Person:

Roe, Mark

Lehman Brothers’ failure and bankruptcy is widely thought to have deepened the 2008 financial crisis whose negative effects the real economy is still experiencing. Yet, while financial regulation has changed in hopes of avoiding another crisis, bankruptcy rules such as those that governed Lehman’s failure, have not been changed at all. When Lehman failed, it lost considerable further value when its contracting counterparties terminated their financial contracts with Lehman. Hit by broad termination, Lehman’s overall value to its creditors degraded beyond the immediate losses that caused its downfall, and then, along with AIG’s failure several days later, the broad termination involving Lehman further deeply disrupted financial markets in the United States, and indeed the world. Lehman’s financial portfolio was thought to be running a paper profit of over $20 billion when it filed, and is said to have lost up to $75 billion as a result of the post-filing liquidation by Lehman’s counterparties of their deals with Lehman. How such a vast shift can occur, whether bankruptcy can ameliorate the problem (yes), and whether bankruptcy law has been updated since the financial crisis to handle the problem (no) are the subjects of this paper.

For bankruptcy to handle a systemically important financial institution successfully, it must market the institution’s financial contracts’ portfolio, which current bankruptcy law prevents. Moreover, regulatory and bankruptcy authorities need authority to sell the portfolio along product market lines, which they lack. Such authority is needed, first, to preserve its overall portfolio value, and, second, to break up and sell a very large portfolio that could not be sold intact in the aggregate, as the most systemically difficult portfolios are embedded in the world’s largest financial institutions and cannot readily be sold intact. Bankruptcy is the best and first place to put that authority. And, from a systemic perspective, bankruptcy needs to be able to dismantle a large failed portfolio, rather than sell it intact to a larger institution, a typical but undesirable solution here. Lastly, although regulatory and other conditions have changed since the financial crisis, making the bankruptcy target a moving one, the bankruptcy target deserves more consideration today, rather than less, because it is a reachable target without the complexities and uncertainties of new alternatives now in motion. Bankruptcy, however, has not been fixed and updated since the financial crisis, leaving the financial system at risk that, if a major financial institution failed and could not be otherwise resolved, the same difficulties would again arise as arose during the 2008-2009 crisis and the failures of Lehman and AIG.

Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to favored creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007-2009. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed.