Putting Repos Back Where They Belong

WARNING: Inside bankruptcy baseball.

For a short and as-clear-as-I-could-make-it primer in repos (and other obscure financial contracts) read my piece about poor Farmer Rex titled A Fable of Financial Contracts: A Guide for the Perplexed (download here). For a sophisticated argument that the exemption of repos from the effects of bankruptcy should be reduced, read Rolling Back the Repo Safe Harbors (download here). Cribbing from the abstract:

Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against pre-bankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to favored creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007–2009. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed. (Emphasis added.)

Filing bankruptcy stops creditors in their tracks. Collective action is the hallmark of bankruptcy and forms the basis of the "creditors' bargain" justification for corporate bankruptcy. Thus, letting some creditors get paid even though others cannot is fundamentally unfair. Even claims that have a strong moral priority, which ultimately have priority in payment, can't flout the bankruptcy filing. They too must participate in the process.

Beginning in 1978 and proceeding incrementally since then, Congress has given repos, which are undisguised loans, greater and greater freedom from the limits of bankruptcy. It turns out that some creditors are more equal than others, and, not surprisingly, those creditors also happen to be large contributors to congressional campaigns.

So what, you ask? Note the italicized sentence in the abstract. The power of some creditors to get their money out before "others" causes the "others" to try to beat the highly-favored ones to the punch and get their money out even before bankruptcy. A reverse cascade, so to speak. This phenomenon was clearly a contributing factor to the meltdown of several financial firms in 2008, which, in turn, was a large part of the financial crisis whose effects linger to today.

In short, the authors' conclusion is sound and Congress should make the change in the Bankruptcy Code.

Don't hold your breath.