There is an assault brewing on the liquidation rights for swaps contracts. Banks were recently asked to give up some of their rights under the law when 18 of the largest U.S., European, and Japanese banks met in Washington DC after several months of discussions. Regulators want to delay termination rights of swaps contracts for 48 hours for troubled financial institutions. The banks agreed, and the new protocol will take effect on January 1, 2015.
The goal is a noble one. It’s an attempt to limit “fire-sales” during the worse part of a financial crisis. There’s a good case to be made for waiting 48 hours to have a counterparty that’s recapitalized and backed by the government. Just waiting these two days can prevent the entire liquidation process. On the other hand, those 18 banks are giving up liquidation rights that exist under current law. When an important foundation of a market is altered, even in a minor way, there will be consequences. Not surprising, asset managers and hedge funds are resisting the change. Since those entities are not under the same regulatory umbrella as the banks, regulators will have to compel them to comply with the new rules.
But here’s the part I’m concerned about: included in the 48 hour delay is a hold on margin collateral. That means they’re getting into the realm of the Repo market. If swaps are pushed along this route, Repo could be next.
When a company declares bankruptcy, its assets are frozen and the company is either liquidated or reorganized. Either way, no one can touch the assets, except those which are legally exempt like Repo and swaps. Officially, they’re both exempt from the “automatic stay” provision of the bankruptcy code. Repo and swaps counterparties have the right to immediately liquidate all of their outstanding trades with the defaulted entity.
The idea behind the 48 hour delay is to prevent these liquidations and the market distorting fire-sales that result. When counterparties liquidate contracts, it makes a market crisis all the more chaotic. In a way, over the past 30 years, liquidations may have increased market volatility. Lehman Brothers is a good example. They had billions of dollars of swaps trades outstanding and within five weeks of their bankruptcy, 80% of their swaps contracts had been liquidated. It was good to get Lehman as a counterparty off of your books, but the Lehman trustee spent years in the legal system with many of these counterparties trying to claw-back collateral. Avoiding a repeat of the Lehman legal mess is one goal behind the 48 hour delay.
Regulators were give new powers under Dodd-Frank in 2010 to seize a failing bank and keep its units operating. But in order to make it work, you can’t have their counterparties trying to liquidating their positions at the same time. Thus the 48 hour delay in termination rights. Basically, regulators need time to transfer the defaulted entity into a “bridge” holding company. As long as the new entity is well-capitalized and government backed, the swaps counterparties are giving up a bad counterparty for good a good counterparty. And there’s no need to liquidate the swaps contracts. Sounds like a win-win? But again, how much market efficiency and liquidity in normal times is being given up to limit financial market stress during bad times?
Repo Property Rights Established
Repo liquidation rights were originally established after Drysdale, then passed along to municipalities after Orange County. Swaps currently enjoy those same liquidation rights. It’s a system that made Repo and swaps markets highly liquid and highly efficient.
Back in 1982 after Drysdale defaulted, there were no bankruptcy laws on the books nor any court cases to establish the legal status of Repo in a default. No one was sure exactly how the outstanding Repo trades would be treated in a bankruptcy. If Repo was legally a “collateralized loan,” then securities held by a creditor would be stuck in the bankrupt entity. If a Repo was a sale and a repurchase transaction, then the securities could be immediately liquidated. It was a major issue that would have ramifications going forward.
Though Chase Manhattan Bank covered Drysdale’s loss and took over Drysdale to liquidate them, there was no immediate resolution of the Repo liquidation rights issue. The issue came up again just three months later when another firm, Lombard-Wall, collapsed in August 1982. In September 1982, one month later, the Federal Bankruptcy Court of New York ruled that a Repo was a sale and repurchase transaction, making it two separate transactions and thus not a single collateralized loan. The court recognized that allowing prompt liquidation was necessary to continue the orderly functioning of the markets. Two years later, in 1984, Congress passed an extension of the Federal Bankruptcy laws so that Repo on Treasurys, Federal Agencys, CDs and BAs were exempt from automatic stays in a bankruptcy by law. The Repo market was off and running, but one aspect of the bankruptcy code was overlooked – municipalities.
Repo Property Rights In Orange County
On December 6, 1994 Credit Suisse First Boston demanded repayment of $2 billion of the Repo trades that they had executed with Robert Citron, the Treasurer of Orange County, California and they immediately seized $1.25 billion of Orange County’s securities. Later that day, Orange County declared bankruptcy, making it the largest municipal bankruptcy in the history of the United States up until that time.
When the county declared Chapter 9 bankruptcy to seek protection, they thought they were preventing a run on their investment portfolio and they’d prevent their Repo counterparties from liquidating their securities. Chapter 9 bankruptcy is a specific type of reorganization reserved solely for municipalities. When the Bankruptcy Act came into being in 1934, a part of it was called Chapter 9 and it allowed specifically for bankruptcy protection to municipalities. A very important feature of Chapter 9 is that the law specifically did not include Section 559 of the larger bankruptcy code. Section 559 allows a repo counterparty to liquidate repurchase agreements in order to recoup their money. In other words, whereas the whole Repo market was set up so that a creditor can sell the collateral in the event of default, Chapter 9 bankruptcy prohibited – or at least didn’t explicitly allow – it to happen. It was, at the time, an untested loophole in the law. Orange County officials were pinning their hopes that by declaring Chapter 9, their Repo counterparties would have their hands tied and wouldn’t be able to liquidate the securities.
Ironically – and perhaps predictably – when Orange County filed for bankruptcy, the result was the exact opposite. The Wall Street firms interpreted the bankruptcy filing as a default, which it was, and began to enforce the terms of the Repo agreements. That meant they all began liquidating Orange County’s positions.
Merrill was the next one to launch a liquidation salvo, selling off all of $800 million in securities that they were holding . The firm contented that they were legally allowed to sell off the securities, because the Repo legal agreement allowed for liquidation in the event of a default. The Orange County Board of Supervisors begged to differ and they authorized their lawyers to begin filing lawsuits against any Wall Street firm that liquidated securities. They alleged that selling collateral was illegal under the Chapter 9 because there was no mention of Repo agreements in the law. Banks were, therefore, legally obligated to return the securities to Orange County. Their argument, though legally clever, fell on deaf ears and the other liquidations proceeded.
All of the same arguments used to suspend swaps liquidation rights could be used to suspend Repo liquidation rights. In the near future, we could see regulators asking Repo counterparties to wait 48 hours before liquidating securities financing transactions. The problem is: Repo is fundamentally different from swaps. In swaps, the two parties agreed to pay the differential (say fixed versus floating) on the notional amount of the trade. It’s all about cash flow. In Repo, the two counterparties actually exchange the notional amount; that is, they exchange cash and securities. If the Repo market were asked to suspend its liquidation rights for 48 hours, the counterparties would be giving up their rights for their cash or their securities for that period of time. It’s a larger issue than waiting for a differential on cash flow for 48 hours.
If the 48 hour waiting period is extended to the Repo market, I’m worried about the unintended consequences. What helps during a market crisis, might hurt the market the other 99.9% of the time. If a bank is teetering on the brink of collapse and their Repo counterparties know their liquidation rights will be suspended for two days, they may pull their funding faster. During that 48 hour waiting period, there will be market distortions. Uncertainty will drive counterparties to panic and act in unexpected ways.
Overall, suspending the liquidation rights for swaps for 48 hours will help address the fire-sale issue, but I’m worried the tradeoff will have unintended consequences. Does market stability during a one week period justify market distortions for the 10 to 20 years in between? That’s a crucial question. I’m not sure the correct answer, but I am certain there are tradeoffs.