Lehman: stress test for bankruptcy laws

September 15, 2008, 10:35 PM UTC

With this morning’s Chapter 11 filing by Lehman Brothers’ parent company (LEH), we’re about to find out whether the bankruptcy laws cushion the impact of a behemoth investment bank’s insolvency on our financial system — as intended — or if those laws, instead, inadvertently exacerbate the problem. The rules have never been tested as they’re about to be.

“I think it’s a really scary time right now,” says Ed Morrison, a professor and bankruptcy expert at Columbia Law School.

In essence, Morrison explains, bankruptcy laws have evolved since 1978 in ways that actually leave investment banks like Lehman Brothers less protected than most debtors would be from hordes of creditors “descending on [it] and tearing it apart,” as Morrison puts it.

But those laws have been written specifically for the purpose of limiting systemic harm from a collapse like Lehman’s, and averting financial meltdown. Whether they really work that way in practice is what no one really knows.

First, the basic facts: Lehman Brothers’ holding company has filed for Chapter 11 bankruptcy protection, but none of the U.S. subsidiaries have. As a practical matter, its brokerage-dealer subsidiaries, asset management unit, and investment management division are all supposed to continue operating as normal.

All U.S. divisions still remain under control of management, and the expectation is that Lehman will try to sell the most attractive operating divisions while liquidating the rest. (Individual investors who have accounts with Lehman’s broker-dealer subsidiaries are supposed to be protected, as their assets are not available to Lehman’s creditors, and their accounts are further protected by the federal Securities Investor Protection Corporation.)

Here’s what makes the bankruptcy of an investment bank unusual. An ordinary bankruptcy petitioner, like an airline or a steel mill, gets immediate protection from its biggest creditors by the operation of law: as soon as it files for bankruptcy, an “automatic stay” takes effect which prevents those creditors from going forward with lawsuits and seizing the debtor’s assets. Metaphorical runs on the bank are prevented, and management gets time to organize its affairs in a way that will, theoretically, maximize value for all creditors, and maybe even allow the company to reemerge in sound health.

With a financial institution, however, the automatic stay offers no protection against many of its most important creditors. In a trend that began in 1978 and was greatly expanded in amendments passed in 2005, most financial contracts — including securities contracts, swaps, repurchase agreements, commodities contracts, and forward trades — are unaffected by automatic stays.

Worse still, as soon as Lehman’s parent corporation goes into bankruptcy, that event (under the contractual language governing most of these) triggers default, allowing the counterparty — the bank or other institution that entered into the deal with Lehman — to immediately accelerate or cancel the contract and seize whatever collateral may cover it.

Why? The thinking, Morrison explains, was that if an investment bank like Lehman ever failed, all its counterparties (like, say, a Bank of America) could extricate themselves immediately from Lehman’s troubles rather than getting mired in a bankruptcy proceeding.

“They won’t be locked in and dragged down with Lehman,” Morrison says. The laws will — theoretically — minimize risk of market meltdown.

Now comes the downside potential. The risk is that lots of these commercial counterparties will choose to terminate their financial contracts with Lehman — say, for instance, credit default swaps — all at once, and then try to rehedge themselves all at once, causing the market to seize up.

“This was one of the big fears that led to the federal government decision to orchestrate a bailout of Long Term Capital Management in the 1990s,” he says.

The International Swaps and Derivatives Association (ISDA) held a special trading session yesterday — on a Sunday — in an effort to “mitigate counterparty credit risk” stemming from the events going on at Lehman, according to a press release the group issued. But it’s far from clear if these kinds of efforts will do the trick.

“The lesson of all this,” says Morrison, “is that once a major institution has hit major distress, there’s nothing bankruptcy law can do. It’s too late. What’s needed is either federal intervention, or federal oversight earlier in the process” to prevent the faulty decisions that led to insolvency.

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