There were several problems with this. First, this created incentives to restructure normal contracts, such as agreements to supply fuel to an airline company, in the form of swaps or derivatives. This was a win-win for creditors and debtors. Creditors were assured easy contract termination, even if the firm entered bankruptcy. Debtors were not generally required to post collateral for their contracts, allowing them to operate with a leaner capital structure.
Second, these rules expanded to define mortgage-backed securities as repos for the purposes of the safe harbor. This was potentially a huge change. Gary Gorton has argued that the demand for short-term securities, fulfilled by mortgage-backed securities, was fueled by the demand for information-insensitive, safe assets. Andrei Shleifer has suggested that these sorts of new, exotic securities were mispriced. While both of these may be a part of the story; there is another interpretation. The surge in securitization can be seen as a form of regulatory arbitrage designed to create short-term funding that would hold up in bankruptcy court. Without the penalty of potentially losing assets during bankruptcy, lenders were more willing to provide short-term funding to over-levered Investment Banks.
As Mike’s interlocutor points out: for non-bank institutions, this change was not the end of the world. Quick liquidation of existing contracts is akin to the Chapter 7 process (rather than the lengthy reorganization of Chapter 11). There are often advantages to slowing down the bankruptcy process, but small firms can be liquidated in an orderly manner.
The same is not true for banks. The special treatment of repos and derivatives in bankruptcy resulted in early termination and seizure of contracts by bank counterparties during moments of crisis or bankruptcy. The going-value of a bank—the excess value they have above and beyond the market value of its assets—is crucially dependent on its solvency and liquidity. Illiquid banks, by virtue of their leverage, are forced to sell their assets at fire sales, which can lower prices, which can lower the value of their assets further in a destructive spiral. Ensuring that certain forms of short-term funding and derivatives went to the front of the line in the Lehman case all but ensured that its bankruptcy would be a disaster.
The unintended systemic consequence of this treatment of bankruptcy was illustrated once before, during the failure of Long Term Capital Management. Intervention by the Federal Reserve happened precisely because regulators were worried that the failure of LTCM would cause a disorderly liquidation; a liquidation that would be worse exactly because derivative contracts could be terminated early.
As Mark Roe points out, the exemption that derivatives and repos enjoyed also warped their incentives to monitor the risk-taking going on at Investment Banks. The rule also possibly artificially increased the amount willing to be lent to banks, and gave them lower borrowing costs.
All of this points to a need to reform the bankruptcy code in order to treat derivatives on par with other claims. While legislative and popular pressure has focused on derivatives as being inherently bad, it would be better to fix legislation that encourages the over-use of derivative contracts and risk-taking; rather than leaving these elements in place, and hoping that other regulatory fixes elsewhere would solve the problem.