The BAPCPA Follies
Dow Jones DBR Small Cap. Wednesday, April 22, 2009
As the rising ranks of the unemployed threaten to overwhelm any stimulus induced recovery, it is ironic that Chapter 11, once a haven for struggling companies, now looks like death row. With so many companies blowing up a nanosecond after declaring bankruptcy these days, fingers are pointing at the gradual evisceration of Chapter 11 protections by creditor advocates, efforts which culminated
in the debtor unfriendly measures embodied in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, or BAPCPA. While BAPCPA's unfavorable treatment of retailers has received most notice, the financial services industry is also experiencing its share of BAPCPA-induced trauma.
Paradoxically, the measures now causing so much distress for the industry were rooted in a desire to protect markets from the snowballing impact of the bankruptcy of a large player. Back in 1978, when the Bankruptcy Reform Act modernized Chapter 11, the initial expression of this concern was limited to protecting pre-bankruptcy margin payments on commodity transactions from clawback by a debtor's estate. Over time, though, other assets and financial contracts were allowed to leak out of the Chapter
11 process, although mostly on an exception basis.
By 2005, the enormous growth of financial markets, particularly those involving complex swaps and derivatives which had never experienced the bankruptcy of a big counterparty, caused industry leaders to grow queasy that a filing by a large enough player could cause systemic damage. By that time also, the conclusion that counterparties' ability to close out their exposures to Long-Term Capital Management had saved the market from the collapse of that firm was gaining traction. The convergence of those thoughts propelled BAPCPA's extension of safe harbor provisions to a seemingly unlimited universe of financial contracts and dramatically increased the number of parties who could freely terminate or accelerate agreements, liquidate positions, and set off claims against margin or collateral called in from a debtor without fear of interference by a bankruptcy court. BAPCPA provided new powers as well through its inclusion of the so-called "master netting agreement", which allowed counterparties to exert all these bankruptcy- protected actions across multiple contracts and products, a response to the belief that the more players were able to net down their all exposures free of Chapter 11 constraints, the less exposed they and the markets would be to travails of a major participant.
Unfortunately, the design of these new bankruptcy provisions missed a few things. First, the expansion of the exemptions to new, even unborn, products meant that neither the markets nor regulators had much experience with how processes like netting and closeout would work for them in a bankruptcy situation let alone when netting was aggregated over many disparate and illiquid instruments. Second, the processes that worked so well with LTCM did so when the underlying products were still subject to the bankruptcy process, hence it was difficult to predict what impact exempting them from that process would have on the behavior of market participants. Third, since LTCM hadn't actually gone into bankruptcy, the risk
that the exemptions might somehow impact other claimants to the debtor's estate was never properly
assessed.
American Home Mortgage's bankruptcy illustrated some of these problems. The firm filed after failing to meet the second of two margin calls from Lehman under a master repurchase agreement secured by mortgage-backed securities which were foreclosed on by Lehman after the bankruptcy filing. American Home subsequently argued that not only were the margin calls fabricated (their own valuation of the mortgage securities being substantially higher than Lehman's), but that the repo was really a secured lending agreement with some extra language thrown in simply to allow Lehman to take advantage of
BAPCPA's safe harbor protections for repo agreements.
Further, noted American Home, repos were properly intended to be secured by fungible products with big
liquid markets - a sensible postulate for such short term instruments - and, as such, its own agreement with Lehman, collateralized as it was by highly customized, lightly traded mortgage backed securities could hardly be considered a repo. Notwithstanding the prudence of that concept, the court ruled against American Home noting that BAPCPA actually explicitly included mortgage securities as permissible repo security, consistent with new market practices that, for good or evil, had developed over the previous few years.
BAPCPA's casual willingness to allow illiquid collateral, and the mind-numbingly complex instruments to which some of that collateral is subject, to be handled outside of bankruptcy is troubling. The difficulty of deriving value for such products, particularly in the dysfunctional markets that accompany the distress of major counterparties, raises questions as to whether it is wise to permit so much of this effort to occur away from the watchful eye of the bankruptcy judge or trustee. Consider also that BAPCA permits counterparties to employ their master-netting agreements across an unrestricted number of esoteric, hard to value contracts and collateral types, mashing them all together to come up with a single net exposure and one begins to appreciate the stunning complexity, even subjectivity, involved in these calculations.
Of course, the debtor is always free to litigate the resulting valuations but given the sheer number of these instruments, the immense concerns over the valuation of financial products in general today, and the generous treatment BAPCPA affords the non-bankrupt counterparty, it is not difficult to imagine that the exercise of rights under BAPCPA may cause value to leach out of a debtor's estate inappropriately.
Another concern is that BAPCA's expansion of this class of super-senior, extra-bankruptcy creditors, counterparties who pull their stakes out of the estate before the bankruptcy bell, may exacerbate the liquidity drains to which troubled financial firms have always been subjected. The safe harbor protections given an expanded array of instruments and counterparties, in conjunction with the trend towards lightly collateralizing financial contracts over the past few years (if at all) almost undoubtedly fed the rapid and enormous collateral calls that firms experienced once the whisper of bankruptcy accompanied the mention of their names. It is no surprise, even, that the totality of these demands could completely overwhelm whatever liquidity reserves a hapless company thought it would need to cover the most draconian calls, and helped to push Bear Stearns and AIG into government-assisted rescues and Lehman Brothers right through the Chapter 11 door.
Lehman's unsecured creditors actually argue that the refusal by JPMorgan Chase, Lehman's primary clearing agent, to release $17 billion of Lehman's money it was holding as security against other exposures was responsible for Lehman's filing. While the unsecured creditors press for discovery to develop their case, Morgan points out that BAPCPA allows just the kind of actions it took to protect its own interests. Maybe so. But that just highlights the destabilizing impact BAPCPA may have had on
counterparty behavior. While once firms moderated their collateral demands lest they individually or collectively push a weak counterparty into a bankruptcy that could pull back that collateral and take years to resolve, with BAPCPA's safe harbors, counterparties are incentivized to grab whatever they can as fast as they can; if they don't someone else surely will and who wants to be the only one fighting it out as an unsecured creditor in Chapter 11?
But while Lehman and its weaker brethren are surely suffering as a result of BAPCPA, one has to wonder if the real victims aren't the other creditors. It's hard to imagine that Lehman's poor bondholders comprehended the hollowing out which might occur if the firm filed, or even contemplated filing, for bankruptcy. Then there's the larger question of what purpose Chapter 11 serves for a troubled financial firm which finds the majority of its assets sucked out courtesy of BAPCPA. We need a process to save financial firms and jobs and, right now, Chapter 11 is not it.