Rolling Back the Repo Safe Harbors

79 Min Read By: Edward R. Morrison, Mark J. Roe, Christopher S. Sontchi

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 prebankruptcy 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 these exemptions to mortgage-backed securities should be reversed.

Contents

Introduction

 I.   Background

II.   Principles for Policymakers

A.   Benefits

1.   Liquidity and Financing Costs

2.   Shadow Banking

3.   Systemic Risk

B.   Costs

1.   Liquidity and Financing Costs

2.   Shadow Banking

3.   Systemic Risk

a.   Raising Systemic Risk by Encouraging Short-term Finance

b.   Raising Systemic Risk by Facilitating Runs

c.   Raising Systemic Risk by Depressing Collateral Values During a Crisis

C.   Costs After Dodd-Frank

III.  Narrowing the Repo Safe Harbors

A.   Narrow the Repo Safe Harbors

B.   Substitution Effects and the Other Safe Harbors

C.   Reduce Bankruptcy Costs for Financial Contract Counterparties

IV.  Potential Critiques

A.   Lessons from Lehman

B.   Post-crisis Laws and Regulations

C.   Effects on the Housing Market

D.   Liquidity in Money Markets

Conclusion

Appendix: Statutory Proposal

Figures

Figure 1.    Overnight Repos as a Percentage of Total Primary Dealer Repo Financing, 2005–2009

Figure 2.    Prevalence of Less Liquid Collateral in Primary Dealers’ Repo Transactions, 2005−2009

INTRODUCTION

Special rules exempt an increasingly wide arc of creditors from the normal operation of bankruptcy. These so-called “safe harbors” exempt the bankrupt debtor’s financial-contract counterparties from the basic rules that halt creditor collection efforts when the bankruptcy begins, that claw back preferential and fraudulent prebankruptcy transfers that harm creditors overall, and that facilitate orderly liquidation or reorganization. These safe harbors for financial contracts exist for one articulated purpose: to promote stability in financial markets.1

Yet there is little evidence that they serve this purpose. Instead, considerable evidence shows that, when they matter most—in a financial crisis—the safe harbors exacerbate the crisis, weaken critical financial institutions, ...

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ABOUT THE AUTHORS

New York City, NY

Edward R. Morrison

Edward R. Morrison is the Charles Evans Gerber Professor of Law at Columbia Law School. He is an expert in bankruptcy law and law and economics, including the causes and consequences of insolvency, both…

Cambridge, MA

Mark J. Roe

Mark J. Roe is a professor at Harvard Law School, where he teaches corporate law and corporate bankruptcy. He wrote Strong Managers, Weak Owners: The Political Roots of American Corporate Finance (Princeton,…

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