One great thing about a new Congress is that bills pending at the end of the prior Congress must be reintroduced. This wipes the slate clean of problematic proposals and reduces the risk of something slipping through without sufficient debate. For example, the proposed Bankruptcy Fairness Act of 2016 (BFA) expired with the 114th Congress. The BFA would have required the Office of Financial Research (OFR) to produce a biannual report to Congress regarding, among other things:
whether amendments to the Bankruptcy Code … and other laws relating to insolvency to modify the treatment of qualified financial contracts and master netting agreements in future situations of insolvency could reduce—
(i) losses in the value of the financial company and its assets;
(ii) losses to other parties in interest;
(iii) moral hazard; and
(iv) risks to financial stability in the United States.”
While such a report may seem innocuous, it might have provided a gateway for eliminating the safe harbors for qualified financial contracts (such as securities contracts, repurchase agreements and derivatives contracts) from the Bankruptcy Code and the Federal Deposit Insurance Act.
One-Sided Criticism of Qualified Financial Contracts
OFR was to produce the report “in consultation with the [FSOC], authors of relevant analytical works, members drawn from the Financial Research Advisory Committee of the [OFR], and other relevant experts.” “Authors of analytical work” are of particular concern. I’ve been reading the Brooklyn Law School’s Symposium on the Treatment of Financial Contracts in Bankruptcy and Bank Resolution. These articles are extremely critical of the current exemption from the automatic stay and other relief provided to qualified financial contracts under the Bankruptcy Code. Moreover, the footnotes in these articles reveal a substantial body of literature advocating elimination of these exemptions.
In contrast, I have read only one recent article defending the current treatment of qualified financial contracts in bankruptcy. The article focused on derivative contracts, without addressing what I would consider the even more compelling case for repurchase and securities lending agreements.
Failing to respond to these critics risks inviting legislation to adopt their recommended reforms, which would sharply curtail the capacity to finance and hedge trading. The failure of a significant counterparty (which must happen eventually) could also become a lightning rod for reform. The trading community will find itself playing catch-up in opposing proposed reforms unless it starts to counter this narrative now.
Monitoring Counterparties
As an example of a misguided criticism, consider the following “critical insight” offered by Professor Mokal in the Symposium:
parties enjoying immunity from bankruptcy’s preservation mechanisms would tend to lend more and at a lower price than they would in the absence of those immunities, and they would tend to monitor their counterparty’s transactions less than they otherwise would.”
His premise is that, if the worst that can happen is an immediate sale of collateral, a lender should be indifferent to the risk of bankruptcy.
Plausible though his premise may seem, it’s contrary to market behavior. In my experience, no one enters into a repurchase or securities lending agreement unless they are sure of receiving the repurchase price or return of collateral when due. For money market funds, this practice is mandated by Rule 2a-7, which requires not only a determination that a repo presents minimal credit risk, but also that the repo seller is creditworthy. This typically means that money funds only do repos with companies on their “approved list” for unsecured investments.
Even granting his premise, his conclusion doesn’t follow. A lender could not disregard bankruptcy risk unless it was certain that the value of collateral upon bankruptcy would exceed the loan. This necessitates a steeper collateral haircut than required by a lender who monitors credit risk, which would reduce the amount lent and increase the cost (insofar as the balance of the collateral would have to be funded by capital).
Professor Mokal misses another “critical insight”—when you lend to someone every day (e.g., overnight repo), it pays to monitor his credit constantly.