The Idea:Reconsider derivatives’ privileged status in bankruptcy.
The US bankruptcy code — specifically, Chapter 11— has existed more or less in its current form since 1978. One central rule, known as the automatic stay, prevents creditors and other claimants from demanding immediate repayment when a company files for Chapter 11, thereby providing time for a judge to oversee an orderly bankruptcy proceeding. Over the years, however, derivatives contracts, along with swaps and repos, have become exempt from the automatic stay, giving derivatives holders an edge — to the extent that they hold collateral, derivative counterparties are repaid at the moment of a bankruptcy filing, while all other claimants (including secured creditors) are subject to the automatic stay. Because of this special rule, derivative contracts essentially get repaid first.
In a recent working paper, Professors Patrick Bolton and Martin Oehmke examine the effects of this special bankruptcy treatment for derivative contracts. Using tools from corporate finance theory, the researchers built a model to answer the following question: from an economic perspective, is it more efficient to have derivatives paid off first, before all other debt? Or would it be preferable to repay lenders to the firm first and then derivative counterparties? These questions are not theoretical; when Lehman Brothers filed for Chapter 11 in 2008, in the largest bankruptcy in US history, it held hundreds of millions of dollars in assets. Yet within hours of the bankruptcy filing, a large percentage of Lehman’s assets had already been claimed by counterparties to its derivatives contracts.
The researchers found that the current regulations reflect too narrow a view of the financial world. Giving special treatment to derivatives may make derivative contracts safer, but transfers risk to other creditors, such as bank lenders, who are now second in line in the event of a bankruptcy. Bank lenders, anticipating this risk, therefore charge higher interest rates. When this feedback effect on a firm’s cost of debt is taken into account, it is usually preferable to put creditors rather than derivative counterparties first in line.
The special status of derivatives in bankruptcy has become an important topic of debate in recent years among policymakers, legal scholars, and regulators (it is the subject of a recent Government Accountability Office (GAO) report, “Financial Company Bankruptcies”, GAO-13-622, Jul 18, 2013). The researchers’ study is the first formal analysis of the costs and benefits of the current provisions. Their findings suggest that the default risk, which under the current system is borne mostly by lenders to the firm, would be more efficiently borne by spreading the loss given default among all investors, including the derivatives counterparties.
Patrick Bolton is the Barbara and David Zalaznick Professor of Business in the Finance and Economics Division of Columbia Business School.
Martin Oehmke is associate professor of finance and economics at Columbia Business School.
© Journal of Finance, 2014 (forthcoming)
Publication type: Forthcoming article