FCIC, 2: On BAPCPA and the Ability to Determine Relative Importance of Causes

I’m still reading and enjoying the Financial Crisis Inquiry Commission report.  I think it’s one of the best introductions to what has happened;  I’m learning new stuff throughout it.  Though one problem I’m having is that while the breadth of the topics is all inclusive, it is difficult to discriminate between how much causation to put on many of the issues, especially as we get further along in the crisis.

Example:  One thing I’m thinking about these days is the role of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 in the crisis. I think the 2005 Bankruptcy Reform is pretty much been proven to be a disaster bill, and if we learned that it helped spark the shadow banking panic that would be even better. During the financial reform debates I did an interview with Stephen Lubben about it. I’ve been meaning to learn more since.

The FCIC document brings up the derivative amendments that were snuck into the bankruptcy reforms and their role in the crisis:

The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight. Subsequently, other laws enabled the expansion of the market. For example, under a 2005 amendment to the bankruptcy laws, derivatives counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy. (p. 48)

Regulatory changes—in this case, changes in the bankruptcy laws—also boosted growth in the repo market by transforming the types of repo collateral. Prior to 2005, repo lenders had clear and immediate rights to their collateral following the borrower’s bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that provision to include many other assets, including mortgage loans, mortgage-backed securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-2007, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source (see figure 7.1). Once the crisis hit, these “illiquid, hard-to-value securities made up a greater share of the tri-party repo market than most people would have wanted,” Darryll Hendricks, a UBS executive and chair of a New York Fed task force examining the repo market after the crisis, told the Commission. (p. 114)

The repo runs of 2007, which had devastated hedge funds such as the two Bear Stearns Asset Management funds and mortgage originators such as Countrywide, had seized the attention of the financial community, and the run on Bear Stearns was similarly eye-opening. Market participants and regulators now better appreciated how the quality of repo collateral had shifted over time from Treasury notes and securities issued by Fannie Mae and Freddie Mac to highly rated non-GSE mortgage–backed securities and collateralized debt obligations (CDOs). At its peak before the crisis, this riskier collateral accounted for as much as 30% of the total posted. In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 had dramatically expanded protections for repo lenders holding collateral, such as mortgage-related securities, that was riskier than government or highly rated corporate debt. These protections gave lenders confidence that they had clear, immediate rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Dimon, the CEO of JP Morgan, told the FCIC, “When people got scared, they wouldn’t finance the nonstandard stuff at all.”

To the surprise of both borrowers and regulators, high-quality collateral was not enough to ensure access to the repo market. Repo lenders cared just as much about the financial health of the borrower as about the quality of the collateral. In fact, even for the same collateral, repo lenders demanded different haircuts from different borrowers. Despite the bankruptcy provisions in the 2005 act, lenders were reluctant to risk the hassle of seizing collateral, even good collateral, from a bankrupt borrower. Steven Meier of State Street testified to the FCIC: “I would say the counterparties are a first line of defense, and we don’t want to go through that uncomfortable process of having to liquidate collateral.” William Dudley of the New York Fed told the FCIC, “At the first sign of trouble, these investors in tri-party repo tend to run rather than take the collateral that they’ve lent against. . . . So high-quality collateral itself is not sufficient when and if an institution gets in trouble.” (p. 293)

But it’s sort of flat. I can’t tell if it is a major cause of the panic, a minor cause, a clarification of standard practices, industry-wide, etc. There’s little original data or research, which is probably expected given the exercise, but it’s tough to distinguish the interesting small things versus the interesting important things. For a general reader that won’t matter too much, but for people trying to figure out where to go next it is very important.  This is true broadly of the topics they bring up.  The section on the shorts and the synthetics (p. 190-195) is a great description I’ll just encourage you to read, but at the end it’s tough to tell how much weight should be placed on this – if it is a major cause, or an interesting sideshow.

They are doing large data dumps on what they researched and founded to go with the report. I’m hoping that this will allow researchers, academics and interested parties to dig in and fill in the missing shades and depth in the causes of the crisis. We’ll see how that works out in practice.

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4 Responses to FCIC, 2: On BAPCPA and the Ability to Determine Relative Importance of Causes

  1. rootless_e says:

    The weird thing about the effect of that derivatives bankruptcy provision was how little difference it made to ISSUERS of credit default swaps – you’d think that AIG risk managers or AIG bondholders or shareholders would be concerned about being shoved down the line of priority. But one of the most remarkable things about the crisis is how much money is managed by people who are not only ignorant about the technicalities, but are basically uninterested. The ability of Goldman-Sachs management to intervene and hedge housing market exposure or that Bakersfield bank CEO to dump CDOs when he could not get answers to basic questions seem (a) rare and (b) not correlated with success. Lehman’s top lawyer … well, check it out


  2. Milton Recht says:

    Congress and the Fed were warned about a bankruptcy effect but chose to ignore the research.

    From “Derivatives and the Bankruptcy Code: Why the Special Treatment?” by Franklin R. Edwards and Edward R. Morrison, Yale Journal on Regulation Vol. 22: 2005,

    “In Fall 1998 the Federal Reserve Bank (the “Fed”) arranged a bailout of
    the massive hedge fund, Long Term Capital Management (“LTCM”), which
    faced the prospect of immediate liquidation if it filed a petition under Chapter
    11 of the Bankruptcy Code. Although the Code generally prevents creditors
    from seizing assets of a firm in bankruptcy (this provision is called the
    “automatic stay”), counterparties to financial derivative contracts (options,
    swaps, repos, and the like) receive special treatment under the Code and are free
    to terminate contracts and seize collateral to the extent they are owed money.
    Defending the Fed’s decision to assist LTCM, Federal Reserve Chairman Alan
    Greenspan explained:

    ‘[T]he act of unwinding LTCM’s portfolio in a forced liquidation
    [precipitated by LTCM’s derivatives counterparties] would not only have a
    significant distorting impact on market prices but also in the process could
    produce large losses, or worse, for a number of creditors and counterparties,
    and for other markets participants who were not directly involved with
    LTCM . . . .’

    The Fed believed that its intervention was necessary to avoid a systemic
    meltdown that might arise from LTCM’s liquidation—a liquidation made
    possible by the Bankruptcy Code’s special treatment of derivative contracts.
    VI. Conclusion
    Our analysis suggests that the Code’s special treatment of derivatives
    contracts cannot be justified by a fear of systemic risk in derivatives markets.
    Indeed, exempting derivatives counterparties from the automatic stay may make
    matters worse by increasing systemic risk….Our analysis, however, should worry members of Congress and legislators in other countries. They have been lobbied heavily by special interest groups (such as ISDA) to expand the special treatment of derivatives on grounds that such legislation is necessary to prevent a systemic meltdown in OTC derivatives markets should a derivatives counterparty suffer financial distress.

    Our analysis casts serious doubt on this proposition. Systemic risk may be a
    real threat, but bankruptcy law has no role to play in addressing it.”

  3. Phil Koop says:

    Milton Recht’s selection of quotations from the Morrison & Edwards paper is tendentious. Had it run just a little further, it would have read:

    “A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay … assets are needed to preserve going-concern surplus only if … they are worth more inside the firm than outside it. This is often true for plant and equipment. It is rarely true for derivatives contracts. This observation, we think, helps rationalize the Code’s treatment of derivatives contracts and other features of the automatic stay.”

    Actually, this is an understatement: the market value of a derivative is higher outside a troubled firm than inside it, because of credit value adjustment, which ultimately reflects the higher cost of funding a hedge.

    The final cautionary note is hardly a call to arms:

    “There are, however, downsides to treating derivatives contracts differently … These
    downsides are probably not significant, but they highlight the fragility of the Code’s treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code’s exemptions for derivatives contracts.”

    The concept of segregated collateral is not peculiar to financial derivatives, the most egregious counter-example being the mortgage. The social value of financial contracts is debatable, and one could criticize segregated treatment on those grounds. But the same could be said of mortgages etc.

    Regarding the tendency of repo market participants to consider (and price) counterparty quality, this FRBNY paper is most illuminating: http://www.newyorkfed.org/research/staff_reports/sr477.pdf. The crux is that different repo markets behaved differently during the crisis. In particular, tri-party repo haircuts hardly changed, in marked contrast to bilateral haircuts.

    When it comes to apportioning blame, one must observe that a significant proportion of mortgage-based debt was funded not by repo, but by another shadow-banking system: SIV’s + commercial paper + money market funds. As long as it is legal to sell an asset to another, bankruptcy-remote entity, repo is not strictly needed.

  4. David Larsson says:

    Mortgage are exempted from the automatic stay?

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