WALL ST HELPED CRAFT OWN DOWNFALL

By Francesco Guerrera, Nicole Bullock and Julie MacIntosh in New York 2008-11-03

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and AIG 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, which were backed by regulators, 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 the law firm DLA Piper.
“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”.
The new code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements.
Both products were widely used 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 asking to settle their trades or forcing the three companies to put up more collateral.
That exacerbated the liquidity squeeze that forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March. Lehman filed for bankruptcy last month and AIG was rescued by $120bn government loan.