Investment banks? What investment banks, says the alert reader. They are all gone, either bought by big banks, dead, or forced to become them so as to be able to pull funds from the Federal Reserve more readily.
The Financial Times report that the changes to the bankruptcy law in 2005 may have played a role in the undoing of these firms. The danger for an investment bank, as the Bear Stearns case illustrated, is that counterparties can become nervous about having credit exposure and can start curtailing certain types of activities and close accounts that would be frozen in bankruptcy. Worse, if a firm is downgraded beyond a certain point, counterparties will stop trading with the troubled firm because exposure to that firm would get them downgraded. And an inability to trade is a death knell for a securities firm.
The irony is that carveouts in the 2005 bankruptcy reform bill intended to help investment banks appear to have worked in the opposite fashion. From the Financial Times:
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.
The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.
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.”…
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.
Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.
Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”