Should Derivatives be Privileged in Bankruptcy?

Patrick Bolton and Martin Oehmke

No 17599, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G21 G33 (search for similar items in EconPapers)
Date: 2011-11
New Economics Papers: this item is included in nep-ban and nep-bec
Note: CF
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Published as PATRICK BOLTON & MARTIN OEHMKE, 2015. "Should Derivatives Be Privileged in Bankruptcy?," The Journal of Finance, vol 70(6), pages 2353-2394.

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