Thursday, December 15, 2011

The Bankruptcy Law Changes of 2005, Rehypothecation, MF Global, and Crisis.

Did you know that the changes made to the bankruptcy laws reordered the subordination of creditors? It's true. Bondholders used to be the most senior of creditors in a bankruptcy. Now, derivative holders are the most senior. That means derivative counterparties gained a strong bankruptcy privilege, according to Prof. Dr. Enrico Perotti, professor of international finance at Amsterdam Business School.

The special bankruptcy treatment extended to mortgage-backed repos and derivative transactions in 2005 played a crucial role in the financial crisis of 2008. Because they were the two main sources of systemic risk in the financial crisis of 2008.

Professor Perotti outlined how over the 2002-2005 period, bankruptcy laws were changed in all EU countries and the US, and secured financial credit (repos) and derivative counterparties gained a strong bankruptcy privilege, amounting to de facto “superiority”, as counterparties could gain immediate repossession of collateral in default (so-called “safe harbor claims”, as opposed to having to accept the “automatic stay” which protects the debtor in Chapter 11 for example)..
With that in mind, consider that banks/ securities brokerage, rehypothecate assets, including 401k, IRA, and even general savings accounts allow the rehypothecation of their assets. Check the fine print of your account agreement.

What is rehypothecation?

It is the practice that allows collateral posted by, let's say, a hedge fund to its prime broker to be used again as collateral by that prime broker for its own funding. In other words, if a firm rehypothecates its assets with its client's assets - co-mingling client funds - and then uses these funds to buy derivatives, the derivative holder can lay claim to the brokerage assets if that firm declares bankruptcy. If this is allowed to continue, it will set a precedent that will enable creditor firms to raid and steal your assets.

This is part of the reason JP Morgan was able to seize MF Global's assets the moment they claimed bankruptcy.

So, it's possible that the next time a firm fails, whomever is the counterparty on the bankrupt organization's credit default swap, will have precedent to step in and steal client money to settle their claims.

For a  less alarmist view which goes into great detail, see:

Revisiting Rehypothecation: JP Morgan Markets Its Latest Doomsday Machine (or Why Repo May Blow Up the Financial System Again)

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