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UBC Winter Finance Conference – 3/5/2011 Should Derivatives be Senior Patrick Bolton and Martin Oehmke Discussion by Jeffrey Zwiebel TexPoint fonts used in EMF. Read the TexPoint manual before you delete this box.: AA A A

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Summary: Derivatives and repos effectively enjoy seniority in bankruptcy as collateral can be seized right away, unlike other claims (they are exempt from the automatic stay on collections in bankruptcy) Does this exemption make sense? Is this a good law or not? Paper develops a model to analyze these questions Very sensible and clear model that includes many of the considerations that are discussed Results generally indicate that this seniority is unwarranted, and does not promote efficiency, and rather can lead to excessive use of derivatives 1

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Three effects of Derivatives 1.Benefit of cash management preventing inefficient liquidation 2.Cost of exogenously given hedging cost using derivatives 3.Asset substitution effect. Ex-post transfer from debtholders to shareholders if derivative can be made senior to debt. 2

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Benefit of Derivatives 1.The benefit is: Provide valuable risk management: Simple Bolton-Sharfstein style contracting friction of nonverifiable cash flows yielding inefficient liquidation and inefficient ex-ante investment: Financing F needed for an investment, raised with debt of face value R Cash in period 1 from an investment is either C L or C H, but nonverifiable. Cash in Period 2 is C 2 and can always be diverted. If C L < R is paid back in P1, creditor liquidates, but this is inefficient. No renegotiation is allowed here. 3

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Benefit of Derivative Continued A derivative is a contract on random variable Z with outcome Z L or Z H with the realization of Z correlated with firm cash flows Key point: Cash from derivatives contract is verifiable, and can therefore be used to hedge project risk and pay creditor Hence the derivative allow a firm to verifiably transfer cash (that can be committed for payments) from good to bad states on average, yielding less inefficient liquidation 4

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Cost of Derivative 2.Cost of Derivative: Use of derivatives is assumed to involve a hedging cost based on notional amount of the derivative –This is a pure deadweight cost – ½ (X) for notional value of X Social optimum determined by trading off this hedging cost with the risk management benefit 5

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Seniority and Transfers 3.Asset Substitution: If derivatives can be issued senior to existing debtholders, there is an ex post transfer from debtholder to shareholders –Seniority effectively follows from the exemption for derivatives to the automatic stay under bankruptcy, together with the pledging of collateral to derivatives –Paper argues that under current law, it is not possible to commit not to undertake such asset substitution (more on this later) –Of course, debtholders anticipate this ex-ante, and demand a higher interest rate –This in turn leads to more default and less financings if derivate hedge is imperfect, which is a real social loss –If instead derivatives were junior to debtholders (or equivalently, are without collateral), then there is no asset substitution effect 6

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Results Results follow from these 3 effects. Among these results: –Lower required face value for debt when debt is senior vs. when derivatives are senior –Junior derivatives yields less inefficient failures to finance and less inefficient liquidation subject to financing than senior derivatives –A constraints that restricts derivative collateral to a partial level will yield results in between junior and senior derivative –Asset substitution may lead to the use of derivatives beyond the point where they provide any risk sharing benefits 7

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Comments: Very nice intuitive story that gets to the heart of what many have in mind with derivatives and seniority Senior derivatives given a “fair shot” here, insofar as they are endowed in the model with a valuable use that comes from a natural contracting friction The use of derivatives raises welfare Key point is derivatives need not be senior to serve risk management role And effective seniority requires higher debt which yields more inefficient liquidation 8

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A few quick questions Paper includes repos into the same discussion as derivatives. But is this the same issue? Repos are surely not serving the same risk management role as derivatives may be serving Similarly, the paper discusses netting provisions for derivatives as similar to exemption for automatic stay in conferring effective seniority. But don’t many other creditors effectively get similar netting treatment? Why no renegotiation? Paper claims unimportant. Not immediately clear. 9

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Law vs. Contracts A key question discussed in paper is whether can contract around legal treatment of seniority Shareholders would like to be able to commit when issuing debt not to endow future derivative counterparties with seniority through collateral Paper argues may not be able to commit to doing so, insofar as this is ex-post optimal And recall, do not want to restrict derivatives, which are beneficial, but only collateralization that make them senior 10

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Contracts Continued Not obvious why clause in debt could not prohibit collateral for derivatives, or require that derivatives be treated as junior claimants to debt in bankruptcy Why has this not been done? –Not possible. Hard to define all derivatives in debt contract –Not desired for some reason outside the model –Extent of potential expropriation of debtholders through effective seniority of derivatives was not well-appreciated in practice before, but we will see such restrictions going forward 11

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Deadweight Loss with Derivatives What is the source of this hedging cost ½ (X)? On one hand seems natural, that counterparty may face some costs of this risk that are passed on to firm This is of course a common assumption in the literature Debtholders and shareholder however face very similar risks in the model, without such a cost Model has a partial equilibrium feel when we consider extra costs for holding derivatives and not other securities without a clear story 12

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A Different Story for Derivatives for Financial Firms Possibly not for risk management at all, but for speculation –Paper acknowledges something like this briefly under certain parameters when asset substitution is extreme Consider a particular type of speculation: Suppose financial firms use derivatives (and leverage) to create distribution with extreme left tail risk –Most of the time yields constant gain –In a rare state, lose a lot This is likely to be easy for a financial firm to do, in a manner that is hard for outsiders to observe 13

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Tail Risk - Continued Why? Managerial career concerns –That is, focus on Managerial-Shareholder conflict rather than Shareholder-Debtholder conflict Would be in managers interest if –Manager cared about relative performance in some nonlinear manner (say from career concerns and firing), and –Either market is unaware of risky position, or the market can infer it but not observe it In such a setting, managers might not care much about the tail event (they get fired anyways), hence bankruptcy rules might not affect behavior much However, suppose that there is an externality from financial crisis, which can be worsened if derivatives are not settled This is a very different story that could perhaps justify the exemption of the automatic stay for derivatives 14

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Conclusion Clean and compelling model of an important issue Results are intuitive and believable Highlights and clarifies several critical considerations with regard to current legal treatment of derivatives under bankruptcy Focuses attention on a number of interesting new questions 15

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