A lot is happening in the financial regulatory overhaul bill that moved swiftly from committee through the US House of Representatives this week. But one vital reform is not locked in yet, although it is reportedly percolating in the Senate and a stripped-down version made it into the House bill passed last Friday.
Derivatives, repos and financial swaps – the huge financial market in protection against foreign exchange and interest rate fluctuations, in liquidity-enhancing transactions, and in guarantees against loan defaults – are treated extremely favourably in bankruptcy law. It has been a successful lobbying effort for this part of the American financial industry: priority treatment is important for the industry, but not well enough understood to engage much public attention beyond the financial press.
But derivatives, repos and swaps should not be so favoured. Yes, they are valuable in managing risk and enhancing liquidity: a derivative allows a company that is sensitive to interest rate changes to trade a fluctuating interest rate for a fixed one, while a repo allows a financial institution with a fixed, illiquid asset to sell it for cash today, by promising to buy it back a week later, thereby getting cash for that week. But they are favoured so much that financial players can set up deals so that they beat all other creditors if the other side of the deal goes bankrupt.
True, somebody has to win and somebody has to lose when there is not enough money to go around. But these super-priorities warp the financial industry’s incentives to avoid problems. Moral hazard – the phrase Hank Paulson, former US Treasury secretary, famously used during the Lehman collapse – applies with a vengeance here. If financial players set their deals up perspicaciously with enough collateral, they need not worry if a counterparty such as AIG or Lehman collapses, as they will be paid before regular creditors. Some players – Goldman Sachs and JPMorgan are those talked about – set up parts of their AIG and Lehman deals to take advantage of these super-priority provisions. Knowing now what can happen in a financial meltdown, other financial players will do the same in the future, making the financial system more fragile.
The point here is not that these transactions are nefarious – they are legitimate ways to manage financial risk – nor is it that their bankruptcy treatment was the sine qua non for the financial crisis, but rather that if the derivatives and repo transactions were not so favourably treated in bankruptcy, financial players would seek other ways to protect themselves. That effort would channel them into stabilising the financial system or at least into making sure they were dealing with stable counterparties. (Ordinary creditors have to return repayments they receive on the eve of bankruptcy, cannot keep eve-of-bankruptcy collateral calls and cannot terminate their contracts with the bankrupt if the contract has turned into a good deal for the bankrupt; derivatives and repo players are exempt from all these rules. The regular rules for creditors are imperfect, but the priorities make the playing field among creditors a very unlevel one, so creditors seek to be covered by the more favourable rules and their efforts to get the better bankruptcy coverage can disrupt markets and financial institutions.)
If the derivatives, repo and credit swap players lack favoured treatment in the future, they will act differently. If they know that their payments from a counterparty might be clawed back if the counterparty goes bankrupt, they will keep a sharper eye on the solvency of their counterparties, because a lower priority will not hurt them as long as their counterparties stay solvent.
They will insist that their counterparties be well-capitalised, instead of accepting the ultra-thin capitalisations that were common on Wall Street. And they will be more interested in building up a derivatives exchange that is safe, transparent and stable even if a constituent financial institution fails. Right now, since Goldman and Morgan know they can get priority anyway by using their muscle to push to the head of the line in a bankruptcy, they have less of an incentive to build up a stable trading exchange for the entire derivatives and repo market, and less of an incentive to be sure that their counterparties are well-capitalised.
This week, as the financial media reported that the derivatives priority might be on the chopping block in Congress, financial players pleaded – maybe successfully, as the package is far from final – that cutting priority could stifle liquidity in the repo market and risk-spreading in the derivatives market. This argument is serious, but flawed. It is serious because losing priority could weaken the market, but flawed because it indicates that these players have not been paying their own way so far. Priority facilitates liquidity and risk-spreading, but others pay for part of those benefits because they lose in bankruptcy and the financial system is potentially rendered less stable.
While some accommodation for derivatives, repos, and credit swaps in bankruptcy is sensible because they differ transactionally from a bankrupt’s other contracts, the extra priorities are not the accommodation that makes sense for the financial system.
Priority proponents say we should fear financial contagion: one institution defaults and then its counterparty cannot meet its own obligations. Priority, they say, helps to contain the contagion. This could be so, but the opposite can also be true. We saw last year that priority also spreads contagion: as AIG and Lehman weakened, financial counterparties made legitimate collateral calls that, without their super-priority, would not stick in bankruptcy. This meant more of the weakened institutions’ counterparties knew that they would have to make similar collateral calls to stay even. This run-like process further weakened AIG and Lehman, and their weaknesses spread outward, facilitating the failure of a well-known money market fund, the Reserve Fund, because it held a lot of ordinary Lehman commercial paper. Whether bankruptcy rules, as they are, facilitate or retard runs and contagion is not easy to figure out; in theory, they could do both. But it is clear that the bankruptcy exceptions do not incentivise counterparties enough to be sure that the institutions they deal with are stable and stay solvent.
Others may say that fixing priorities will not matter. If Washington always bails out financially central institutions, derivatives counterparties will not care where they rank, as they would expect the government to make them whole regardless. Even if denied priority, they would not do more privately to stabilise the financial market in the future.
True, but if the financial players were sure they would be bailed out, they would not fight these priority reductions as hard as they are now doing. Nor would they have fought so hard over the years to get the priority that bankruptcy law now accords them: that priority needed lobbying for multiple, major amendments to the bankruptcy law. And Lehman, after all, failed. Fearing a single financial institution’s failure, derivatives and repo financiers lacking priority would seek solutions that should make the financial system more stable.
The best private incentives fixes did not make it into the House bill as passed last Friday. A last-minute amendment to the House bill would give regulators authority to force a 10 per cent loss on some of a failed institution’s derivatives in a bailout, but kept the derivatives’ favoured priorities in place otherwise. This is a step in the right direction conceptually, but it is too clumsy to work well in a crisis. The way to fix the derivatives and repo priority problem is to end the priorities cleanly and clearly, thereby pumping up private incentives to structure a more stable financial system.
The writer is a professor at Harvard Law School, where he teaches bankruptcy and corporate law