Template:M intro isda bankruptcy phase transition: Difference between revisions

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You may recall from your first law lecture that legal systems don’t ''like'' [[doubt|not knowing what will happen]]. Financial services types have a particular aversion. Which, yes, is ''highly'' ironic, seeing as the financial markets ''depend for their existence'' on [[Doubt|uncertainty]]. ''Anyhow''.
You may recall from your first law lecture that legal systems don’t ''like'' [[doubt|not knowing what will happen]]. Financial services types have a particular aversion. Which, yes, is ''highly'' ironic, seeing as the financial markets ''depend for their existence'' on [[Doubt|uncertainty]]. ''Anyhow''.


The administrator won’t care. She will quietly do what she can — and given her discretion, that is a lot — to stop major creditors jumping her gun and swiping valuable assets. Hence all the learned talk among [[legal eagles]] of [[voidable preference]]s, [[safe harbor]]s and like [[magic]]al notions. In some jurisdictions, contractual rights may be suspended and legal action stayed. Creditors may lose their rights to call in loans or close out transactions.
The administrator won’t care. She will quietly do what she can — and given her discretion, that is a lot — to stop major creditors jumping her gun and swiping valuable assets. Hence all the learned talk among [[legal eagles]] of [[voidable preference]]s, [[safe harbor]]s and like [[magic]]al notions. In some jurisdictions, contractual rights may be suspended and legal action stayed. Creditors may lose their rights to call in loans or close out transactions.
 
====Bankers: meh====
{{drop|F|or most creditors}}, this is not quite as drastic as it sounds.  The damage is already done. There are many ways of falling into [[Bankruptcy - ISDA Provision|bankruptcy]] – ''eight'' at least, by [[Bankruptcy - ISDA Provision|ISDA’s reckoning]] — but to one owed money by a bankrupt it doesn’t much matter which one applies.
 
Your goose is already cooked. suspending its right to claim from a borrower money that it does not in any case have is no great loss. Indeed, ''none'' of these discretions make much difference: the bank is owed 100 million pounds; it will get back significantly less than that. There is not much that an insolvency administrator can do to make that worse.
 
If you are in the hole for a hundred million quid, you are in the hole for a hundred million quid. No amount of clever shenanigans in your contract can get you your money back. This is the fictive nonsense of legal relations: a legal contract is a bus ticket in a hurricane.
 
====Derivatives counterparties: not so fast====
{{drop|B|ankruptcy might not}} make much odds to a “normal” creditor like a lender, but a swap counterparty is in a very different boat. How it manages its rights under its portfolio of transactions, and what exactly it is or is not allowed to do under the Master Agreement, makes an ''enormous'' difference. The question of whether you are in the hole ''at all'', and by how much, is a direct function of ''what action you can take under your contract''.
 
A debt is a known, static thing. A hundred mill stays a hundred mill from day to day.<ref>Okay, sure: interest accrues, but at a predictable rate, and the whole loan’s market value is only minimally volatile as a function of interest rate moves: in any case, this is pocket calculator stuff compared to the volatility of net levered derivative portfolio .</ref> Individual swap exposures can gyrate wildly. The roulette wheel is still spinning in a way it really isn’t for a term loan. You can stop the wheel spinning, and crystalise your position, only by exercising rights under the contract. These are rights that, in bankruptcy, ''may be suspended''. You are forced to stay on risk to an underlier against a counterparty whom you know ''has no capacity to pay you''.
 
But wait, there is more: you have not ''one'' swap exposure, but ''thousands''. Some are in your favour, some against you.<ref>Sidebar for [[equity derivatives]] nuts: the way dynamic synthetic equity swaps tend to trade is not by amending notional sizes but just trading multiple offsetting legs: if I want to upsize, I just trade another long swap. If I want to down-size I trade a short swap. I assume the longs and shorts net out to a single net exposure. An HFT account might trade thousands of times an hour in the same name. This means it could have ''extraordinary'' theoretical gross notional exposures: literally, planet-sized. Of course, it is absurd that anyone would ever pull them apart, but by crystalline application of nervousness that lies behind [[Netting opinion|netting opinions]], they ''could''. </ref> Your entire risk management philosophy depends on these positive and negative transaction exposures offsetting each other and netting down to a single collateralised sum that, you expect, will be near to zero on any day. But that depends on you being able to exercise your contractual rights to enforce that netting. If the bankruptcy phase transition has abrogated your right to close out, set off, or net, you are ''[[munted]]''.

Revision as of 13:24, 12 September 2024

Here is a scenario:

You are a credit officer in the commercial division of your local bank. It transpires your customer, who recently drew a £100 million fixed-rate term loan from you, is on the point of bankruptcy.

What to do?

Insolvency vs. bankruptcy

Here is a quick primer on the difference between insolvency and bankruptcy: “Insolvency” is an oddly nebulous financial state: essentially, that one cannot meet one’s debts as they fall due (cashflow insolvency), or that one’s liabilities exceed one’s assets (balance-sheet insolvency); while “bankruptcy” is a more determinate legal state: definitive formal steps have been taken to put a legal entity into administration, or to wind it up, usually on account of its insolvency.

An insolvent entity may file for bankruptcy or its creditors may petition for it. But it need not. Technically, insolvent entities can limp around indefinitely without ever entering formal bankruptcy. GameStop was arguably insolvent for much of 2019, and look at that sweet unicorn now.

Insolvency is usually, but not necessarily,[1] a precondition for bankruptcy.

The water is further muddied because many finance contracts, and notably the ISDA Master Agreement, conflate the concepts of insolvency and bankruptcy. ISDA’s crack drafting squad™ defines “Bankruptcy” to include measures of formal legal bankruptcy,[2] and measures of financial insolvency[3] and some that are a bit of both.[4]

But, bottom line: insolvency is an accounting concept; bankruptcy a legal one.

The phase transition of bankruptcy

Now. In the jurisprudence of company law, formal bankruptcy is a “phase transition”: the whole “legal context” surrounding a company changes upon its bankruptcy. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints an insolvency administrator and invests her with wide, nightmarish discretions to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her mercy.

You may recall from your first law lecture that legal systems don’t like not knowing what will happen. Financial services types have a particular aversion. Which, yes, is highly ironic, seeing as the financial markets depend for their existence on uncertainty. Anyhow.

The administrator won’t care. She will quietly do what she can — and given her discretion, that is a lot — to stop major creditors jumping her gun and swiping valuable assets. Hence all the learned talk among legal eagles of voidable preferences, safe harbors and like magical notions. In some jurisdictions, contractual rights may be suspended and legal action stayed. Creditors may lose their rights to call in loans or close out transactions.

  1. ↑ Nothing’s easy, is it? It is not unheard of for a solvent entity to file for a “strategic bankruptcy”. But let us not get distracted.
  2. ↑ You really want to do this? Okay: True bankruptcy events: Section 5(a)(vii) limbs (1) (Dissolution), (4) (Institution of bankruptcy proceedings), (5) (Winding-up resolution), (6) (Appointment of administrator) and parts of (8) (Analogous events)
  3. ↑ Practical insolvency events: Section 5(a)(vii) limbs (2)(Cashflow insolvency and arguably balance sheet insolvency too) (3) (Composition with creditors)
  4. ↑ Hybrid events: Section 5(a)(vii)(7) (Enforcement of security)
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