Secured lenders get the shaft from derivatives in bankruptcy. So why are banks backing a corporate exemption?
Banks are tacit supporters of the corporate exemption from the OTC derivatives clearing and exchange trading requirements currently being mulled in the Senate. This is a bit odd, since banks are also usually secured lenders, and they get the shaft in bankruptcy if a company has a lot of outstanding, collateralized, derivatives. This leads one to conclude that the potential losses on their loans must pale in comparison to the lucre they reap from their much bigger derivatives businesses.
How so? Well, since the bankruptcy reform of 2005, derivatives have been excluded from the bankruptcy process. That is, most normal contracts must continue to be serviced until a firm is reorganized or liquidated. But, as Seton Hall law professor Stephen Lubben noted in a recent interview with Mike Konczal, derivatives dealers can cease making payments on contracts and seize collateral upon a counterparty’s bankruptcy—collateral that would otherwise be distributed to the senior lenders (i.e., the banks) and other creditors. This means banks—or at least their lending arms—could end up holding the bag.
Many transactions that were structured as normal contracts before the “reform” were subsequently structured as swaps to exempt them from bankruptcy rules. That, according to Mr. Lubben, is one reason for the exponential growth of the OTC markets after 2005.
You’d think that banks would want corporates to clear their OTC derivatives and trade them on exchanges. After all, the rules for margining and collateral on exchanges are more traditional. But their derivatives franchises, rather than the calculus of their lending businesses, might be driving their strategic views.
If corporates are forced to clear and trade derivatives on exchanges, the dealers will lose their pricing oligopoly, be forced to pile up more capital against remaining bilateral deals and will probably have to cut back on complexity. If their desire to make sensible loans and protect their place in the capital structure rebounds as a result, that would be reason enough to pass the bill.
http://rortybomb.wordpress.com/2010/05/06/an-interview-about-the-end-user-exemption-with-stephen-lubben/#more-5792