Monday, November 3, 2008

At the Extreme of BAPCPA's Unintended Consequences: Did Arcane Provisions of BAPCPA Contribute to the Bear Stearns, Lehman Bros. & AIG Collapses?

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Sounds fanciful: How could BAPCPA possibly have contributed to the financial demise of these financial giants? According to an article last week in the Financial Times of London, knowledgeable bankers and attorneys are now saying that changes in BAPCPA that had been promoted by bankers' trade groups and were designed to protect large financial institutions in the event of a large customer's bankruptcy, instead had extremely detrimental consequences for some of those very institutions.

Certain derivatives and financial transactions were made exempt from the automatic stay by BAPCPA, in order to allow financial institutions to unwind trades and transactions efficiently in the event of a bankruptcy filing by a major customer. Specifically BAPCPA amended Section 362 to exempt from the automatic stay setoffs by a newly defined entity, a "financial participant." I'll spare you the full 130+ word definition at Section 101(22A), but to get an idea of the type and magnitude, this is an entity which has any of a set of agreements (such as securities and commodities contracts, swap, repurchase and master netting agreements) "of a total gross dollar value of not less than $1,000,000,000 [yes, that's $1 BILLION] in notational or actual principal amount outstanding . . . or has gross mark-to-market positions of not less than $100,000,000 (aggregated across counterparties) in one or more such agreements or transactions with the debtor."

Also very importantly the term "repurchase agreement" was greatly expanded at Section 101(47) to include mortgage repurchase agreement, presumably including the now-notorious mortgage-backed securities and collateralized debt obligations.

In the brief and neutral words of a detailed BAPCPA Section-by-Section Analysis written in 2005 by the Collier Editors-in-Chief Alan Resnick and Henry Sommer, on these changes:
Many Code sections are amended, and several new sections are added, to clarify and expand the protection for certain financial contracts, including the right to liquidate, terminate, or accelerate securities contracts, forward contracts, commodities contracts, swap agreements, and repurchase agreements, in the event of a participant's bankruptcy.
So how could mere bankruptcy code changes designed to protect financial institutions, and pushed by knowledgeable organizations like the Securities Industry & Financial Markets Association and the International Swaps & Derivatives Association, lead to the demise of some of the most venerable of these institutions? By newly exempting credit default swaps and mortgage repurchase agreements from the automatic stay, instruments which Bear Sterns and Lehman Brothers used extensively, creditors of these institutions--such as hedge funds and other financial institutions--no longer had the disincentive that the institutions could file bankruptcy and freeze their transactions and their collateral if they were pushed too hard. These creditors, instead of being normally cautious about settling trades and about forcing these institutions to put up more collateral, became aggressive along these very same lines, which greatly accelerated the credit and liquidity squeeze that led to these institutions' demise.

According to this Financial Times article, the Securities Industry & Financial Markets Association and the International Swaps & Derivatives Association deny this connection between the BAPCPA amendments and these financial institutions' troubles.

by: Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

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