Too risky for bankruptcy is too risky to do

In the midst of financial turmoil on Wall Street, some experts are pointing to bankruptcy laws as one reason for the crisis.

Here’s their concern: Several financial assets including repurchase agreements are exempted from bankruptcy control. This means, for example, that a repo lender gets to keep the collateral when a repo borrower goes bankrupt.

If repos were not exempted from bankruptcy control, the collateral would become part of the bankrupt company’s assets, to be shared with all creditors.

The purpose of the 1984 exemption was to prevent troubles at a bankrupt company from infecting the financial system. In other words, the purpose was to prevent systemic risk. But some experts claim the law increases systemic risk, because it spurs businesses to do repos instead of regular loans, which are not protected from a bankruptcy; it lets repo lenders ignore risk in their lending decisions; and it protects them from their bad decisions.

The impact got even more profound after the Bankruptcy Act of 2005 added mortgage-backed securities to the list of exempted repo collateral.

Law professor Jay Lawrence Westbrook of the University of Texas discussed these issues in testimony before the House Subcommittee on Commercial and Administrative Law Committee on the Judiciary September 26, 2008. From his testimony:

These exemptions are often claimed to be necessary to the accomplishment of certain transactions, but as a prominent Wall Street lawyer put it to me: “If the prospect of bankruptcy makes the deal too risky, it’s too risky a deal to do.” That is especially true for financial institutions and should be doubly true for those “too big to fail.”

I want to share with you today the following major points:

1. The 2005 amendments to the Bankruptcy Code greatly expanded the scope of the exemption of financial assets from the control of the bankruptcy laws.

2. The expansion included exempting for the first time mortgages and mortgage securities, the epicenter of the current financial earthquake.

3. The amendments also used ambiguous language that blurred the boundary between financial contracts and other contracts, creating a lack of predictability and an opportunity for abuse.

4. These exemptions considerably reduce the capacity of the bankruptcy laws, both liquidation and reorganization, to do their traditional work of ensuring an orderly, predictable, and fair resolution of financial distress.

5. The 2005 expansion could be undone without substantial difficulty. Prospectively, business could easily adjust.

6. Given the highly unusual circumstances of systemic risk now presented, even a retrospective suspension of those exemptions could be made a condition of government aid where appropriate.

See Westbrook’s talk for more detail and his suggestions for reform.