BREAK ‘EM UP Reason #3: The U.S. Bankruptcy Code Was Changed to Favor Derivatives Over Loans

A law passed during the height of the bubble in 2005 altered the treatment of derivatives in the U.S. Bankruptcy Code to greatly favor derivatives counterparties over other creditors. The law’s title was, ironically, “The Bankruptcy Abuse Prevention and Consumer Act of 2005”. Bankruptcy law had been designed to rehabilitate debtors while protecting creditors. The 2005 revisions moved in a different direction with what has become the usual political spin. Proclaimed to be measures to reduce systemic risk, the provisions actually result not only in favoring derivatives counterparties, but also “front-running” the FDIC, which is tasked with “resolving” failing banks. The derivatives counterparties walk away immediately with all their collateral, further reducing a failing bank’s already stressed assets.


The U.S. Bankruptcy Code wasn’t always kind to derivatives contracts. When I was in the electric power rating group at Moody’s in the mid-1990s examining the impact of increasing numbers of power marketing companies and contracts, the power trading contracts were considered “executory contracts” in the legal world. That meant that the “performance” of parties to the contract was in the future. “Performance” hadn’t happened at the time the contract commenced, as in a loan where the bank has performed its role by lending the money at closing.

Utilities experienced the setting aside of power marketing contracts in bankruptcy. If the utility was owed money by the bankrupt power marketer, the obligation could be “cherry-picked”. That meant contracts determined to be unfavorable to the debtor would not be included in the bankrupt estate (the vehicle for resolving creditor claims and rehabilitating the debtor). This was a credit consideration for the electric power industry.

Normally in bankruptcy, the Code imposes a “stay” on creditor claims. Cash paid to creditors in months prior to the filing actually has to be returned to the “estate”. Over the course of what may be years, who owes what to whom is tallied for those who have their claims properly documented. Secured creditors were able to claim their security interest — a car, a home, or secured inventory for a business. The debtor had actually bought the car, the home, or the inventory. Derivatives were about future actions.

The 2005 act significantly broadened the specifics surrounding derivatives contracts’ treatment in bankruptcy. Derivatives contracts were exempted from the automatic stay, meaning their collateral (largely cash) could immediately be taken by the counterparty. The types of exempted derivatives contracts were broadened, including adding specific references to the Master Agreement discussed in the Reason #6 post.

With huge percentages of derivatives now moved into the FDIC-guaranteed banking subsidiaries of bank holding companies, all of the cash collateral underpinning these contracts is now ahead of FDIC involvement in resolving a failing bank. Not only are these derivatives counterparties able to avail themselves of the perceived taxpayer backing, they are now at the top of creditor claims in bankruptcies including municipal bankruptcies such as we saw with Detroit.

The 2005 law certainly made life in the derivatives world much more certain, but those left holding the short straws can’t possibly say it reduced systemic risk. Moving derivatives out of the banking subsidiaries and out of bank holding companies is the clear step to reduce systemic risk while maintaining sophisticated derivatives users’ ability to engage in them.

As an aside, books on the Lehman bankruptcy describe the firm’s last hours. Over the weekend before the Monday, September 15, 2008, bankruptcy filing, an assemblage of bankers and other interested parties quickly transferred Lehman contracts to other parties to avoid any question of how so many contracts would fare both legally and in all the modeling. One wonders who got an invitation to that party. Still, years later even some of the biggest banks were resolving derivatives claims with the Lehman estate. They disagreed on their respective models’ valuations, the value of what was owed, or what was or should have been terminated.


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