Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors’ cash demands shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties, who, unlike most other secured creditors, can seize and immediately liquidate collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor them over the bankrupt’s other creditors. Their right to jump to the head of the bankruptcy repayment line, in ways that even ordinary secured creditors cannot, weakens their incentives for market discipline in managing their dealings with the debtor because the rules reduce their concern for the risk of counterparty failure and bankruptcy.

If derivatives counterparties and financial repurchase creditors, who are treated similarly well in bankruptcy, were made to account better for counterparty risk, they would be more likely to insist that there be stronger counterparties on the other side of their derivatives bets, thereby insisting for their own good on strengthening the financial system. True, because derivatives counterparties bear less risk, nonprioritized creditors bear more and those nonprioritized creditors thus have more market-discipline incentives to assure themselves that the debtor is a safe bet. But the derivatives markets’ other creditors—such as the United States—are poorly positioned either to consistently monitor the derivatives debtors well or to fully replicate the needed market discipline.

Bankruptcy policy should harness private incentives for counterparty market discipline by cutting back the extensive advantages Chapter 11 and related laws now bestow on these investment channels. More generally, when we subsidize derivatives and similar financial activity via bankruptcy benefits unavailable to other creditors, we get more of the activity than we otherwise would. Repeal would induce these burgeoning financial markets to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG-, Bear Stearns-, or Lehman Brothers-style financial meltdown, thereby helping to maintain systemic financial stability. Repeal would end the de facto bankruptcy subsidy of these financing channels. Yet the major financial reform package Congress enacted in response to the financial crisis lacks the needed changes.

 

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