While the decision in Mirant may have made sense for the specific case at the time, it clearly results in a huge increase in systemic risk. Derivatives holders can now game bankruptcy to try to make sure that as much as possible of the future value of their derivatives is accrued after a bankruptcy event rather than before.

Financial weapons of mass destruction, indeed.

You missed the critical point. The counterparties in trades with Bear at the time Bear files bankruptcy DO NOT get a priority based on pre-bankruptcy market movements, only POST-bankruptcy market movements. Thus, if the counterparty’s side of the trade is in-the-money at the time Bear files bankruptcy, it is as if the trade is reset into an at-the-money trade, and as compensation, the counterparty gets an unsecured, nonpriority claim for the amount of the appreciation that occurred before Bear’s bankruptcy filing, and the counterparty can take just as much of a haircut as a general unsecured creditor on that claim. Now afterward, if the trade appreciates in value, the counterparty gets a priority claim for that, but that is totally separate.

Read my example above in my posting at 2:25pm.

PS – this is not legal advice.

What a mess!

I’m a bit slow, but after rereading your description I actually think I understand how Mirant makes sense. It was precisely to deal with the possibility of hedging being thrown out of kilter that claims before bankruptcy are unsecured, but claims for everybody including existing counterparties who already have an unsecured claim have priority after bankruptcy.

I like the way in which WaMu is allowing a non-bank to loan it $8 billion, but then that private entity is not regulated, and all the while, the insolvency issues are swept away while the illusion of an FDIC guarantee is projected into this smoke and mirrors congame, where now you see reality and now you don’t and — meanwhile, according to Hussman, counterparties are protected….yah, right!

Thank you, that’s clear now. One more question. If the Mirant precedent is followed, what happens to counterparties who owed Bear money. Is it possible that their debt would be fixed at the bankruptcy date value too? Or does the whole concept of hedging potentially get thrown out of kilter once a major counterparty goes bankrupt?

(Btw, conservatively invested in old-fashioned products and not in need of legal advice.)

The implications of a Bear counterparty getting a nonpriority claim for pre-bankruptcy appreciation of the counterparty’s rights are like this.

Suppose a fund bought credit protection from Bear by entering into credit default swaps (CDSs), referencing the ABX. Suppose by Day X, suppose the ABX falls a lot and the fund could sell its positions against Bear for $1000k, and suppose on Day X Bear files bankruptcy. The fund would have unsecured nonpriority claims for $1000k, subject to taking a haircut like all the other unsecured creditors. So for example, if Bear’s unsecured bondholders get paid 10% of par in bankruptcy, the fund would also get paid 10%, and only get $100k on its claim of $1000k.

Now, suppose after filing bankruptcy, Bear wants to keep its trading business running, Bear could request that the bankruptcy court give priority unsecured creditor rights to counterparties trades Bear enters after it filed bankruptcy, and also for counterparties on trades with Bear outstanding at the time Bear filed bankruptcy. Suppose after Bear files bankruptcy, the ABX index falls a bit more, and the fund’s swap rights appreciate another $50k. The fund would have a priority claim for this $50k of appreciation, and so would get paid before Bear’s general unsecured creditors on the $50k.

PS – This is not legal advice. Seek your own advisor. It is very foolish not to do so.

Could you please explain a little more clearly what the implications of this: “the court gave counterparties a priority for claims under trades for market movements that occured ***AFTER*** Mirant filed bankruptcy, but not market movements that occurred ***BEFORE*** Mirant filed bankruptcy.” are.

An example of this is the bankruptcy of Mirant, which had a book of energy trades. The debtor wanted to preserve the business, and the court gave counterparties a priority for claims under trades for market movements that occured ***AFTER*** Mirant filed bankruptcy, but not market movements that occurred ***BEFORE*** Mirant filed bankruptcy. Here is a link to commentary from the law firm Strook regarding the Mirant case. http://www.stroock.com/SiteFiles/Pub437.pdf

If you want to read the actual law, look at 11 usc sections 502(a), 502(g)(2), and 562; these provisions give a Bear counterparty an unsecured, nonpriority claim for amounts due under existing trades with Bear at the time Bear filed bankruptcy. Also, look 11 usc 752 or 766, these provisions give a “customer” a priority claim for assets held by Bear in the person’s brokerage account. There is not a similar provision giving a priority to counterparties to Bear’s existing trades at the time it files bankruptcy.

PS – This is not legal advice; seek your own advisor. People like Bob Rodriguez at FPA Funds and Andy Weiss at Weiss Asset Management get advice from lawyers so they don’t make foolish mistakes like Hussman’s regarding counterparties’ rights in bankruptcy.