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Collateral and Derivatives

posted by Stephen Lubben

One of the arguments I've been seeing a lot of lately is that industry X needs an exemption from the financial reform legislation, because the new requirements that most swaps be collateralized -- that is, backed up with collateral to support the "out of the money" party's ability to perform -- would drain capital out of said industry.

But never mentioned is the simple fact that many of these industries did not transact under derivative agreements until after the 2005 amendments to the Bankruptcy Code massively expanded the safe harbors that exempt derivatives from key provisions of the Code. After 2005, many ordinary commodity supply agreements suddenly became swaps. Warehouse loans to mortgage originators suddenly became repo agreements. The economic terms of the deals were essentially the same as before, but now the agreements were exempt from the automatic stay and the normal rule that you can't terminate a contract simply because the other side is in bankruptcy.

So I suspect that many of these industries that claim that they would be hurt by having so much money tied up in posted collateral could easily avoid this fate by simply returning to normal, non-derivative contracts. But then they'd have to give up their special bankruptcy exemption . . . of course, they shouldn't have that in the first place.


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In your essay, you mention that the Safe Harbor Provisions could allow the Central Clearing Authority to be off the hook. Since I believe that the shared risk and pooling of collateral is the main argument for a Clearing House, this would seem to be a serious flaw. Indeed, I wonder if the CCA increases or decreases risk.

In any case, it seems to me to be a weak buffer in the case of a panic, at best. Check The Economics of Contempt as well:

Exchanges vs. Clearinghouses (This is Important)

On Clearinghouses

I'd be more sympathetic to your argument against preferred treatment for derivatives collateral if I could understand the Code's standard treatment in the first place.

What is the argument for putting an automatic stay on non-firm-specific collateral? (Derivatives collateral is usually securities: non-firm-specific.) I understand why you don't want a secured party to exercise its remedies against production machinery, but why not against securities?

The only answer I hear from bankruptcy practitioners is that this allows for financing of the firm. I don't buy this. DIP financing is usually a market-tested alternative.

This paper (http://ssrn.com/abstract=1265070) addresses the argument that Joe mentions. In short, I argue that derivatives are part of going concern value that should be protected, particularly if they are hedges. The "firm specific asset" argument strikes me as a red herring. In the paper I'm primarily concerned with non-financial debtors, but I'd probably extend the argument now.

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