Legal Foundations of Financial Collapse

Carolyn Sissoko

We have transitioned over a period of thirty years from an environment where over the counter trade in financial derivatives was illegal to an environment where the same contracts are granted privileged status under the Bankruptcy Code. • What motivated this change? • How secured lending increases systemic risk• How the Fed saved the repo market• Lessons of the crisis• Solutions

The bankruptcy codeGoal: distribute the assets of bankrupt firm as equitably as possible across the firm’s creditors Major Tools: Automatic stay: Creditors prohibited from collecting debtsAvoidance power of trustee: recent payments can be recalled (avoided) by trustee of bankruptcy estate

Amendments to the bankruptcy code enacted in 1978, 1982, 1984, 1990 and 2005 exempt derivatives and repurchase agreements from avoidance and the automatic stay.

Consequence: collateral can be seized and sold as if there was no bankruptcy trustee. Derivatives and repos are granted super-priority in bankruptcy.

Details of bankruptcy amendments – 1

1978 Commodity broker and forward contract merchant exemptionValidates mark to market process used by commodity exchanges. Forward contracts included because they are collateralized commercial (non-financial) contracts.

1982 Securities brokers and clearing agencies exemptionExemption applied only to contractual rights “set forth in a rule or bylaw of a national securities exchange, a national securities association or a securities clearing association”

These exemptions are unexceptional and have probably been part of the practice of bankruptcy for centuries.

Details of bankruptcy amendments – 2

1984 Repo exemption (first exemption of unregulated financial contracts)

In the challenging environment of the early 80s repos were crucial to the banking system’s adaptation to a world with money market funds.Supported by Paul Volcker (who had the task of revitalizing banking system)

Restricted to repos backed by Treasury and Agency securities, bank certificates of deposit and bankers’ acceptances

Applies to contractual rights including any right “whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.”

Details of bankruptcy amendments – 3

1990 Swap exemptionSwaps trade a fixed stream of payments for a stream of payments that will be determined by future prices or events in financial markets

Technically illegal, but treated as forward contracts. In 1993 CFTC was granted authority to exempt them from regulation.

Financial industry argued that OTC derivatives needed same treatment as exchange traded derivatives. 1990 law copied the broad exemption enacted in 1984.

Swap market grew exponentially. Synthetic assets.

Details of bankruptcy amendments – 4

2005: The no derivative left behind actMaster agreements, cross product netting, broadening of all exemptions to make them uniform and to include new derivatives not yet invented.

Definition of exempt contracts ceded to financial industry: “any margin loan” is a security. Swaps defined by swap dealers.

Repos: any repo on a stock, bond, mortgage, “mortgage related security” or other securities contract is exempt. Implications are huge. Repos effectively monetize their collateral. When repos on junk bonds are granted super-priority in bankruptcy, the legal structure encourages the financial system to treat low quality assets as if they are liquid – and encourages financial institutions to be aggressive in demanding collateral, when the natural illiquidity of mediocre assets appears.

Why were the exemptions passed? Systemic Risk

Traditional bankruptcy can cause “chain of failures”: Collateral is a liquid asset for financial firms. When collateral is tied up in bankruptcy, financial firms’ liquid assets decline. Also because collateral can’t be sold while in bankruptcy, it may fall in value causing losses. Netting of offsetting derivative contracts may not be recognized by a bankruptcy court, because bankruptcy receiver has the right to cherrypick contracts.

But: The laws are far too broad to represent a serious effort to address systemic risk. Why isn’t there a focus on large participants or particularly dangerous contracts? (Edwards and Morrison, 2004) Why aren’t the hedges put in place by a bankrupt firm protected from termination? (Lubben, 2008)

Underlying reasons: Exemption from bankruptcy proceedings makes it easier for financial institutions to use derivatives to hedge risk. Protect financial firms from losses due to counterparty credit risk.

Alternate view of systemic risk: A qualitative model

Assumption:Banks are best suited to evaluate each other’s business practices

Unsecured lending: banks are not protected from losses and will reduce exposure at the first sign that a counterparty is poorly managed lending by the banking system to unsound banks will be small systemic risk cannot grow large Secured lending: banks are protected from losses may be willing to do business with unsound counterparties, so lending by the banking system to unsound banks may be quite large protection of collateral increases willingness to be exposed to counterparty credit risk protection of collateral makes high leverage seem safe systemic risk may be high

Alternate view of systemic risk: A qualitative model

Implication: the safe harbor exemptions to the bankruptcy code may have increased systemic risk by encouraging banks to rely on collateral rather than counterparty risk management to protect themselves from losses

Check against data:Did secured lending increase after the exemptions were passed?Is there evidence that systemic risk increased after the exemptions and the increase in secured lending?

Secured lending increased after exemptions were passed

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

Total IR and currency swaps outstanding(notional values)

$ Bi

llion

Secured lending increased after exemptions were passed

1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 -

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Credit default swaps outstanding (notional values)

$ Bi

llion

Secured lending increased after exemptions were passed

2000 2001 2002 2003 2004 2005 2006 2007 2008 20090

500

1000

1500

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4500

Collateral posted against derivative contractsfrom ISDA Margin Surveys

$ Bi

llion

Evidence that systemic risk increased after the passage of the exemptions and the increase in secured interbank lending

The financial crisis itself

The sequence of events is consistent with the view that the bankruptcy amendments caused a dramatic increase in secured interbank lending, which facilitated the operation of financial institutions that mismanaged risk. It was the failure of these institutions – Bear StearnsLehman BrothersAIG – that caused the crisis and set off the systemic risk event.

Secured Lending and Systemic Risk

Leverage and the repo market

“Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the "repo" system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome. The investment banks, to protect themselves, controlled, to some extent, the use of credit by customers that were hedge funds. But the internal hedge funds, owned by the investment banks, were subject to no effective credit control at all.” -- Charlie Munger

2-28-2008: half of Bear Stearns balance sheet was financed on the repo market.

Secured Lending and Systemic Risk

Huge interbank exposures

“The ability to net may also contribute to market liquidity by permitting more activity between counterparties within prudent credit limits. This added liquidity can be important in minimizing market disruptions due to the failure of a market participant.” -- President’s Working Group on Financial Markets Report on Long Term Capital Management, 1999

Except that there were no “prudent credit limits”. Bear Stearns and AIG were both granted far more credit than was prudent.

Secured Lending and Systemic Risk

Bankers bank runsNo counterparty wants to be the one that didn’t demand collateral or withdraw its repurchase agreements fast enough.

Every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued.

Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs.

Fed acts to save repo market

March 2008: Term Securities Lending Facility: investment banks can temporarily trade highly rated private sector debt for Treasury securitiesPrimary Dealer Credit Facility: loans to investment banks against investment grade collateral September 2008: Expansion of collateral accepted in TSLF and PDCFReg W exemptions: Commercial banks allowed to use deposit based funding to support repo market. By October 1, 2008: PDCF: $150 billion, TSLF: $230 billion.

A lesson of the 2008 crisis

Collateralized lending does not protect lender from losses when the borrower is a large financial institution.

Bear Stearns and Lehman: Without the intervention of the Federal Reserve many of the largest repo market participants would have been forced to sell collateral in order to meet their obligations. These forced sales would have driven asset prices far below those observed in 2008 – and all the major players in the repo market would have posted much larger losses than they did. AIG: Without Fed bailout counterparties would have been short $22 billion in collateral at time of bankruptcy. The 2008 crisis demonstrates that the only protection a bank has against the failure of a large counterparty is the intervention of the central bank. Collateral was worse than useless throughout the crisis, because it served to destabilize financial institutions rather than to stabilize them.

Forgotten Keynes

Bankruptcy code exemptions are built on the fallacy that there is such a thing “as liquidity of investment for the community as a whole.”

Collateral is presumed to be “liquid”. Consequences:• banks do not set aside reserves or hold capital to protect themselves against

losses that they cannot imagine• banks do not monitor counterparties carefully (because they rely on collateral)• the financial system as a whole is undercapitalized and • the weakest financial institutions end up interconnected with every other firmIn such an environment, when one firm starts to wobble the whole financial

structure can easily come tumbling down.Thus, collateralized interbank lending only protects lenders if the central bank is

willing to intervene to prevent a fire sale of collateral.

What, then, is the role of collateral?

The lender of last resort has a long tradition of protecting financial systems where interbank lending is unsecured.

Collateral serves only to create the illusion of a security that does not exist. This illusion causes banks to reduce the capital they set aside to protect against unexpected losses and to cut back on monitoring the credit risk of their counterparties.

In short, the existing collateralized derivatives regime is inherently destabilizing.

It is not designed to function in an environment where a large financial institution can fail, it tends to reduce capital levels and increase lending to weak firms, and finally, because of the safe harbor exemptions, it all but guarantees that a run on a large financial institution will take place.

Solutions

• Prohibit large financial institutions from entering into over the counter derivative contracts that require them to post collateral in order to force their counterparties to evaluate their credit risk and cut their credit lines when they become risky

• Remove the safe harbor protection for repos of less liquid assets by repealing those sections of the 2005 Bankruptcy Act that apply to repurchase agreements

• Financial statements need to give the user an idea of how the collateral situation may change over the quarter by reporting the maximum amount of collateral that could be called