The Examiners: Code Changes Should Focus On Safe Harbors

If you could make one change to the bankruptcy code, what would it be?

It’s the safe harbors.

The bankruptcy code works well, but even good codes could be improved. Everyone will have a favorite for making a typical industrial firm bankruptcy work better. (Mine is to better handle the time value of money during a bankruptcy proceeding.)

But only one piece of the code can spill over to damage the entire American economy in a serious way. And it’s those safe harbors for repo and derivatives. They need narrowing and fixing.

An ever-widening array of financial instruments has become exempt from bankruptcy during the past decades. Derivatives and repo contracts that qualify for such exemptions need not pay attention to the automatic stay (which prevents creditors from dismembering the debtor by seizing and selling security and assets). They are also exempt from rules on clawing back preferential payments a creditor squeezed out from the debtor on the eve of bankruptcy, on fraudulent transfers and more. If these exemptions just affected localized firms, they might not do economic damage and would often enough be sensible financial policy. But if the bankrupt debtor is big enough, the exemptions can seriously damage the real economy.

On repo, too much is bankruptcy exempt. About half of repo is in U.S. Treasury debt, for which exemption from bankruptcy is just fine. (A Treasury repo transaction is a loan for which a U.S. Treasury serves as security. Even in a financial crisis, U.S. government securities retain their value.) But nearly half of repo-eligible securities are pools of mortgages, which are highly sensitive to bubbles and bursts in the housing market—like that at the foundation of the 2008-2009 financial panic, when housing-related securities lost value sharply. The Federal Reserve Bank of New York bailed out the repo dealers. The U.S. bailed out the nexus for much of the housing securities: Fannie Mae and Freddie Mac , the big mortgage dealers.

These mortgage securities should not be repo-eligible, and until recent decades, they were not.  Returning them to their traditional status will reduce the excessive weakness of this part of the financial market. Players lacking the repo bankruptcy exemption will find more stable ways to handle their financing needs, as they once did.

On derivatives, derivatives players can terminate their contracts en masse if a major derivatives dealer files for bankruptcy. And they did when a medium-sized dealer—Lehman Brothers—went bankrupt. When they all terminate their contracts at once, world financial markets are disrupted, financial transactions are mutilated and there are real economy effects as financial institutions need time to recover their balance. The better way to handle these contracts is to bar the parties from closing out their contracts for a short period of time. During that short period, the derivatives portfolio would be sold in an orderly manner (with, say, Barclays buying its energy derivatives, Goldman Sachs its equity derivatives, and another firm picking up the interest swaps). The buyers would then be on the hook and could manage the contracts safely. The bankruptcy code doesn’t allow such a safe sale for derivatives portfolios even though, ironically enough, it’s now well-developed now in bankruptcy for industrial firms. And Dodd-Frank surprisingly doesn’t either—it only allows the entire portfolio to be kept intact, and only for a day. But if there’s a huge bankruptcy, the portfolio will need to be broken up in a business-coherent way and sold to retain its best value and to not disrupt world financial markets. Again.

Mark Roe is a professor of law at Harvard Law School in Cambridge, Mass.