptually to spread contagion as they are to contain it.

Consider information and collateral contagion next. The Code's priorities also facilitate information contagion and encourage simultaneous liquidation of collateral in a financial crisis. Both difficulties were strongly in play in the financial crisis and the Code's priorities exacerbate both. Information contagion comes when lending markets discover they do not understand counterparty financial strength and stop lending until they acquire enough information; bankruptcy superpriority discourages early information acquisition. Collateral value contagion comes when financiers simultaneously sell similar collateral, depressing its price, thereby compromising the immediate value of other collateral. The lowering of other collateral value induces other lenders to themselves declare a default, seize collateral, and liquidate that collateral. The Bankruptcy Code allows derivatives and repo creditors, but not most others, to immediately seize and sell off their collateral, thereby facilitating collateral contagion. These two effects--information contagion and collateral-value contagion--are run-enhancing consequences of the priority rules we have. Prior analysis has not, as far as I know, shown the logical links between bankruptcy's payment priorities and these two crisis-exacerbating difficulties. See Roe (2011, pp. 567-569).

Clearinghouses

Clearinghouses and collateral have been a major focus of reforms. Much of this effort is helpful, but much of it must be incomplete, as applying the M-M hypothesis to the setting shows us. Clearinghouses can enhance transparency, which is good here, especially in that it might alert government players to a problem earlier than otherwise. But much of the justification for the clearinghouses, as well as for strong collateral requirements, is that they are thought to reduce systemic risk. On this level, the argument is weak or at least not self-evident. See Pirrong (2009); Roe (2010; 2011, pp. 586-587, 2013).

Granted, a clearinghouse enables participants to net contracts, which reduces risk for those inside the clearinghouse system. But the risk is not assuredly eliminated. It can be, and often is, just transferred to creditors outside the insider clearinghouse system as an example illustrates.

A weak financial institution, say, Bank of America (BOA), has two separate contracts, one with AIG and one with Citibank. BoA owes $100 million to AIG and another $100 million to Citibank. The contract with AIG is a derivatives contract, which goes through the clearinghouse; the contract with Citibank is another kind of contract, maybe just a regular loan, and does not go through the clearinghouse. BoA also has a contract with, say, Bear Stearns, through the clearinghouse for $100 million, with Bear on the losing end.

Without a clearinghouse, BoA has a $100 million asset (the $100 million that Bear owes it) and owes $200 million. Having only $100 million (if these are its only assets and liabilities), BoA would have to pay AIG and Citibank each $50 million and each of those two would suffer a $50 million loss.

But, AIG could fail if it is unable to collect the full $100 million. This is where the clearinghouse protects AIG, which is particularly important if AIG is systemically vital. AIG's winning contract with BoA nets against Bear's losing contract with BoA. The clearinghouse here eliminates counterparty risk for these three players, but only by transferring the risk to Citibank, which instead of losing $50 million, ends up losing the full $100 million. If Citi is as systematically important as AIG, the clearinghouse has not reduced systemic risk. It has moved it.

Regulators have celebrated the clearinghouse. Among its most important advertised features is that it reduces risk for its participants. And, as advertised, it does--but only for its participants. However, Citibank now loses $50 million more, since it cannot crack into the clearinghouse's assets. If that extra loss pushes a systemically vital Citibank over the precipice, the clearinghouse has not, as it has been advertised to do, reduced systemic risk.

The extent to which the clearinghouse reduces systemic risk, if it does so at all, depends primarily on the relative systemic importance of MG and Citibank in these renditions of the clearinghouse basics, and secondarily on whether the clearinghouse can settle out the transactions much faster than any alternatives, but does not derive from the clearinghouse's capacity to reduce the underlying risk, which it does not really reduce.

Much recent regulatory activity has focused on enabling, enhancing, and requiting clearinghouses for these kinds of financing arrangements. As said, clearing houses offer multiple benefits, including better transparency, better pricing, and better regulatory potential. But some of their central proposed benefits do not withstand a Modigliani-Miller analysis, as much of what gets justified as reducing systemic risk is really just moving that risk somewhere else in the system.

Dodd-Frank uncertainties in application

Congress reacted to the financial crisis with major financial reform legislation, which did not alter the bankruptcy rules but did potentially move a wider array of financial institutions out from under the Bankruptcy Code's repo rules and into a new financial resolution regime, which the Federal Deposit Insurance Corporation (FDIC) will run. For such financial institutions, Dodd--Frank's 'Orderly Liquidation Authority' brings back the classic bankruptcy bar on counterparties immediately collecting on their derivatives and repos, but only for a single business day, and it then otherwise reaffirms the safe harbor superpriorities; Dodd--Frank, [section] 210(c)(8)(C)(i). Although that bar on collection endures for a single business day, it is still more reorganization-oriented than the bankruptcy safe harbors, which contemplate no delay in the bankrupt's counterparties cashing out.

Dodd-Frank potentially also allows the FDIC to choose among assets and liabilities that could be transferred from a failed financial institution to a bridge corporation. It requires that an entire counterparty's book be transferred if any is transferred, but does not require that the entire book be transferred; Dodd-Frank, [section] 210(h)(1)(B). Such a choice creates the potential to adjust priorities, see Roe and Skeel (2009), but is limited by a statutory floor, namely that all creditors are entitled to the value they would have received in a Chapter 7 liquidation of the company and the requirement that a failed firm's derivatives' book with a particular counterparty be transferred intact, without cherrypicking. In such circumstances, much of the decision-making on reorganization rests with the centralized regulator.

However, the hurdles to moving systemically vital financial institutions that are not themselves banks or similar is not automatic, with some commentators seeing the hurdles to using the statute as substantial. If the hurdles are not overcome, then the (unchanged) bankruptcy rules govern. If they are overcome, commentators have tended to conclude that the orderly liquidation authority will have the effect of bailing out the subject institution.

CONCLUSION

American bankruptcy law subsidizes derivatives and repo contracts, at the expense of other debt, by moving them up on the bankruptcy repayment queue above other creditors of the failing firm. By favoring, safe-harboring, and prioritizing such short-term financial contracts, the rules weaken market discipline during ordinary financial times in ways that can leave financial institutions weaker than they would be otherwise. This weakness, in turn, exacerbates financial failure during an economic crisis. The crisis can emanate from elsewhere in the economy--as the 2007-2008 downturn emanated from the mortgage market--but then magnify its impact.

Because the strongest priorities in the Code are available only for short-term financing arrangements, they thereby favor short-term financing arrangements over more stable longer-term arrangements. While proponents of these priorities for derivatives and repos justify them as reducing contagion, there is good reason to think that they do not reduce contagion meaningfully, but contribute to runs and, most importantly, undermine market discipline ex ante. Basic application of the Modigliani--Miller framework suggests that the risks policymakers might hope the favored treatment would eliminate are principally shifted from inside the derivatives and repurchase agreement markets to creditors who are outside that market. The most important outside creditor is the United States, as de jure or de facto guarantor of too-big-to-fail financial institutions.

REFERENCES

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Greenspan, A. 2008: The Age of Turbulence. Penguin Press: New York. ISDA (International Swaps and Derivatives Association). 2009a: ISDA Margin Survey, available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.

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MARK J ROE (1)

Harvard Law School, 1525 Massachusetts Ave., Griswold Hall 502, Cambridge, MA 02138, USA.

E-mail: mroe@law.harvard.edu

(1) Professor, Harvard Law School. An earlier version of the argument I present here appeared in more extensive form in Roe (2011).

(2) Compare Ferguson and Johnson (2010) with Cochrane and Zingales (2009). Cf. Taylor (2009).

(3) Bear Steams, Form 10-Q (29 February 2008).

(4) In an interest rate swap, one party trades a floating interest rate for a fixed one on, say, $100 million of debt that neither party has borrowed or lent. The $100 million 'notional' amount is often reported as the transaction's size--with that notional amount totaling $400 trillion at year-end 2008. But it's the smaller interest payment obligation that is being swapped and the collateral transferred is even smaller. That lower collateral amount goes into the text's still-big $4 trillion number.

(5) For more extensive analysis, see Roe (2011, pp. 560-64).

(6) See Edwards and Morrison (2005, p. 101); Partnoy and Skeel (2007, p. 1049); Roe (2011, pp. 564-569); and Skeel (2009, pp. 10-11).