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Bankruptcy protection backfired, critics claim

A change in the U.S. bankruptcy code in 2005, intended to insulate financial institutions from systemic risk, instead hastened the demise of Bear Stearns, Lehman Brothers and American International Group, some experts told the Financial Times.

Industry trade associations defended the change.

The 2005 Bankruptcy Act protected repo lenders by exempting repos collateralized by mortgage-backed securities from the bankruptcy of a repo borrower. It extended the same exemption to derivatives.

From reporters Francesco Guerrera, Nicole Bullock and Julie MacIntosh writing in the Financial Times October 30 2008:

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” attorney William Goldman told the Financial Times. “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.”

The Securities Industry and Financial Markets Association, the trade body that lobbied for the changes, rejected the criticism, saying the 2005 rules “enhance legal certainty for contracts, [and] reduce legal risk … and systemic risk”.

The International Swaps and Derivatives Association added that the 2005 clarifications “provided legal certainty by clarifying existing federal policy”.
 

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