Lehman, AIG: Protections for investors are limited in financial storm

It is hard to imagine large numbers of Americans glued to their computers and televisions all day following events in the financial markets, but as most see the value of their homes and their retirement assets shrinking rapidly, people are focused on the problems of Wall Street -- on Lehman Brothers, AIG, and Merrill Lynch -- which threaten to overwhelm the news cycle even in an election year. Uncertain about how this storm might affect them, many will reach out to their accountants and financial advisors to be reminded of state and federal laws protecting bank and brokerage accounts and insurance policies, and the limits to those protections.

For small business owners and individuals waiting to buy or sell a home, the credit freeze is the single most important factor in their business decisions and ultimately in the declining value of their assets. In some ways the Lehman Brothers bankruptcy and AIG's problems and the connections between the institutions involved in this crisis could make the credit crunch worse. The sale of Merrill Lynch will have only local consequences in terms of employment and real estate values. New York City will lose thousands of jobs and a major taxpayer, pundits say.

Lehman Brothers Bankruptcy

Chapter 11 reorganization is not available to brokers under U.S. bankruptcy laws. Lehman Brothers holding company the parent, but not the brokerage-dealer subsidiaries, asset management unit, and investment management divisions has filed for Chapter 11 bankruptcy protection. The broker-dealer subsidiaries are all supposed to continue operating as normal, so that the company can avoid forced liquidation of its brokerage unit.

In ordinary bankruptcy filings, as soon as a petitioner files for bankruptcy, an "automatic stay" takes effect which prevents creditors from going forward with lawsuits and seizing the debtor's assets. Management has time to organize its affairs, maximize creditor value, and possibly emerge as a healthy company.

With a financial institution, however, according to cnnmoney.com, there is no automatic protection against many of its most important creditors. Amendments to the bankruptcy laws in recent years have ruled that most financial contracts - including securities contracts, swaps, repurchase agreements, commodities contracts, and forward trades - are not affected by automatic stays. These contracts go into default as soon as the parent declares bankruptcy and the creditors (other banks) can immediately accelerate or cancel the contract and seize whatever collateral may cover it. Depending on the reactions of the creditors, the Lehman bankruptcy can either bring an end to the impact of the troubled firm on the credit market or be the start of a new chapter in the credit crisis.

Values of Broker Accounts and Bank Accounts

Individual investors who have accounts with Lehman's broker-dealer subsidiaries are supposed to be protected, as their assets are not available to Lehman's creditors, and their accounts are protected by the federal Securities Investor Protection Corporation, according to cnnmoney.com.

Small business owners should be reminded that the FDIC only covers $100,000 in bank accounts and that loans will be hard to come by until credit markets stabilize. Home values will continue to plummet until buyers have access to credit.

AIG Life Insurance and Home Owner Insurance Policyholders

AIG's problems will impact not only the credit market, because of the insurance company's investments, but also individual policyholders, depending on the policy, although limited protections exist.

Life insurance policyholders are protected by state guaranty associations for at least $100,000 in cash surrender or withdrawal value on their policy and at least $300,000 in death benefits, said Peter Gallanis, president of the National Organization of Life and Health Insurance Guaranty Associations in Herndon, Va., cnnmoney reports. "If you've got $100,000 or less in cash surrender value on your contract, there is a very good chance that your policy will be transferred and you'll never miss a beat," Gallanis said. New York, Connecticut, and Washington, D.C., protect life insurance policyholders up to $500,000.

State guaranty associations are funded by insurance companies which have to pay a fee to help ensure any failed institutions' customers or risk losing their license, according to cnnmoney.com.

Policyholders with a life insurance policy worth more than the limit, "will be given a choice of either having the policy level reduced to the level guaranteed by the guaranty association or else picking up the cost of receiving policy protection in an amount over and above what the guaranty association provides," Gallanis said.

State guaranty associations also cover holders of homeowners' policies who have filed a claim with a company that then fails, Roger Schmelzer, chief executive of National Conference of Insurance Guaranty Funds Inc. in Indianapolis told cnnmoney. "The guaranty fund steps into the shoes of the insurance company from a claims-paying perspective."

Industry experts say payments on claims could be delayed. If a policyholder does not have a claim, then he might consider looking for another insurance company. In some cases, banks or mortgage holders require higher than B ratings. If AIG's rating continues to sink, policy holders will be required to find another carrier.

As an insurance company, AIG would not have had to mark to market its real estate investments held in long-term portfolios according to accounting rules. But when the company needed to raise capital, potential investors required that information.

And in yet another instance of the connections between companies in this financial crisis, when Lehman Brothers offered a value for its sub-prime and Alt-A investments last week, those values could then be assigned to AIG's holdings, cnnmoney says.

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