Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.
The
2005 changes made clear that certain derivatives and financial
transactions were exempt from provisions in the bankruptcy code that
freeze a failed company’s assets until a court decides how to apportion
them among creditors.However, experts say the new rules might have accelerated the demise
of Bear, Lehman and AIG by removing legal obstacles for banks and hedge
funds that wanted to close positions and demand extra collateral from
the three companies.“The changes were introduced to promote the
orderly unwinding of transactions but they ended up speeding up the
bankruptcy process,” said William Goldman, a partner at DLA Piper, the
law firm. “They wanted to protect the likes of Lehman and Bear Stearns
from the domino effect that would have ensued had a counterparty gone
under. They never thought the ones to go under would have been Lehman
and Bear.”
Here is the full story. Here is previous MR coverage of this topic. Here is a short article on petards. Here is Wikipedia on petards. Here are pictures of petards.
There were concerns about this very issue raised by legal scholars in the wake of the ’05 amendments. Check out “Credit Derivatives & The Future of Chapter 11″ by Stephen Lubben at Seton Hall Law School. Full text here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906613
Thinking aloud (always fraught with peril, i.e. “petard risk”), one would say this provision may have unintended consequences, but not of the variety outlined.
For instance, whether or not you can “get at” someone’s collateral outside of a bankruptcy proceeding doesn’t obviously inform how much collateral you demand against a certain set of risk(s). So, had the rules remain unchanged, we might still have expected … “spiraling demands” for collateral, as risk assessments went up, in general. Put another way, you’d likely want more collateral going into a bankruptcy proceeding, too, as you reassessed the risk(s).
Put yet another way, all that seems to have been pointed out is that “just in time collateral” is no substitute for “crisis capital” on hand, maybe. In other words, you cannot build a well capitalized book overnight, if you need to, especially in a crisis/panic environment.
On the other hand, taking collateral out of the bankruptcy context speaks to a point that Greenspan brought up. He said that loan officers know the risks of counterparties better, in his experience, than any regulator could. Now, if you do not have to go to court with all the other (unsecured?) creditors, you might focus only on your own collateral as ample security, and “ignore” a consideration of whether everyone else is extending too much credit to the same person, a factor that might be part of your calculation(s) were you to face a bankruptcy proceeding.
Still, if you look at what has happened in London, with the freezing of trading assets of Hedge Funds – some of which may even face margin calls in the interim, to add insult to injury! – you can see why such legislation is sound and the other has to be addressed using some other mechanism, most likekly.
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