Lehman: stress test for bankruptcy laws
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.
Many different factors play into this and both dems and republicans have a piece of the problem. Dems pushed for everyone in america to own a house even those who couldn’t afford it or weren’t qualified(subprime mortgages) and in response the fed lowered rates. The republicans eased on regulation. Our government (both reps & dems) created this bubble along with the fed and then the fed tried slowly raising rates to get it under control after it was to late. Investment firms are guilty of pure greed. I have no sympathy for the shareholders because they milked it for 3-4 years. Of course lets not forget the slimmy mortgage broker getting americans to sign on the dotted line. Even those who didn’t need a subprime mortgage.
“faulty decisions” is what we used to call “unfettered greed”.
Adam,
Simplified – Republicans want LESS regulation, thus since Bush (who I voted for sadly) took over there HAS been less. Democrats want MORE regulations. When you say ‘The Government’ remember who is setting the ‘overall’ playing field – the President. Obviously nobody on Wall Street can say ‘no’ to brokering a deal if it makes them cash. They do not care what happens afterwards. As far as the CEO’s golden parachutes, the lessons of the Investment Banking Model are clearly a failure. Expect the fallout of all this to be Obama in the White House, more Federal oversight, less tax loopholes, but more stability than we had under Bush.
One last thought – the National Debt was just over 5 Trillion when Bush II took office. Now it is almost 10 Trillion. The govt GAO office tallied the Iraq War costs to be 2.7 Trillion over the last 5 years. My Voting record has been Reagan, Perot, Clinton, Bush II, Bush II
There must be a law in case of mismanagement. Why do the CEO’s get away with pockets full of gold during several years and are just dismissed with royals benefits, with no harm done by them to the society, taxpayers, market, shareholders, stakeholders.??
I don’t have any faith in our government to do anything anymore…
Faulty decisions – like deciding Subprime Home Loans = AAA ratings?
Seems folks (in business, govt, the media) can’t take an ounce of responsibility for being dumb and/or greedy – and no the Fed can’t stop people from turning the market from a means to allocate resources into a game
I don’t know what planet these other commenters live on, but isn’t it clear that these financial institutions cannot regulate themselves? Laisse fair government attitudes fueled mortgages that should have never been underwritten which led to the real estate bubble and created bad mortgage-backed securities that did-in these financial firms. In other words, the house down the street from you that is boarded up is one of a million pin-pricks that bled these firms to death. The problem is that no one should have approved that mortgage down the street for no money down and no financial documentation from the borrower. It’s as simple as that. What happened to good old fashioned banking principles and federal oversight to keep things in check?
The Social Security administration is loosing it,s solvency and have begun a retro active overpayment collection against millions of americans. This is an attept to save Social Security from bankruptsy. This action is forcing millions of SSA recipiants into bankruptsy first . This is going a much bigger problem than anything the US has evr faced.
@Reid Bump:
“You’ve got to be kidding me. It is government intervention in the market that created this entire bubble and its subsequent burst.”
Ummm, I think deregulation of the industry by the Republican legislature is really what fueled the bubble. Sure, the firms themselves bear most of the blame and once again we have a situation where a lucky few benefit from the profits and the rest of us (taxpayers) may have to subsidize losses. So now we are in a very awkward situation. Either have responsible oversight like we used to, or let floundering firms fail. Whatever the outcome, it is pretty clear these firms cannot be trusted to be responsible.
Did anyone else happen to see the guy with the ax in the window at Lehman this morning?
Lack of federal regulation that has allowed corporate America to privatize profits and expects taxpayers to socialize the losses is what is at the heart of our current economic meltdown. Freddie Mac and Fannie Mae are prime examples. Let them fail. Where is all of the enthusiasm for unfettered capitalism when the shareholders and CEO’s are the ones on the short end of the stick. Situational committment to “free markets” seems to be part of the corporate mantra anymore. No one is bailing out all of the average folks that got caught in the subprime mess and American taxpayers shouldn’t be expected to bail out corporations unless they are willing to be nationalized so we share in the good times as well.
Actually the bubble has been caused by Financial Institutions handing out risky mortgages….that has caused this bubble….ignoring sound financial sense….
What’s needed is to let the companies fail – stop threatening to use my tax dollars to rescue greedy bastards from their own stupidity!
“What’s needed is either federal intervention, or federal oversight earlier in the process” to prevent the faulty decisions that led to insolvency.”
Would that be the same oversight that worked so well for Fannie Mae and Freddie Mac?
Reid are you out of your mind? You are in denial if you think there is too MUCH oversight. The govt did not make anyone at Lehman take any actions which led to their own mess.
FYI – look up FASB rule 157 regarding valuation of assetts. Guess which firm adhered to it while none others did. Yep – Goldman Sachs.
If we have too much govt oversight nobody will ever take risks as it would be illegal (depending on how far those supposed govt oversight rules went). If however no additional oversights are initiated, then we have the free market to determine what is good and what is not good overall. Clearly the Wall Street mentality of serving only their employees and not their customers is not the way to go.
If you truly support no additional oversights then you are part of the problem, not the solution.
Personally I think total adhesion to FASB Rule 157 would have avoided most of this mess, but then again greed blinded most to it – except at Goldman that is. At least there is ONE firm that has integrity out of the big 5.
Just my .02 worth.
the Feds have had this task of assuring safety of the financial system since 1933. I’m not sure they’ve learned a lot in those 75 years. 
The CEO’s of this financial instution should have to do prison time and give back every dime they have earned for being greedy and caring only about their own future. It is beyond my comprehensive as to how they can sleep at night knowing the ordinary workers are struggling to survive while they have their billions in the bank.
The Feds overseeing these operations are suffering from poor leadership and “Good Job Brownie” politics. It is a shame that so many average citizen investment dollars are going to be gradually siphoned away in this mess.
“What’s needed is either federal intervention, or federal oversight earlier in the process” to prevent the faulty decisions that led to insolvency.”
You’ve got to be kidding me. It is government intervention in the market that created this entire bubble and its subsequent burst.
And what’s to make us think the Feds have the necessary ability to prevent faulty decisions? Who is kidding who?
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This blog is about legal issues that matter to business people, and it's geared for nonlawyers and lawyers alike. Roger Parloff is Fortune magazine's senior editor (legal affairs). He practiced law for five years in Manhattan before becoming a full-time journalist.
With yet another tax payer bail out, the keating five is now relevent. McCain economic judgement and continued support of deregulation after the S & L scandal which he directly benefited from financial is valid. The American people deserve to know.