An Interview About the End User Exemption with Stephen Lubben

There have been two things I never quite understood about derivatives reform. One is that I never felt I knew the full motivation of all the corporate end-users who wanted exemptions from derivatives rules. The other thing is trying to figure out why the over-the-counter derivative market jumped after 2005.

Someone recently pointed out that the more favorable treatment of derivatives after the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act gave corporate end-users an incentive to turn regular “boring” contracts into swap and other derivatives contracts that did the same exact thing. That a lot of this “magic” and “innovation” in the explosion of the OTC derivatives market was really a type of capital structure arbitrage.

Another person also noted that there were also new incentives, after the 2005 Bankruptcy Reform, to pile into the repurchase agreement (“repo”) market, as the repo definition was explicitly defined to include mortgage backed securities and was explicitly excluded from bankruptcy. Lots of money going into lending through, and then quickly coming out of, the repo markets is behind a very popular shadow banking theory narrative of why the crisis was so explosive.

(Considering that I think of that 2005 bankruptcy reform as an anti-human machine designed to “sweatbox” poor people suffering under medical debt and income volatility, also having a narrative about how that bankruptcy reform encouraged the elite to gamble even more recklessly in liquidity risk and capital structure arbitrage, gambling which ended up ravaging the world economy and almost causing another Great Depression, would make me very, very happy.)

So with this in mind I wanted to find a derivatives bankruptcy expert. And I found one of the best to interview. Stephen J. Lubben is the Daniel J. Moore Professor of Law at Seton Hall in Newark and a blogger at the excellent Credit Slips. He took the time to speak to me about this matter.

Mike Konczal: Let’s say I am an airline, and I use derivatives to hedge energy risk like the price of fuel rising. Why would I want an “end-user exemption” to exclude me from the new derivatives regulation?

A big part of the derivatives reform package is to move over-the-counter derivatives into clearinghouses, so there is more clear information on the overall derivatives market. It is also hoped that the clearinghouse will act as a kind of a cop who regulates counterparty risk. That counterparty risk is the risk that the other person won’t be able to perform or pay his end of the bargain.

The idea with this is to collateralize derivative positions. This turns the derivative from an unsecured contract into a secured contract. This would make the risk of the derivative not getting paid more remote, or at least the losses would be less.

From an end-user’s perspective, say a transportation company hedging energy costs or another company hedging currency costs, the reason they don’t like that they’ll be included in this central clearing system is that they would have to put up collateral too. And that means that they would have to put lots of assets in some sort of holding pen to account for the possibility that they might not perform, assets into a non-usable static location.

Why does the derivatives market take off after the 2005 Bankruptcy Bill? Were there any changes?

What happened in 2005 was that the bankruptcy code provisions dealing with derivatives were pretty massively expanded. Now the industry trade group will tell you it just codified existing status quo. I would clarify that by saying that codified the most industry favorable interpretation of the status quo, and that’s what happened.

So what happened after 2005 was a pretty complete exemption from bankruptcy for derivatives, in three regards. First of all, normally when you file a bankruptcy petition, and you have contracts with people, they have to keep performing on those contracts until you decide if you are going to reorganizing or liquidate. Not so with derivatives. Derivative counterparties have an option to terminate their contracts.

So to use your airline example, when an airline goes into bankruptcy, it’s counterparties on all of its fuel hedges could terminate the contract if they wanted to. This gives them an option to cut off their losses if they think the contract is going the wrong way. This is an option others don’t have in bankruptcy.

The other thing they get that secured creditors don’t get is that derivatives holders can take their collateral. If they collateralized the derivatives position they can take that collateral and leave. Normally a secured creditor has to go to the bankruptcy court and ask court permission to get collateral. But not so with a derivative counterparty.

And the third big change that 2005 codified was that now it is quite clear that you can’t bring any sort of preference or fraudulent transfer action against a counterparty. For example, a day before bankruptcy you decide to pay off your cousin without paying anyone else, that’s called a preference in bankruptcy and you can bring that back. Any creditor who gets better treatment 90 days before the bankruptcy usually has to give that better treatment back to the bankruptcy estate, and the money is distributed out equally to all creditors. Not so with derivatives.

We saw some of this in AIG, where counterparties didn’t have to fear that grabbing collateral during the days AIG was going down the tube would lead to future litigation, because they knew that wouldn’t be brought back.

So it sounds, all things equal, you would prefer to make a regular contract into a derivatives contract after 2005.

Yes, and we saw some things change after 2005. Supply agreements started to morph into swaps or another forms of derivative to take advantage of the bankruptcy exemptions. You see this especially with utility contracts. So a manufacturer’s got some sort of contract with the utility to provide electricity or natural gas. Post 2005, the utility decides it is going to rewrite that contract into an electricity swap or a natural gas swap, basically move it out of the bankruptcy code.

Is it useful to think of this as some sort of capital structure arbitrage by structuring normal contracts as derivatives?

Well, first off from a bankruptcy person’s perspective, if you convert something that is a normal contract into a derivative you are putting more risk of loss onto the remaining unsecured creditors because you’ve jumped ahead in line. That itself is a kind of arbitrage or a wealth transfer from the remaining counterparty to the derivative counterparty.

And since they have this super-priority status, they may have gained an edge in terms of pricing and things like that. And who are the unsecured creditors left behind? The obvious people are employees with unpaid wage claims. The other one are tort creditors. So there is a wealth transfer going on there.

I’ve also heard that the 2005 Act brought repo into this safe harbor. Repo markets are behind a popular narrative in the crisis, one of a “shadow banking run.” Can you talk about 2005 Bankruptcy Act encouraged the use of repo markets?

Repo as it was traditionally understood, say 30 years ago, was basically short-term secured lending, basically on very high-quality collateral, either government debt or AAA corporates. Over the past 10 years it expanded and basically people started doing repo on all other kinds of debt, including mortgage backed securities.

And then in 2005 one of the amendments to the bankruptcy code was to include mortgage backed securities in the definition of repo for the safe harbors. So that meant that there were very strong incentives to securitize anything you could get your hands on, including subprime mortgages, so then the big investment banks like Lehman could use it for their overnight borrowing needs.

There are two side effects to this. The first is that it probably over-encouraged lending in the mortgage market so that it could be securitized and then used for repo. But more importantly, it did encourage any mortgage related loan to be re-characterized as a repo agreement. So again you could have the benefits of the exemption of the bankruptcy code.

Most particularly, we saw warehouse lines of credit, which used to be used by mortgage originators to make home loans until they had a sufficient number of loans to be securitized, well those lines of credit began being converted from regular old loans and lines of credit into repo agreements, so again they could be exempt from the bankruptcy code. With the exemption from the bankruptcy code there may have been a tendency on the part of the banks to overextend on those lines of credit because they were seen as almost risk free because they had an out from the bankruptcy code.

As you said regarding AIG, the special treatment can encourage a bank run.  Could you explain this further?

When these provisions were enacted they were said to reduce the risk of bank runs. The problem is that they probably exacerbate them.

Because the special treatment of derivatives encourages parties to close out positions, and either demand collateral or take their collateral and run, all without any possibility of subsequent challenge, it fosters a run on the bank. One benefit of provisions like the “automatic stay” in bankruptcy is that it imposes a cooling off period, and the provisions regarding derivatives totally undermine that.

The other problem you have is that you have because of the lack of automatic stay and the ability to terminate contracts, when someone like Lehman files for bankruptcy everybody basically rushes to terminate all of their contracts with Lehman and set them up again with some other bank that is still in business.

This means at the very moment where the market is digesting the information that Lehman has failed it also has all these counterparties out there closing Lehman trades and buying new ones, so you are generating extra froth in the market there.

The third problem I have, as a bankruptcy person, it also represent a destruction of value in the bankruptcy estate that is ultimately going to reduce the value of the estate for creditors. All those trades where Lehman didn’t have any exposure but it was sitting in the middle of the trade making the spread, well if those trades could have been sold to someone it would have meant more money to pay off bondholders. But because of the safe harbor, all of the counterparts can just terminate that deal. Which means you basically destroy an asset of the bankruptcy estate.

As far as I understand the safe harbor estate was created for the purposes of netting in clearinghouses. Is that a good idea?

When the first few rounds of safe harbors were created, they were very narrowly targeted. You had some in the 1980s, specific commodity futures trades, and all of those trades were with clearinghouses. These are where you had a party in the middle who, and if they weren’t able to net positions they themselves would face either liquidity or solvency problems.

Somehow over the years the safe harbor rules went from these kinds of places to the over-the-counter market, where there is no central counterparty.

So one approach might be to cut them back only to places where there is central clearing. I think that is workable as long as you have really strong regulation of the central clearing party.

Are there other obvious problems for stakeholders or the idea of corporate governance in this issue?

The chapter 11 process as a whole depends on shared sacrifice, and equal treatment of creditors. Once you start creating these loopholes, well every creditor would like a loophole. But once you start going down that road you destroy the whole purpose of chapter 11 and you might as well put everyone in chapter 7.

But if we believe chapter 11 is more efficient than liquidating everybody, because there are times when it is better to reorganize, then creation of these loopholes is counterproductive. Many of the arguments for derivatives are arguments that could be true for any creditor. We need to think hard about whether or not this is necessary.