Credit Default Swaps’ Status in Bankruptcy Challenged by Court

The current issue of Institutional Risk Analytics discusses an issue that is a tad arcane for many readers, but more important than it seems on the surface. The 2005 bankruptcy law changes, among other things, provided that that derivative transactions were exempt from bankruptcy provisions, meaning that creditors have to put in their claims against the failed business and have the court sort out who gets what. The Financial Times explained how this provision had the perverse effect of accelerating the collapse of Bear, Lehman, and AIG:

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag.

Institutional Risk Analytics adds some new wrinkles today: first, that it was predictable that these rules would be challenged on constitutional grounds, and second, the high odds of successful challenge makes the Fed’s argument that it had to bail out AIG for 100% of the value of its credit default contracts dubious. As an aside, Andrew Ross Sorkin’s account makes it abundantly clear that while the top bankruptcy lawyer in the US, Harvey Miller, had been retained by Lehman but was kept idle until the authorities had decided Lehman had to file for bankruptcy, no one in authority bothered to talk to him to understand the implications and process of a bankruptcy. There is no evidence that the Fed or Treasury sought advice on bankruptcy mechanics and issues from their own outside counsel.

Note the argument that Whalen makes, that the banks were keen to have this rule in place. Is the Fed’s implicit alignment with this position (ie, not considering challenging it, or arguing with the banks that were demanding more collateral that the Fed, which as of October 2008, was a creditor to AIG, could and would challenge this position in court? This is a significant source of potential leverage the Fed had: “Let’s pay this out. You don’t accept our offer of 85 cents on the dollar. You put AIG into involuntary bankruptcy. Aside from the fact that you become public enemy number one by destroying the the markets and probably your own firms in the process, we WILL challenge the BK laws as far as the seniority of your derivatives contracts are concerned. Do you really want us coming after you for the collateral you already received, arguing it is now fraudulent conveyance? I don’t think so.” There is such a thing as bluffing and jawboning, and the Fed made no efforts along those lines. As IRA put it:

We have always held the view that the attempts by the large dealer banks, ISDA and regulators to carve out a special, privileged place in the law for OTC derivatives contracts in the event of default is inherently unfair and is doomed to failure, or at least would be challenged, on Constitutional grounds. This case and others make that challenge and review process a reality and also leaves much of the world of complex structured finance in a shambles when it comes to the legal reality of counterparty risk.

Indeed, the same legal art that gave the swap counterparties in this latest case the impression that they were senior to the other creditors of the bankruptcy estate was used by former Treasury Secretary Hank Paulson and his successor, Timothy Geithner, to justify the rescue of American International Group (AIG). The very same type of investment contracts that Secretary Paulson and Secretary Geithner swore under oath, over and over again, just had to be paid at par in the case if AIG were just set aside by New York Bankruptcy Judge James Peck.

And notice that the world has not ended when the holders of OTC contracts are treated like everyone else. Indeed, Judge Peck has made a number of rulings over the past two years re-leveling the playing field between holders of OTC contracts and other claims against the Lehman bankruptcy estate. As we have noted before, the admirable conduct of the Lehman Brothers bankruptcy case by Judge Peck and US Bankruptcy Trustee Harvey Miller is the starkest condemnation possible of the AIG bailout, a hideous political contrivance that ranks with the great acts of political corruption and thievery in the history of the United States.

And IRA notes in this very useful post that the implications extend well beyond Lehman and AIG:

The question of the enforceability of the documentation in a complex structured securitization involving OTC swaps is not just a matter of debate in the AIG case. Across the US and around the world, investors and trustees are grappling with this same issue. The result is litigation by bond trustees against bond issuers as well as claims by guarantors such as MBIA (MBI) and the housing GSEs, including the Federal Home Loan Banks, against sponsor banks. Many of these claims regarding derivatives are being made in the context of claims for the repurchase of defaulted residential and commercial loans.

The wave of loan repurchase demands on securitization sponsors is the next area of fun in the zombie dance party, namely the part where different zombies start to eat one another. The GSE’s are going to tear 50-100bp easy out of the flesh of the banking industry in the form of loan returns on trillions of dollars in exposure, this as charge-offs on the several trillion in residential exposure covered by the GSEs heads north of 5%. The damage here is in the hundreds of billions and lands in particular on the larger zombie banks, especially Bank of America (BAC) and Wells Fargo (WFC).

So now that the losses on dud mortgages are continuing to rise, investors and guarantors are seeking recourse from the banks that originated the paper. And it looks like they will have some success. This is going to get interesting and downright ugly.

IRA highlights one case, where claims against Countrywide are being asserted not just against the subsidiary, but against BofA itself. Our impression was that BofA was confident that it could limit its liability to the assets held by BofA (that it, unhappy investors would not be able to make claims that would impair BofA ex Countrywide; if not, you’d be nuts to do the dea:

Notice, for instance, that in the MBI litigation against Countrywide Financial et al, MBIA Insurance Corporation v. Countrywide Home Loans, Inc. et al. the lawsuit now includes BAC explicitly.

The action “arises out of the alleged fraudulent acts and breaches of contract of Countrywide in connection with fifteen securitizations of pools of residential second-lien mortgages” Take particular care to savor the fact that these are second lien pools and that, where defaults have occurred on the primary mortgage, loss severities on the seconds will tend to be 100%. Or the cost could be more than par if you count the cost of remediation and recovery efforts.

Note the fact that MBIA is trying to go after BofA itself does not mean it will succeed. But expect to see more of this sort of action.

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  1. Mr. E

    This is among the largest issues facing the financial system. Why are these bilateral contracts considered to be super-senior to debt is criminal at best.

    Other bilateral contracts – like delivered purchase orders that haven’t been paid yet, and even Currency transactions, are are literally last in line when a bankruptcy occurs.

    Changing this rule would do more for transparency and reducing non-useful speculation than any Tobin Tax. We would see wholesale adoption of clearinghouses almost overnight. Positions in clearinghouses are discoverable and easy to monitor by regulatory agencies.

    I don’t know why the Feds are so compliant on this issue. Trades don’t have any special status over real world transactions.

    Why do OTC transactions have legal precedence over debt issued by a company?

    Also, you have to figure that the ICE and the CME are extremely interested in this case. I don’t know why they haven’t teamed up with a friendly partner to bring a case like this before.

    This is huge for the business model of Eurex, ICE, and the LCH.

  2. Rita

    In the Bush Administration’s overall attitude of granting companies just about any regulatory relief requested and then some, is it any surprise that the Fed, Congress and any and all administrative agencies went along with the 2005 changes that made these vehicles bankruptcy remote?

    Just about any legislation can be subject to constitutional challenge. It’s another thing entirely to have that challenge be ultimately successful. Most legislation is passed with some concern regarding constitutionality. It is unlikely that the 2005 legislation was passed thinking that it could not stand traditional constitutional attacks.

    Moreover, constitutional challenges can take years to wind their way through the appellate process. In the summer and fall of 2008, the Fed and Treasury didn’t think they had the luxury of time. There is much to be critical about with regard to the Fed and the Treasury without inventing spurious casus belli.

  3. dd

    The Fed and the Treasury were both intimately involved in creating the supra-legal instruments and bestowing priority status to the detriment of traditional creditors and bondholders.
    At some point it will impact corporate bond markets as investors understand that holding an entity bond is a liability with all the upside in interest rate swaps, CDS, and SIV noteholders. Peck did a nice job explaining the consequences and re-balancing the playing field.

  4. Transor Z

    Swaps had to be resolved pre-bankruptcy prior to BACPA. The express congressional rationale since the late 1970s has been to preserve orderly markets/minimize systemic risk. In 2005, BACPA greatly expanded the range of transactions qualifying as “swaps” under 11 U.S.C. sec. 560.

    How Chris thinks this Supreme Court as presently comprised would uphold such a constitutional challenge I’m not sure.

    Edward R. Morrison and Joerg Riegel, Working Paper No. 291: Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, Columbia Law School (2006)

  5. Independent Accountant

    I have long maintainted the Fed could have done nothing and told Vampire Squid (VS) it will push AIG into bankruptcy. Then call a press conference and explain why. It’s amazing what “equitable subordination” can do. Even if VS’s executives would have stayed out of prison, VS would have gotten pennies on the dollar.

  6. David Merkel

    I could be wrong here, but if it is a contract, then it comes ahead of mere financial claims; it is a general creditor. That said, if it is a contract on a financial claim, perhaps it should have that claim’s priority in bankruptcy.

    My two cents.

  7. Economics of Contempt

    Yikes. Whalen is extremely confused here, on several levels. Judge Peck didn’t even touch the derivatives safe harbor in his opinion — in fact, he explicitly concluded that the contractual provisions at issue were not part of a “swap agreement,” and therefore didn’t implicate the Section 560 safe harbor. Claiming that Judge Peck “set aside” CDS contracts is just factually untrue.

    I know it was Whalen who made these claims, not Yves, but still, that doesn’t make them any less false.

    1. Yves Smith Post author

      I pinged Whalen re your and csissoko’s concerns. He asked me to thank readers for their instructive comments. He also passes along this remark from a lawyer who has litigated in commercial bankruptcies for decades:

      Peck said that the flip clause was ancillary to the swap. Even if the flip were built right into the ISDA swap agreement, it doesn’t follow that a forfeiture clause would survive. In that case, there would be conflicting bankruptcy provisions, one the safe harbor and the other the anti-forfeiture or ipso facto provision. It is likely, in my opinion, that the flip would not survive even if were part of the swap agreement itself.

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