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Should Derivatives be Privileged in Bankruptcy?

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  • Patrick Bolton
  • Martin Oehmke

Abstract

Derivative contracts, swaps, and repos enjoy "super-senior" status in bankruptcy: they are exempt from the automatic stay on debt and collateral collection that applies to virtually all other claims. We propose a simple corporate finance model to assess the effect of this exemption on firms' cost of borrowing and incentives to engage in swaps and derivatives transactions. Our model shows that while derivatives are value-enhancing risk management tools, super-seniority for derivatives can lead to inefficiencies: collateralization and effective seniority of derivatives shifts credit risk to the firm's creditors, even though this risk could be borne more efficiently by derivative counterparties. In addition, because super-senior derivatives dilute existing creditors, they may lead firms to take on derivative positions that are too large from a social perspective. Hence, derivatives markets may grow inefficiently large in equilibrium.

Suggested Citation

  • Patrick Bolton & Martin Oehmke, 2011. "Should Derivatives be Privileged in Bankruptcy?," NBER Working Papers 17599, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17599
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    File URL: http://www.nber.org/papers/w17599.pdf
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    References listed on IDEAS

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    1. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?," The Quarterly Journal of Economics, Oxford University Press, vol. 125(3), pages 1195-1252.
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    Cited by:

    1. Sebastian Infante, 2013. "Repo collateral fire sales: the effects of exemption from automatic stay," Finance and Economics Discussion Series 2013-83, Board of Governors of the Federal Reserve System (U.S.).
    2. Maryam Farboodi, 2014. "Intermediation and Voluntary Exposure to Counterparty Risk," 2014 Meeting Papers 365, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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