Don LawsonIn April 2005, the United States Congress (the governing body responsible for the United States Bankruptcy Code) overhauled and updated the Bankruptcy Code with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act, more commonly referred to as BAPCPA.  The new law went into effect on October 17, 2005.  It is fair to say that there is not a single bankruptcy attorney actively practicing bankruptcy law that is not aware of BAPCPA.  However, most bankruptcy attorneys and the general public may not be aware of an obscure rule in BAPCPA dealing with securities and derivative transactions.  Derivative transactions are often extremely complex financial instruments used mainly by large financial institutions, banks, hedge funds and insurance companies as a way to mitigate and manage risk.  Further down I will give an example of a typical derivative transaction, (for more information on derivatives see here and here).  The purpose of this article, however, is not to explain derivatives themselves but to explore the unprecedented treatment that certain derivative holders receive in bankruptcy and its potential unintended consequences.

Perhaps one of the most important, if not the most important, protection afforded an individual or business filing for bankruptcy is the Automatic Stay.   The Automatic Stay occurs instantly when a bankruptcy is filed and stops all creditors, except child support, alimony, divorce and debts rising from any criminal activity, from taking any action to collect their debt.  This protection is extremely important and is essential to allowing debtors, especially businesses, the opportunity to reorganize without the fear that creditors can come and seize assets without the Bankruptcy Court’s approval.  Without the protection of the Automatic Stay, creditors would rush to seize the assets of a debtor, harming the individual debtor and potentially crippling the business debtor’s ability to reorganize their company.

However, under BAPCPA, one creditor is granted super powers in Bankruptcy.  One creditor is 100% exempt from the Automatic Stay[1].  That creditor is a qualified derivative counterparty.  A qualified derivative counterparty is someone (a person, financial institution, insurance company, hedge fund, etc.) that is betting on the opposite side of a derivative transaction.  The specific sections of the Bankruptcy Code dealing with derivatives, their special treatment and who is considered a qualified derivative counterparty are listed in the table below[2]:

Financial Market Provisions

So, how would a derivative and a derivative counterparty come to exist?  Perhaps a perfect example of a derivative and a derivative counterparty and their potential risks is Jefferson County, Alabama’s funding of its water and sewer improvements.  In the late 1990’s, Jefferson County, Alabama entered into an agreed order with the EPA to improve and upgrade its existing water and sewer system.  As is typical for this type of improvement, Jefferson County issued municipal bonds (Muni’s) to pay for the improvements.  The project was initially slated to cost approximately $1.5 Billion.  However, by the early 2000’s, the costs had ballooned to nearly triple that amount.  By then, the County was using JPMorgan Chase, Goldman Sachs and other financial institutions to underwrite the new bond issues.  And this is where it gets confusing.

As required by state law, all Muni’s are required to be issued at a fixed rate of interest.  State law requires the interest rates on Muni’s to be fixed to allow for proper budgeting and to avoid the risk of interest rates increasing, causing the bond payments to increase.  Thus, the bonds were issued at a fixed rate of interest.  However, the County, on the advice of JPMorgan Chase “Swapped” its fixed interest rate for a floating rate via an Interest Rate Swap.  An Interest Rate Swap is a derivative used mainly by large financial institutions, insurance companies and hedge funds to mitigate and manage interest rate risk.  The Institution that the Jefferson County entered into the Interest Rate Swap with is the derivative counterparty.  In the above Interest Rate Swap, the derivative counterparty agreed to pay the County’s fixed interest rate to the bond holders and the County agreed to pay the derivative counterparty the current floating rate.  The decision to enter into the Interest Rate Swap would later prove to be catastrophic for the County.

However, remember that this Interest Rate Swap occurred in the early 2000’s when floating interest rates were lower than long-term fixed rates due to the DotCom crash in 2001.  After the DotCom crash, and similar to today, the Federal Reserve was artificially keeping short-term floating rates low in an effort to stimulate the economy.  Thus, for years the County’s Interest Rate Swap was “in the money” as floating rates were lower than fixed rates.  All was well for the County until 2008.  In 2008, the Nation was plunged into a recession mainly driven by turmoil in the financial markets.  As a result, several large financial institutions failed.  In the aftermath, numerous financial, investment and insurance companies that did not fail had their ratings cut, meaning that the Market viewed these institutions as weaker and riskier.  Among those institutions that had their ratings cut were Financial Guaranty and XL Capital Assurance.  These two insurance companies guaranteed the bonds the County issued.  As required by State law, all municipal bonds must be guaranteed against default.  Because Financial Guaranty and XL Capital Assurance were no longer AAA rated, the bond holders (the institutions that purchased the bonds as investments) were no longer allowed to hold them in their portfolios.

The reason for this is that most Muni’s are purchased by investment companies to hold as ultra-safe investments in their clients’ portfolios.  As part of that ultra-safe status, the bonds must be guaranteed against default.  With the bonds no longer guaranteed, the bonds went into default.  This caused two major problems for Jefferson County:

1. The underlying Interest Rate Swaps had to be “unwound”.  What that means is that Jefferson County had to cancel the Interest Rate Swap early and then compensate the counterparty for the interest it should have received had the Interest Rate Swap not been cancelled.  To do this, Jefferson County had to calculate the amount of interest payments the counterparty would have received over the life of the bond issuance against what the counterparty would receive if it entered into the Interest Rate Swap at the time of the default.  Because interests rates had dropped to record lows (both fixed and floating), Jefferson County was required to pay $647 Million to unwind the Interest Rate Swaps[3].

2. The other major problem for Jefferson County was that because the bonds were in default, the original issuer of the bonds, ironically JPMorgan Chase, was required to purchase them back from the bond holders.  As a result, the fixed interest rate that Jefferson County was required to pay increased to the default rate of 10%.  Thus, in one month Jefferson County found itself required to pay an astronomical penalty of $647 Million AND saw its interest rate increase more than three fold.  This ultimately led to Jefferson County filing what was the largest municipal bankruptcy in US history (only surpassed by the July 18, 2013 bankruptcy filing of the City of Detroit).  Had Jefferson County not entered into the Interest Rate Swap agreements, none of this would have happened.  I realize this is very complicated and confusing. But the point of this example is to show how complicated, confusing and potentially dangerous these transactions can be.

There is much more to the Jefferson County story, including massive corruption and jail time for several City and County officials, but hopefully this story illustrates some of the risks inherent in derivative transactions.

In June of this year, Jefferson County filed a plan in the United States Bankruptcy Court that would, if approved by the Court, allow it to emerge from what is now the second largest bankruptcy in municipal history.  The plan came after a deal was worked out with the largest unsecured creditors, including JPMorgan Chase and Goldman Sachs.  The creditors, in part because the corruption surrounding this deal, agreed to large reductions in the principal balances.  This marks the first time in history that U.S. investors holding municipal debt have been forced as part of a bankruptcy case to take losses on the principal owed to them[4].  Of note, even though it has been proven that the banks, as well as the County officials, committed massive fraud and criminal acts as a part of this debacle, not a single banker has gone to jail.  Interestingly, Jefferson County, very wisely, refused to secure this debt with any collateral, even though it was pressured heavily to do so, especially after the debt went into default but prior to the bankruptcy filing.  Had Jefferson County pledged collateral (such as future tax revenues as is the norm when municipalities’ issue General Obligation Bonds), the derivative counterparty could have seized that collateral to recoup its losses.  There is currently a debate regarding the City of Detroit’s bankruptcy filing over this exact issue[5] .

The above story was to illustrate what a derivative is and their potential dangers.  Derivative transactions represent, by far, the largest credit exposure held by banks and financial institutions.  It is estimated that there are somewhere between $600 Trillion and $1.5 Quadrillion of global derivatives, roughly 10 to 25 times the size of the World economy[6].  I say estimated because, as scary as it sounds, no one actually tracks the total exposure of derivatives.  And as can be seen from the above example with Jefferson County, seemingly unrelated events (the collapse of the two insurance companies guarantying the County’s bonds) can have devastating consequences on innocent people.  The United States alone accounts for approximately $250 Trillion to $333 Trillion of the global derivative exposure, or roughly 17 to 22 times the size of the entire US economy.

Another way of looking at the total amount of derivative exposure just in the United States would be to compare it to the total amount of Student Loan debt.  Recently, Student Loan debt has received a great deal of attention.  It is now commonly known that Student Loan debt exceeds $ 1 Trillion, surpassing all outstanding credit card debt.  It is estimated that there is anywhere from 250 to 333 times more derivative exposure in the United States than Student Loan debt, yet this is seldom discussed.  More shocking is that four banks, JP Morgan Chase ($78.1 Trillion), Citi ($56 Trillion), Bank of America ($53 Trillion) and Goldman Sachs ($48 Trillion) account for 94.4% of the total exposure.  Perhaps even more shocking is that the vast majority of these derivatives (87%) are in Interest Rate Swaps[7].  And this is where it gets interesting.  In Part Two, I will explain some very important changes to the laws regulating banks and financial institutions and some possible unforeseen dangers of those changes in concert with the special treatment afforded qualified derivative counterparties in Bankruptcy.

 


[1] The provision in the Bankruptcy Code exempting Qualified Derivative Counterparties has actually been a part of Bankruptcy Code since the early 1980’s, but was broadened and strengthened under BAPCPA.

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