Friday, October 31, 2008

2005 Change In Bankruptcy Regs Created Catalyst For Collapse of Bear Stearns, Lehman and AIG

I have long contended that the voluminous regulations in the United States create pitfalls and opportunities that few understand. A simple sentence or paragraph added to some regulation may be truly understood by fewer than 10 people on the entire planet, but one of those 10 is probably making millions on that added sentence or paragraph. FT is reporting on some 2005 bankruptcy rule changes introduced to protect, among others, investment banks. The added rules backfired and was a key element in the collapse of Bear, Lehman and AG:

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 changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

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, [because of the change in code].

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