2005 Bankruptcy Act impacted repos and housing bubble

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 had a profound impact on the repurchase market, the housing bubble and the financial crisis of 2007 and 2008, several bankruptcy experts have concluded.

Regarding repo, the act added mortgages and interests in mortgages, including mortgage-backed securities and CDOs, to the list of repo collateral that is given a “safe harbor” in the Bankruptcy Code. Safe harbor means that when a repo borrower goes bankrupt, the repo lender does not have to join the other creditors dividing up the remains.

The purpose of the 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 increased systemic risk, because it (1) lets repo lenders ignore risk and makes them eager to do more repo loans, (2) makes repo borrowers ravenous for more collateral, so they can get some of those repo loans, (3) lets banks get by with less equity because regulators think a bank that is selling securities overnight on the repurchase market, to get a repo loan, is taking less risk that if it holds the same securities longer term, and (4) artificially drives down the value of repo collateral, when repo lenders rush to sell collateral they’ve had to seize.

Seton Hall University professor Stephen J. Lubben argues in the American Bankruptcy Law Journal that safe harbors should be repealed, but he says it must be done carefully.

He says the 2005 Bankruptcy Act affected repos in several ways. Among them:

The traditional “warehouse loan” used by mortgage originators was transformed into a repo agreement that received the protections of the safe harbors. Traditional warehouse loans were short-term loans secured by mortgages recently originated. The loan provided the originator with liquidity until enough mortgages had been originated to form the basis for a securitization. Post 2005, warehouse financing arrangements typically have been documented as “master repurchase agreements” under which an originator sells mortgage loans to its former lender with a simultaneous agreement by the originator to repurchase from the lender. The repurchase is then consummated when the securitization happens.

The economic effect of the deal is the same, but now the lender no longer has to worry about becoming involved in a bankruptcy proceeding. This may have encourage excessive lending to mortgage originators.
 
Perhaps more importantly, following the 2005 Amendments, repurchase agreements became much more common in asset-backed commercial paper conduits and structured investment vehicles, the financial structures that were amongst the first to collapse in the financial crisis. At heart, an asset-backed commercial paper facility is a means of securitizing lower quality assets in a way that will allow the originator or buyer of these assets to issue highly rates money market instruments traditionally among the cheapest form of corporate finance available. Banks and similar lenders found conduits and structured investment vehicles attractive because they allowed them to continue to offer traditional receivables financing without the regulatory implications of making a loan that would appear on their balance sheet.

These off-balance-sheet vehicles were thus holders of long-term assets financed using short-term paper. This presented an obvious problem, since there are historical examples of periods when commercial paper would not “roll,” such as after the Penn Central bankruptcy filing in 1970. To overcome this problem, the sponsoring bank granted a credit line, or “liquidity backstop,” to the conduit.

Moreover, after the 2005 amendments to the Code, which were accompanied by corresponding amendments to the relevant banking statutes, sponsoring financial institutions increasingly used repo agreements to increase the credit rating of the asset-backed commercial paper issued by conduits and structured investment vehicles. If a repurchase agreement provided for full recourse to a highly rated sponsor – that is the ability to return all the assets – the asset-backed commercial paper could be rated based on the credit rating of the sponsor, which seemed to remove any need to reflect on the quality of the underlying assets being placed in the conduit – and thus the ability to turn lead into gold, or so it seemed.