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Tweak bankruptcy law so big banks can fail more easily: critic Print E-mail
Wednesday, 18 November 2009

By Ronald Fink

Congress would do better to rein in banks that are too big to fail by repealing parts of the Bankruptcy Reform Act of 2005 than by creating new resolution authority for the government, a noted bankruptcy expert wrote on Tuesday.

Seton Hall University law professor Stephen Lubben noted on the blog Credit Slips that changes to the federal bankruptcy law enacted by Congress four years ago have made it more difficult to use Chapter 11 to restructure banks. Provisions of the law eagerly sought by bank lobbyists put derivatives out of reach of creditors.

As a result, for example, Goldman Sachs and other banks that owned credit default swaps sold by AIG could claim that they were first in line for payment on the contracts. But Lubben insisted that such an "automatic stay" for swaps weakened the government's negotiating position with those AIG counterparties. Because the government could not realistically threaten to put AIG into Chapter 11, Lubben insisted, it did not have as much leverage as it might have had in negotiating discounts on the value of their claims.

The special inspector general for the Troubled Asset Relief Program criticized the Federal Reserve Bank of New York on Monday for paying 100 cents on the dollar to Goldman and other banks holding such swaps.

"A credible threat to put AIG into Chapter 11 might well have saved billions of dollars," Lubbens wrote. But he said the Treasury and the Fed were unable to make such a threat, "given their generally dismissive relationship with Chapter 11 and an extreme case of cold feet following" the failure of Lehman Brothers.

Lubbens also predicted that the financial industry will cite the legal battle now raging between the Lehman estate and Barclays as more evidence that Chapter 11 doesn't work well for financial institutions and that new resolution authority being sought by the Treasury from Congress is therefore necessary.

But the law professor said such a view "ignores the degree to which the financial community created the Lehman mess, by both undermining Chapter 11 through the reckless expansion of the derivative safe harbors in 2005 and by the general refusal to work with the existing Chapter 11 system both before and after Lehman." Lubbens said that refusal was evident in the case of Bear Stearns as well as AIG.

He noted that Congress would effectively be reinventing the wheel by creating new resolution authority for banks that are too big to fail. And others have said big bank resolutions under such authority are likely to cost taxpayers more than bankruptcies, even if Chapter 11 proceedings required federal help to make liquidation of bank assets an orderly process.

As the New York Times put it in an editorial on Wednesday, "Unless the final legislation is very tightly written, resolution authority could be misconstrued as bailout authority-the ability of regulators to use taxpayer money to keep failing firms alive."

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