Friday, May 21, 2010

Proposed New Bankruptcy Law

This Forbes article has a good overview, and refutation, of some of the provisions in the new laws being proposed. I particularly like these sections of the article:
Such political gamesmanship will wreak havoc in financial markets for those who invest in long-term securities or bonds. The risk of bank failure in normal market cycles is priced into bonds based on the knowledge that creditors are protected through an orderly bankruptcy process. Higher interest goes to those whose debt is subjugated to that of others whose claims come first. Under the new FDIC rule, you cannot price the risk because you don't know the ideology of the FDIC commissioner, his staff, the board or the administration in Washington. Politics adds a new layer of uncertainty that will force a re-pricing of bonds, securities and underwriting, while exposing small investors to a new level of risk.

[...]

But the problem with Lehman wasn't its bankruptcy, per se. The problem was that administrations and Congresses, going back to the 1980s, had removed derivatives contracts from being dealt with through the orderly bankruptcy process. This meant that, unlike other creditors, those with derivatives contracts could break them and demand immediate payment. This prevented them being unwound in an orderly manner, and thus helped put downward pressure on asset prices.

The answer is to have the rules of bankruptcy apply to derivatives, thus making those contracts priced accordingly, not create new uncertainties that can't be fairly priced for all other creditors and the economy.

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