Derivatives Markets in Bankruptcy

By treating derivatives and financial repurchase agreements much more favorably than it treats other financial vehicles, American bankruptcy law subsidizes these arrangements relative to other financing channels. By subsidizing them, the rules weaken market discipline during ordinary financial times in ways that can weaken financial markets, thereby exacerbating financial failure during an economic downturn or financial crisis emanating from other difficulties, such as an unexpectedly weakened housing and mortgage market in 2007 and 2008. Moreover, and perhaps unnoticed, because this favorable treatment in the Bankruptcy Code is readily available only for short-term financing arrangements, the Bankruptcy Code thereby favors short-term financing arrangements over more stable longer term arrangements. While some policymakers and proponents of bankruptcy’s favorable treatment justify it as reducing financial contagion, there is reason to think that the safe harbors do not reduce contagion meaningfully and did not reduce it in the recent financial crisis, but instead contributed to runs and weakened market discipline. A basic application of the Modigliani–Miller framework suggests that the risks policymakers might hope the favored treatment would eliminate are principally shifted from inside the derivatives and repurchase agreement markets to creditors who are outside that market. The most important outside creditor is the United States, as de jure or de facto guarantor of too-big-to-fail financial institutions.