It is done:  today, Lehman Brothers filed the largest bankruptcy petition ever with the US Bankruptcy Court.  Hank Paulson is drawing a line in the sand.  In the long run, this will be a good thing, for two reasons:  if Lehman winds up in a relatively orderly fashion, it will prove to the market that it can survive a big insolvency.  And it's a clear, strong signal to markets that they shouldn't expect the feds to protect them from counterparty risk.

In the meantime, what a mess:

Regulators and others were preparing for a hectic Monday. The New York Stock Exchange prepared contingency plans over the weekend to reassign the approximately 200 blue-chip stocks that Lehman's specialist unit trades, according to people familiar with the matter. If Lehman is forced into liquidation, the exchange will likely transfer the stocks to one or more of the remaining specialist firms, most likely using the same technology and staff that currently trade the stocks.

Dozens of Wall Street desks have trades with Lehman. As word spread that the Barclays deal was falling apart, worries that the company could be thrown into bankruptcy mounted, and traders labored to get out of those contracts.

At approximately 2:30 p.m., government officials hosted a call, and a trading session was opened to ease fears. One trader said it was agreed that other brokers would pick up contracts that trading desks have with Lehman. If Lehman does open on Monday, the deals struck on Sunday, often at a worse price, would be void. "It is utter chaos here," the trader said.

At many Wall Street firms, traders of credit-default swaps -- contracts that act as insurance against debt defaults -- were told to come to work immediately. Concerned investors were rushing to buy swaps tied to other brokerages and corporations, sending the cost of protection on investment banks such as Goldman Sachs and others sharply higher.

In a statement Sunday, the International Swaps and Derivatives Association, a trade group whose members include many large dealers, said a "netting trading session" took place between 2 p.m. and 6 p.m. on Sunday. The idea was to allow firms to try to unwind their derivatives transactions with Lehman by finding other parties to step into Lehman's shoes.

"The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy filing," it said. It added that trades conducted during this period "are contingent on a bankruptcy filing on or before 11:59 p.m. New York time" on Sunday. If no filing takes place, the trades will be canceled, ISDA said.

As it happens, I was on a panel about new technology regulation this morning.  This crisis can be seen as a failure to adequately regulate new financial products that came out of the revolution in financial theory that took place in the late 20th century.  One of the main problems, I think, is that regulators became obsessed with certifying things as safe.  The agency was supposed to check them out, make sure they were safe, and then approve or disapprove. Thus we hoped to make life in America as safe as a whiffle ball game.

But it is not possible to make things perfectly safe, not least an enormously complicated financial system like ours.  But having declared things safe based on the verdicts of 3 government approved rating agencies, we didn't put much focus on how to wind things up if they failed.  The FDIC has a very smooth system for handling the liquidation of commercial banks, and as a result, no one panics.  We should have been thinking about something similar for investment banks.

We need to shift our focus on regulation from a fruitless search for 100% safety to accepting risk, and trying to make the markets more robust to withstand it.  The government should encourage, rather than discourage, multiple sources of information and analysis.  It should pay more attention to outlying risks.  And it should have systems in place to wind down the inevitable failures, rather than letting the outcome depend on how Hank Paulson is feeling this morning.


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