Tuesday, March 10, 2009

the value of derivatives and other financial market contracts are based principally on their fluctuating market value

From The Economics Of Contempt:

"Special treatment of derivatives in bankruptcy

I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. (For an explanation of why it's important to give derivatives special treatment in bankruptcy, see the excerpt at the end of this post.)

Josh Marshall kicked off the outrage a few days ago, when he highlighted the exemption for derivatives in a post titled, "How the Rules Were Rigged":
But separate from the immediate financial implications related to AIG, it does point us toward the larger political economy point: the self-reinforcing cycle in which financialization leads to vast sums of money concentrated in the hands of paper-jobbers, who then mobilize that money in Washington to rewrite the laws to privilege them for even greater profits.
Arianna Huffington, among others, quickly agreed with Marshall's interpretation:
It's worth noting that, thanks to the industry-written 2005 Bankruptcy Bill, derivatives claims are not stayed in bankruptcy -- so the financial institutions that gambled and lost would nevertheless be the first ones paid off. Isn't gaming the system fun?
The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps. But just to be sure—to provide that all-important legal certainty—the 2005 bankruptcy bill amended the definition of "swap agreement" to explicitly include credit default swaps. There was no substantive change, just a clarification—a process otherwise known as "modernizing" the financial regulations in order to keep up with financial innovations. Given how rarely our financial regulations have been modernized over the past 25 years, it's a bit strange that one of the few successful efforts to actually modernize financial regulations is attracting so much criticism.

Moreover, the special treatment of derivatives and other financial contract isn't unique to bankruptcy proceedings. In old-fashioned FDIC receiverships (which everyone seems to love right now), "qualified financial contracts" (QFCs) — e.g., derivatives and securities contracts — have long been exempt from the FDIC's avoidance powers, in order to permit the orderly netting of derivatives contracts. Since major bank holding companies (e.g., Lehman, Citigroup) aren't covered by the FDIC resolution process, it's only natural for the FDIC's QFC exemption to be extended to the Bankruptcy Code. Essentially, exempting derivatives from the automatic stay in bankruptcy is a way to harmonize insolvency procedures.


This FDIC article provides a nice explanation of why it's important that derivatives and other financial contracts be exempt from the automatic stay. It's all about close-out netting:
As with other financial instruments, including bonds and equity securities, derivatives pose credit, market, liquidity, operating, legal, settlement, and interconnection risks. One of the primary ways to reduce the risks to individual parties in derivative or other financial contracts is the ability to settle the transactions by payment of a single net amount. Netting is simply taking what I owe you and what you owe me and subtracting to yield a single amount that should be paid by one of us. Netting can be a valuable credit risk management tool in all multiple transaction relationships by reducing the credit and liquidity exposures by eliminating large funds transfers for each transaction in favor of a smaller net payment.

Close-out netting, or the ability to terminate financial market contracts, determine a net amount due, and liquidate any pledged collateral, is a valuable tool to protect against credit and market risks in cases of default. This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value. If one of the parties to a derivative or other financial market contract is placed into bankruptcy or receivership, the normal stays on termination of contracts and liquidation of collateral could create escalating losses due to changes in market prices. As a result, the ability to terminate the contract and net exposures quickly can be crucial to limit the losses to the non-defaulting party because such contracts can change in value rapidly due to market fluctuations.



Don said...

"This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value"

This makes it sound like it is simply a procedure to put these investments on an equal footing with fixed investments, since, theoretically, when the assets were dispersed, the fluctuating claims could be worthless.

Don the libertarian Democrat

March 10, 2009 5:48 PM

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