Should Derivatives Be Privileged in Bankruptcy?

57 Pages Posted: 21 Nov 2011  

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Martin Oehmke

Columbia Business School - Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: November 2011

Abstract

Derivative contracts, swaps, and repos enjoy "super-senior" status in bankruptcy: they are exempt from the automatic stay on debt and collateral collection that applies to virtually all other claims. We propose a simple corporate finance model to assess the effect of this exemption on firms' cost of borrowing and incentives to engage in swaps and derivatives transactions. Our model shows that while derivatives are value-enhancing risk management tools, super-seniority for derivatives can lead to inefficiencies: collateralization and effective seniority of derivatives shifts credit risk to the firm's creditors, even though this risk could be borne more efficiently by derivative counterparties. In addition, because super-senior derivatives dilute existing creditors, they may lead firms to take on derivative positions that are too large from a social perspective. Hence, derivatives markets may grow inefficiently large in equilibrium.

Suggested Citation

Bolton, Patrick and Oehmke, Martin, Should Derivatives Be Privileged in Bankruptcy? (November 2011). NBER Working Paper No. w17599. Available at SSRN: https://ssrn.com/abstract=1962490

Patrick Bolton (Contact Author)

Columbia Business School - Department of Economics ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Martin Oehmke

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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