Working Paper: NBER ID: w17599
Authors: 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.
Keywords: derivatives; bankruptcy; risk management; collateralization
JEL Codes: G21; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| derivative contracts shift credit risk from derivative counterparties to the firm's creditors (G32) | inefficiencies (D61) |
| supersenior status of derivatives (G19) | inefficiently large derivatives market (G19) |
| changes in bankruptcy law that eliminate preferential treatment of derivatives (K35) | enhance overall welfare (I30) |