Derivatives Skip Bankruptcy Courts

Now this is something I hadn't paid attention to. There was a provision of the 2005 bankruptcy bill—odious pile of lobbyist-authored faeces that it is—that helped cause the current situation.

TPM reader GG explains:

Respectfully, you guys are totally misunderstanding something crucial in the AIG bailout: Derivatives claims are not stayed in bankruptcy. (Yet another brilliant innovation from the 2005 bankruptcy reform legislation.)

If AIG were to go down, derivatives counterparties would be able to seize cash/collateral while other creditors and claimants would have to stand by and wait. Depending on how aggressive the insurance regulators in the hundreds of jurisdictions AIG operates have been, the subsidiaries might or might not have enough cash to stay afloat. If policyholders at AIG and other insurance companies started to cancel/cash in policies, there would definitely not be enough cash to pay them. Insurers would be forced to liquidate portfolios of equities and bonds into a collapsing market.

In other words, I don't think the fear was so much about the counterparties as about the smoking heap of rubble they would leave in their wake.

Additionally, naming AIG's counterparties without knowing/naming those counterparties' counterparties and clients would be at best useless, and very likely dangerous. Let's say Geithner acknowledges that Big French Bank is a significant AIG counterparty. (Likely, but I have no direct knowledge.) BFB then issues a statement confirming this, but stating it was structuring deals for its clients, who bear all the risk on the deals, and who it can't name due to confidentiality clauses. Since everyone knows BFB specialized in setting up derivatives transactions for state-affiliated banks in Central and Eastern Europe, these already wobbly institutions start to face runs. In some cases this leads to actual riots in the streets, especially since the governments there don't have the reserves to help out. If you're Tim Geithner, do you risk it? Or do you grit your teeth and let a bunch of senators call you a scumbag for a few more hours?

So, everybody else gets to wait and see, in the case of a bank failing, whether they get ANYTHING because the derivatives players get first crack at the organization, even if it breaks the debtor organization into pieces? This is horrendous.It makes sense, mind you, since this whole thing is based around managing risk and they clearly didn't want horrible unpredictable innumerate judges getting involved in this game.

It's still horrendous, though. It shows why institutions are so unwilling to lend. Who wouldn't be? You don't know how bad their derivatives situation is, don't know whether they'll have any money to pay you back, and don't know if you'll get a thin dime after the derivative traders get through with them!

And the fact that this might be an international security issue? That scenario in the fourth paragraph sounded frighteningly real, and the prospect of Geithner being responsible for the well-being of the European (and African, and Asian, and...) banking system is pretty terrifying itself. He's not a guy that inspires a lot of confidence and, well, hope. But now we know why AIG can't fail.

Then again, if it's in the public interest to have something exist, and the private sector can't run it, the solution seems, well, pretty obvious. Doesn't it?