May 11, 2010

Bankruptcy Reform Will Limit Bailouts If Bear Stearns or AIG had been able to keep their derivatives creditors at bay, there would have been much less justification for a taxpayer rescue.

Filed under: Uncategorized — ktetaichinh @ 3:09 pm
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President Obama and his spokesmen accuse critics of fending off the legislation to protect outsized profits that big Wall Street banks earn from derivatives. By structuring derivatives as private contracts tailored to particular parties, the leading banks (including J.P. Morgan, Goldman Sachs and Bank of America) do indeed earn major profits. According to J.P. Morgan CEO Jamie Dimon, his bank has “$700 million or a couple of billion dollars” at stake. And if derivatives were turned into plain vanilla contracts that traded like stocks or bonds, most of these profits would disappear.
Since the banks stand between investors in the deals, they are often able to make a big profit on the difference between the prices at which investors are willing to buy and sell. If investors have better information about how the deals are priced, the “spread” between those prices should shrink, hurting the banks’ profits on the deals. Derivatives trading is largely concentrated in five large Wall Street banks: J.P. Morgan Chase, Goldman, Morgan Stanley, Bank of America Corp. and Citigroup Inc. Commercial banks made an estimated $20 billion from trading derivatives, according to the Comptroller of the Currency and industry estimates.

One small factor in Wall Street’s favor: The Obama administration, which supports strict regulations of derivatives, thinks the bill is too stringent. That could give ammunition to opponents who say it could tighten credit.

But the financial services industry has legitimate concerns. Many derivative contracts are so specialized they cannot realistically be converted into plain vanilla, exchange-traded instruments. While there may be a large market for contracts that insure against a default by Yahoo or General Electric, for instance, a credit default swap on a regional business or a more esoteric security might not be suitable for trading on an exchange. Big fees for structuring custom-made derivatives are not illegitimate.

This is where bankruptcy comes in. Remarkably, the word bankruptcy isn’t mentioned a single time in the 227 pages of the Dodd bill dealing with derivatives. Yet the treatment of derivatives in bankruptcy was a major excuse for the now-discredited bailouts of the 2008 financial crisis.

Normally, when a company files for bankruptcy, its creditors can’t immediately terminate their contracts and can’t pester the debtor for more collateral or repayment. This rule is essential to the orderly resolution of a company’s financial distress. But derivative contracts get special treatment. A series of amendments to the bankruptcy laws starting in the 1980s and running through 2006 exempted derivatives from this and other core bankruptcy rules.

These special rules for derivatives were well-intentioned, and they were supported by Federal Reserve Chairman Alan Greenspan, former Fed Chairman Paul Volcker, and the Reagan, Clinton and Bush administrations. Officials in both parties thought that any interference with these contracts could undermine confidence in the derivatives markets. What we now know is that the threat to the financial system is much greater if thousands of contracts could be terminated and other parties tried to sell the assets that are collateralizing them all at the same time. This could create a huge downward pressure on asset values.

Simply flipping the switch and giving derivatives the same treatment as other contracts in bankruptcy could break the impasse on derivatives regulation. With bankruptcy as a more effective backstop for financial institutions in distress, lawmakers wouldn’t need to force every derivative onto an exchange. And if the framework left enough flexibility in the derivatives market for both plain vanilla and more specialized contacts, there would be less need for the financial services industry to fight reform tooth and nail.

Perhaps best of all, these simple changes would reduce the need for bailouts. If Bear Stearns or AIG had been able to stop their derivatives creditors from demanding collateral or cancelling their contracts by filing for bankruptcy, there would have been much less reason for regulators to step in with a taxpayer bailout.

Given the simplicity of the reform, why isn’t anyone talking about it? Jurisdiction seems to be the answer. Bankruptcy changes ordinarily go through the Judiciary Committee, and Mr. Dodd is anxious to keep financial reforms in his Banking Committee. But Ms. Lincoln’s proposals show how easy it is to coordinate if there’s a will to do so. If the Agriculture Committee can join in, so can Judiciary.

If there were a silver bullet in financial reform, legislation would have been enacted long ago. There isn’t, but removing the special treatment of derivatives in bankruptcy comes close. It could provide the basis for a sensible compromise on derivatives regulation while also addressing the bailout problem.

Mr. Jackson is a professor at the University of Rochester. Mr. Skeel is a professor at the University of Pennsylvania law school.


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