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Should Derivatives be Privileged in Bankruptcy?

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  • Patrick Bolton
  • Martin Oehmke

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

  • Patrick Bolton & Martin Oehmke, 2011. "Should Derivatives be Privileged in Bankruptcy?," NBER Working Papers 17599, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17599
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    References listed on IDEAS

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    Cited by:

    1. Sebastian Infante, 2013. "Repo collateral fire sales: the effects of exemption from automatic stay," Finance and Economics Discussion Series 2013-83, Board of Governors of the Federal Reserve System (U.S.).
    2. Gaetano Antinolfi & Francesca Carapella & Charles Kahn & Antoine Martin & David Mills & Ed Nosal, 2015. "Repos, Fire Sales, and Bankruptcy Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(1), pages 21-31, January.
    3. Maryam Farboodi, 2014. "Intermediation and Voluntary Exposure to Counterparty Risk," 2014 Meeting Papers 365, Society for Economic Dynamics.
    4. Oehmke, Martin, 2014. "Liquidating illiquid collateral," LSE Research Online Documents on Economics 84518, London School of Economics and Political Science, LSE Library.
    5. , & Yorulmazer, Tanju, 2013. "Liquidity hoarding," Theoretical Economics, Econometric Society, vol. 8(2), May.

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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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