London conference: More calls to fix bankruptcy exemption for mortgage-backed repos

The special bankruptcy treatment extended to repurchase agreements in 2005 played a critical role in the financial crisis of 2007-2008, and changes must be made, experts cautioned at a financial conference in London June 1.
 
The warnings came just days after Thomas M. Hoenig, the president of the Federal Reserve Bank of Kansas City, said the elimination of the special bankruptcy treatment for mortgage-backed repos is one of the three most important reforms that must be taken to avoid another financial crisis.

The Dodd-Frank Act, a 2,300-page law approved last year to prevent another bank bailout, does not deal with the bankruptcy provision.

The London conference, on the future of banks’ funding, focused on both repurchase agreements and derivative transactions. Each has become a key source of financing for major banks. 

Both were given special bankruptcy treatment in Europe and the United States between 2002 and 2005, according to conference speaker Enrico Perotti, professor of international finance at Amsterdam Business School.

They also were the two main sources of systemic risk in the financial crisis of 2007 and 2008, according to U.S. regulators. The prime examples of systemic risk caused by repos were Bear Stearns and Lehman Brothers. The prime example of systemic risk caused by derivatives was American International Group and its credit default swaps.

The special bankruptcy treatment given repos and derivatives means that repo lenders and parties to derivative contracts can keep the collateral if their trading partner becomes insolvent. This exempts them from the “automatic stay”  rule in bankruptcy, which prohibits most creditors from trying to collect ahead of others.

The financial crisis happened when repo lenders and derivative parties lost confidence in the mortgage-backed securities they’d accepted as collateral for repo loans and credit default swaps. They demanded to be paid, forcing their troubled trading partners into fire sales of their holdings to raise cash. They were  unconcerned that they might drive their trading partners into bankruptcy, because they were exempt from the automatic stay. Perotti said.

From a press release following the conference, which was sponsored by the International Centre for Financial Regulation, a trade association based in London, and the University of Chicago Booth School of Business:

Professor Perotti outlined how over the 2002-2005 period, bankruptcy laws were changed in all EU countries and the US, and secured financial credit (repos) and derivative counterparties gained a strong bankruptcy privilege, amounting to de facto “superpriority”, as counterparties could gain immediate repossession of collateral in default (so-called “safe harbor claims”, as opposed to having to accept the “automatic stay” which protects the debtor in Chapter 11 for example).

The exemption attracted financial companies to the repurchase and derivative markets, because the transactions appeared to be safe. But that turned out to be an illusion.

As often in financial regulation, this leads to unintended consequences. As a default leads to repossession of collateral for all safe harbor claims, repossession accelerates fire sales, resulting in a disorderly resolution, with a rush to sell collateral ahead of others, creating a downward spiral in valuations. The timing of the jumps in risk spreads on Lehman, two days after the default, demonstrates this effect, as does AIG.

Perotti said all companies – not just banks – that want to repo and use derivatives, and keep the bankruptcy exemption, should have to make a public listing of all collateral and pay a fee. The goal would be “to help reduce excess credit creation and to reduce the risk of fire sales of collateral,” according to the conference press release.

Such a levy would be less disruptive than strict quantity limits and easy to adjust counter cyclically, with a low cost in normal times. It would also ensure the monitoring of the stock of contractual and contingent liquidity risk, as it is not net but rather gross liquidity that has systemic risk effects. Professor Perotti likened the charge, to “charging for drinks once the party gets going,”  instead of the classic central banker concept of taking away the punchbowl.

David Skeel, professor of corporate law at the University of Pennsylvania Law School, and a bankruptcy expert,  proposed that repos collateralized with cash continue to enjoy the bankruptcy exemption but all others should be subject to the automatic stay.

Hat/tip to freelance business journalist Katherine Heires of MediaKat LLC for alerting RepoWatch to the conference.