Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

Abstract

Lehman Brothers’ failure and bankruptcy deepened the 2008 financial crisis whose negative effects the United States’ economy suffered from for several years. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost considerable further value when its contracting counterparties terminated their financial contracts with Lehman. These broad terminations degraded Lehman’s overall value to its creditors beyond the immediate losses that caused its downfall. 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 value loss can occur and how bankruptcy can ameliorate the problem are the subjects of this Article.

For bankruptcy to handle a systemically important financial institution successfully, it must be able to market those parts of the failed institution’s financial contracts portfolio that are saleable at its fundamental value, i.e., other than at fire sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio, intact, or allow for the liquidation of each contract, one-by-one. The latter is what happened for Lehman, disrupting markets worldwide. The former — sale intact — cannot be accomplished as a business matter for a very, large financial contracts portfolio (and the most serious are embedded in the world’s biggest financial institutions) and would be economically undesirable even if possible. Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell a very large portfolio that is too large to sell intact.

Congress and the regulators have said that bankruptcy is the favored means for financial resolution. Yet, while regulatory initiatives have sought to make failure less likely and resolution more viable than it proved during the crisis, bankruptcy law has neither been fixed nor even updated here since the financial crisis. If a major financial institution were to fail today, the same bankruptcy problems that arose during the past crisis and vexed Lehman could again disrupt the country’s and the world’s financial systems. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of limiting bankruptcy to its current constraints of either a sale of the entire portfolio or a Lehman-style close-out of each contract, one-by-one.

Keywords: safe harbors, bankruptcy, financial crisis, contagion, bank run, qualified financial contracts, derivatives, orderly liquidation authority, repo, Lehman Brothers, Dodd-Frank

JEL Classification: G20, G28, G32, G33, G38, K22