One reason was The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Its provisions encouraged lenders to lend into the boom and flee at the bust.
Today, after seven years of calls from critics for fixes to these provisions, The Wall Street Journal reports regulators may be making progress toward repairs.
The 2005 bankruptcy act was largely sold to Congress as a way to prevent scofflaw households from filing bankruptcy and getting out of paying their bills when they had enough money to pay their debt.
According to a New York Fed staff report about the act:
Lenders blamed the steady rise in personal filing rates on “soft” bankruptcy law that motivated households to borrow more than they could afford, with the bankruptcy option in mind, then repay less than they could afford in the event of bankruptcy.
In general, the act made it more expensive and more difficult for consumers to file for bankruptcy, which was Congress’s way of addressing the concerns of credit card companies and others. It also set new restrictions on borrowers of student, auto and home loans.
After the act passed, between 2005 and 2008 lenders poured billions more dollars into credit card, student, auto, home and other lending. This helped finance the final frenzied stage of the boom – a boom that continued even though the Federal Reserve raised interest rates relentlessly from June 2004 to August 2007 and even though the bankruptcy act made the loans less attractive for consumers.
Then, when the lenders began having second thoughts, provisions of the bankruptcy act encouraged a rout, economists have shown.
Here are some examples of how these new bankruptcy rules worsened both the boom and the bust.
Student loans: Prior to 2005, most student loans guaranteed by the government or made by non-profits were not dischargeable in bankruptcy. In other words, a bankrupt borrower still had to pay these loans off. In 2005 the new act said most privately funded student loans also could not be discharged in bankruptcy. They, too, had to be paid off. Suddenly it was safer for private lenders to make these loans, and it was also safer for investors to buy securities backed by pools of these loans. Private loans and securities surged.
In 2000-2004, student loan securitizations averaged $30 billion a year, according to the Securities Industry and Financial Markets Association. In 2005 they more than doubled to $63 billion. In 2006 and 2007 they averaged $64 billion a year.
Auto loans: Before 2005, a buyer of a new car could file bankruptcy and get the debt reduced to the fair market value of the car, which could be a big reduction because new cars lose value quickly. The 2005 act said consumers couldn’t get this debt reduced in bankruptcy unless they had owned the car for 2 1/2 years. Suddenly it was safer for lenders to make these loans, and it was also safer for investors to buy securities backed by pools of these loans.
In 2000-2004, auto loan securitizations averaged $83 billion a year, according to SIFMA. In 2005 they jumped to $109 billion, and in 2006 and 2007 they averaged $87 billion a year.
Mortgages: While the 2005 act made it harder for borrowers to discharge student and auto loans in bankruptcy, the act had a different effect on homeowners.
Prior to 2005, bankrupt borrowers could discharge student, auto, credit card and other types of debt and then focus their resources on making their mortgage payments and saving their homes. That strategy became harder in 2005, when the act made it tougher to qualify for bankruptcy, more expensive to file and harder to discharge student or auto loans.
This should have hurt mortgage lenders, but another feature of the act helped them. Here’s how:
Before 2005, repurchase agreements were exempt from the automatic stay in bankruptcy court if they had super safe collateral like U.S. treasuries. This meant that when a repo borrower filed bankruptcy, the repo lender could immediately sell this collateral and thus avoid entanglement in long, complicated bankruptcy proceedings. In bankruptcy court jargon, these repos had a “safe harbor” in bankruptcy court.
In 2005, the bankruptcy act expanded the safe harbor to include repos collateralized with mortgages and interests in mortgages, including mortgage-backed securities and collateralized debt obligations, and mortgage derivatives.
The stated idea was to head off systemic risk by preventing problems at a bankrupt company from spreading to another firm. But the consequence was to make repos backed by mortgage securities attractive to lenders, and it motivated financial markets to create more of these securities.
By that time, after a year of rising interest rates, securitization of government-backed home loans was on the decline, according to SIFMA. But securitization of mortgages financed by private mortgage lenders jumped from an average of $245 billion in 2000-2004 to $726 billion in 2005. In 2006 and 2007 they averaged $596 billion.
Repurchase agreements: Many of these securities became collateral on the repurchase market. At the repurchase level, the category that included repos of student, auto and private home loan securities grew from an average of $222 billion outstanding in 2004 to $448 billion in 2007, according to the Federal Reserve. (Editor’s note: These are corporate repos conducted by primary dealers, who were thought at the time to be doing 90 percent of the repos.)
In 2008 when the financial crisis hit, repo lenders quickly tried to sell their collateral into a market panic, driving down the values of the securities and threatening the solvency of many of the nation’s largest financial institutions. Shadow banking collapsed.
In 2009 student loan securitizations fell to $21 billion, and soon the private for-profit college industry was struggling. Auto loan securitizations sank to $64 billion, possibly cushioned in part by used cars. Private home loan securitizations dropped to zero. The repurchase market for this sector fell to $160 billion, even though the Fed was doing everything in its power to keep money flowing through repos.
Realizing in hindsight that the repo provision of the 2005 bankruptcy act worsened the fire sales of mortgage collateral in 2008, experts have often spoken of needed reform, for example here and here. Recently regulators hinted at action. So far, none has been taken.
Some recent expressions of concern:
Thomas M. Hoenig, the president of the Federal Reserve Bank of Kansas City, said in a May report that the elimination of the special bankruptcy treatment for mortgage-backed repos was one of the three most important reforms that must be taken to avoid another financial crisis.
Experts at a financial conference in London said 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.
In A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements in March, economists Darrell Duffie and David Skeel noted that every day the broker-dealer affiliates of large U.S. financial institutions roll over $100 billion or more of new repo financing. If one of these institutions files for bankruptcy, the safe harbor gives its repo lenders “significant additional priority over other creditors.”
Briefly speaking, we both believe that repos (and certain closely related qualified financial contracts) that are backed by liquid securities should be exempt from automatic stays, or receive an effectively similar treatment. Repos backed by illiquid assets, on the other hand, should not be given this safe harbor.
International regulators felt pessimistic about being able to reverse the bankruptcy provisions.
In Strengthening Oversight and Regulation of Shadow Banking – Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, a paper published by the Financial Stability Board August 29, regulators argued that while changes in bankruptcy law and creation of an authority to acquire collateral in a crisis could help with financial stability issues, they weren’t a practical solution.
Recommendation 11: Changes to bankruptcy law treatment and development of Repo Resolution Authorities (RRAs) may be viable theoretical options but should not be prioritised for further work at this stage due to significant difficulties in implementation.
U.S. regulators were more determined.
These safe harbors for financial contracts exist for one articulated purpose: to promote stability in financial markets.
Yet there is no evidence that they serve this purpose. Instead, considerable evidence shows that, when they matter most — in a financial crisis — the safe harbors exacerbate the crisis, weaken critical financial institutions, destabilize financial markets, and then prove costly to the real economy. Worse, the best available evidence also shows that the safe harbors distort the capital structure decisions of financial firms by subsidizing runnable short‐term financing at the expense of other, safer debt channels, including longer‐term financing. When financial firms favor volatile short‐term over more stable long‐term debt, they (and markets generally) are more likely to experience a “run” in the event of a market shock, such as the downturn in housing prices during the most recent recession.
It is time for the Bankruptcy Code to get out of the business of regulating financial markets.
Then international regulators had a bankruptcy breakthrough on derivatives.
At the request of regulators from Germany, Japan, Switzerland, the United Kingdom and the U.S., the International Swaps and Derivatives Association, Inc. (ISDA), negotiated an agreement between 18 major global banks that would allow the imposition of a 48-hour automatic stay on derivatives. The idea was to give regulators time to stabilize the solvent parts of the bankrupt company, such as moving them to a bridge company or finding a buyer.
This apparently encouraged regulators to try to reach a similar agreement on repos.
Reporter Katy Burne at the Wall Street Journal reported April 14 that just such negotiations were underway.
Under the changes proposed, firms trading with a troubled financial institution would agree to temporary waivers of certain contractual rights they currently enjoy, such as the ability to terminate their contracts early, buying regulators and the firm time to arrange a lifeline.
Regulators already pushed for the changes on derivatives called swaps, a roughly $700 trillion global market that allows users to hedge or speculate on everything from the path of interest rates to the price of oil.
Last year, the largest 18 banks in the U.S., Europe and Japan agreed to wait up to 48 hours before seeking to pull out of their swaps early, and before collecting related payments, when a trading partner is failing. Those changes took effect in January.
Now, regulators want firms to apply similar changes to the key short-term contracts like repos and securities lending agreements, said industry executives involved in the discussions.
“Work is under way amongst market participants to expand the process to other types of contracts,” said Eva Hüpkes, adviser to the secretariat of the Basel, Switzerland-based Financial Stability Board, a body that promotes international financial stability and is encouraging banks’ expansion of the work done for swaps.
Banks are generally on board with the proposal to expand the swaps initiative to cover repos and other contracts, said people familiar with the matter.
This triggered push-back from some repo lenders.
Such a change could have unsettling unintended consequences on investment funds that are repo lenders, wrote portfolio managers for Wells Fargo Advantage Funds in an April 30 commentary. For example, it could severely limit money market funds from making repo loans collateralized by government securities, or it could drive money market funds to conduct repos only with the New York Fed, the portfolio managers said.
If reporter Katy Burne’s sources are right, in the coming months we’ll be hearing more from regulators about repos and bankruptcy.
The goal is to amend the additional contract types sometime later this year, the people familiar said.