INTRODUCTION
The AIG, Bear Stearns, and Lehman Brothers failures were at the heart of the 2008-2009
financial crisis and economic downturn. Some said their failures sparked a financial panic,
others that it exacerbated the downturn. Some said their failures transmitted financial
troubles emanating elsewhere in the economy in a way that brought the underlying
economic damage to a head.1 Here, I show that the Bankruptcy Code’s favored treatment of
these firms’ massive derivatives and financial repurchase (repo) contracts facilitated the
firms’ failures, by undermining market discipline in those markets in the years before these
firms failed.
The Bankruptcy Code did so by sapping the failed firms’ counterparties’ incentives to
account well for counterparty risk—the risk that their financial trading partner would fail (as
AIG, Bear, and Lehman eventually did). Policy-makers at the highest levels expected private
monitoring to substitute for public monitoring, perhaps unaware that bankruptcy rules
reduced those private incentives. Alan Greenspan, who chaired the Federal Reserve,
extolled the derivatives players’ “strong incentives to monitor and control [counterparty
risk] . . . . [P]rudential regulation is supplied by the market through counterparty evaluation
and monitoring rather than by authorities. . . . [P]rivate regulation generally is far better at
constraining excessive risk-taking than is government regulation.”2 As late as 2008,
Greenspan praised “counterparties’ surveillance”
STANFORD LAW REVIEW
as “the first and most effective line of defense against fraud and insolvency.” “JPMorgan,” he
said, “thoroughly scrutinizes the balance sheet of Merrill Lynch before it lends. It does not
look to the Securities and Exchange Commission to verify Merrill’s solvency.”3
We now know that such scrutiny was not thorough. Worse, in the end, the financial sector
relied on the government for far more than verifying counter party solvency, obtaining the
Federal Reserve’s and U.S. Treasury’s cash to bail out the seriously insolvent.
I show here that bankruptcy priority perniciously weakens market discipline in the derivatives
and repo markets because the stronger counterparties know that they often enough will be
paid even if their derivatives or repo counterparty fails. Were the Bankruptcy Code
superpriorities not so broad, the failed firms’ financial trading partners would have
anticipated that they might not be paid if they had weak counterparties that failed.
Understanding this, they would have been further incentivized to lower their exposure to a
potential failure of Lehman, AIG, or Bear. Were the superpriorities not in the Code, each
failed firm would itself have been incentivized to substitute away from their own risky, often
overnight financing and toward a stronger balance sheet to better attract trading partners.
Were the superpriorities not in the Code, the three firms’ counterparties would have had
reason to diversify away from some trades with the failed firms into trades with other
financial firms. Were the superpriorities not in the Code, the extra risk borne by
counterparties would be more accurately priced and, at the higher pricing, we’d have had
less systemically risky activity. Together, those incentives to market discipline should have
made each of these three firms less financially central and less interconnected.
They would likely have had less superpriority debt. The financial system would have been
more resilient.
These bankruptcy-based problems are not small. When Bear failed, a quarter of its capital
came from the repo market via short-term, often overnight,borrowings.4
Without the Code’s priorities, such a precarious capital structure would not have been viable.
When AIG failed, its excessive credit default derivatives exposure destabilized it further.
Without the Code’s priorities for AIG’s derivatives trading partners, such a precarious
position for AIG would not have been so easily viable. Without the Code’s priorities, AIG’s
counterparties would have had reason to worry earlier about AIG’s potential to fail to make
good on its derivatives obligations.
