American Airlines logo (Photo: planebuzz.com)

AMR Corporation — the parent company of American Airlines, which provides a large number of South Florida jobs — filed for bankruptcy under Chapter 11 today.

According to The Miami Herald:

Unable to cut costs enough to fend off creditors, American and its parent company, AMR Corp., filed for Chapter 11 protection Tuesday morning while it tries to lower its debt and reorganize its business. American is one of the five largest private employers in Miami-Dade County, with about 9,000 workers.

The Herald adds that American Airlines

is responsible for about 70 percent of the traffic at Miami International Airport, which is one of American’s five hubs across the country. That status meant something of a windfall for Miami during the recession, with American adding flights out of MIA amid cutbacks by competitors across the country. American funnels most of its Latin American connections through MIA.

Sydney Jimenez, president of Transport Union Workers of America (TWU) Local 568, tells The Florida Independent that what is going to happen with the Chapter 11 filing remains unknown, but “if you go with what has happened at other airlines, it is going to be a painful transition for every employee group.”

“It is too soon to tell, but if you go by what other airlines have done,”  Jimenez says, “and you see the contract they have you would assume that pensions and certain things in our contract as far as productivity will come into play in order for the bankruptcy process to take place and put them in a competitive stance matching up against the other airlines that have gone to bankruptcy.”

George Rojas, president of TWU Local 561, tells the Independent his union represents approximately 800 American Airlines workers, responsible for aircraft maintenance, vehicle maintenance and storage personnel, 95 percent of whom work at Miami International Airport.

“We have to see what’s gone on with other companies; we expect similar changes,” Rojas says, adding, “Of course if they decide to close or minimize their operations elsewhere that could impact our members adversely.”

“We view this as very unfortunate,” Rojas says. “We’ve been working with the company to secure a contract but it is very unfortunate that things turned out this way.”

The Dallas Fort Worth Star-Telegram reports that ”American’s workers gave up $1.6 billion a year in contract concessions to help the airline stave off bankruptcy in 2003,” adding that “for pilots and flight attendants most notably, there are factions within the unions that adamantly oppose any contract provisions this year that would appear concessionary. Still, union leaders know they cannot escape economic reality.”

Allied Pilots Association president David Bates said in a statement issued Tuesday:

I spoke with newly appointed AMR Chief Executive Officer Tom Horton and Vice President-Flight Captain John Hale a short time ago and received assurances that American Airlines will be operating a normal schedule. The announcement of a bankruptcy filing should not cause any interruptions to your flight schedules or problems on your layovers.

By the Spring, the auto makers will need to provide the White House with a restructuring plan that demonstrates viability.

Bush’s announcement is similar to the proposal that died in the Senate a few weeks ago, when the lame-duck, largely unpopular president didn’t have the political clout to twist the arms of Southern Republicans with foreign car manufacturers plants in their states to sign on.

To take a step back from the politics at work, it’s important to note that Bush is essentially asking the car companies for a rapid, bankruptcy-style restructuring outside of the court system. In bankruptcy court, the end goal is to come up with a viable restructuring plan that creditors agree to support. The clear upside to an out-of-court bankruptcy is that the companies get to continue to operate without the stigma of Chapter 11, which auto executives and some experts say would drive down already-dismal sales. But, at the same time, there are many challenges, perhaps insurmountable, to an out-of-court restructuring.

Here’s the kicker. Normally, a company can’t just go to it’s creditors and say, look we’re broke, we are only going to pay you 40% of what we owe you. Under Chapter 11 protection, that’s exactly what happens. It works because creditors are pooled into groups. The company needs to build consensus, not win over every creditor. The exact rules vary by type of debt and amount.

In the next few months, GM and Chrysler are going to need to put together plans by working with individual creditors, rather than pools or classes of lenders and other interests (unions, suppliers, etc.) That doesn’t make for an expedient process.

Which brings me to my next point. Even though it is easier to reach agreements in bankruptcy court, the negotiations take time. Several experts I spoke with last week said a GM bankruptcy process would take years. Guaranteed. So, the White House expectation that GM and Chrysler can put together this plan in a matter of three months is pretty much impossible.

Bush said today that if these companies can’t come up with a plan by March 31, they’ll have to pay back the loans. Presumably, the companies will be forced into Chapter 11, unless the next administration or Congress takes serious action.

U.S. Federal Reserve Headquarters (Flickr: NCinDC)

The complex structure of modern capital markets is increasingly the cause of financial crises. External shocks like a decline in housing prices are intensified as they move through the convoluted chains of dealings that link market participants. Concentration of trading among a small group of dealers only heightens the many risks.

In hindsight, the Federal Reserve’s decision not to bail out Lehman Bros. was a major miscalculation that helped generate the wave of financial anxiety, distrust and uncertainty that doomed American International Group and other institutions. It also helped freeze up credit markets that are only now beginning to thaw. If government overseers had shown greater appreciation and knowledge of the plumbing of the financial system they regulate, some form of Lehman might still be around.

Illustration by: Matt Mahurin

In any case, central bankers and finance ministers frequently act like Pritzker Prize-winning architects charged with trying to unstop clogged plumbing. As a result, they find, as Woody Allen described: “Not only is there no god, but try getting a plumber on weekends.”

In fairness, even experienced professionals struggle to understand the structure of modern markets. One is Jeremy Grantham, chairman of GMO. He recently rated his knowledge of the markets this way: “I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. … It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect [to solve the financial crisis].”

One consequence of the system’s complexity and interconnectedness is that it is difficult to analyze the solvency of financial institutions. The speed with which liquidity and access to funding can evaporate — as with the Dutch bank, Fortis — renders financial statements virtually meaningless.

Agreements governing a firm’s ties to other financial companies also increasingly affect perceptions of its solvency. For example, the downgrade of AIG to below an “AA” credit rating triggered margin calls in excess of $10 billion from the company’s lenders. It also gave AIG’s outside trading parties the right to terminate certain contracts, triggering losses of $4 billion to $5 billion. AIG did not have the resources to meet its obligations — and the government had to step in and bail out the world’s largest insurer.

How a company’s financial distress will affect the overall system can depend on how it is restructured. In the case of Lehman, it was the holding company that filed for bankruptcy protection. The investment bank’s other businesses continued to run. That means financial institutions doing business with Lehman were differently affected by its collapse.

The effects of the demise of Washington Mutual, the largest bank failure in U.S. history, were different. The Federal Deposit Insurance Corp. seized the Seattle thrift following a wave of deposit withdrawals. J.P. Morgan Chase subsequently agreed to acquire WaMu’s banking operations and assume its loan portfolio in a $1.9 billion deal engineered by the government regulator. WaMu’s customers were largely unaffected.

Lehman Bros., New York (Flickr: James Chen)

What’s predictable when financial institutions fail is that investors lose money. With Lehman, unlucky creditors included banks on every continent that had bought Lehman securities and bonds. Because J.P. Morgan did not assume WaMu’s senior unsecured debt, subordinated debt and preferred stock, investors in those financial instruments lost out.

Those losses can be steep. Market estimates of how much Lehman’s debt is worth range from 10 cents to 15 cents on the dollar — a potential loss to investors of 85 percent to 90 percent. In general, recovery rates will be determined by the nature of the assets that Lehman’s counterparties hold — private equity stakes, principal investments, hedge-fund equity, complex slices of risk in structured financial instruments and derivatives. The difficulty in valuing these assets — and the illiquidity of others — may exacerbate investor losses.

One way to examine the complexity of today’s financial plumbing is to focus on a Chapter 11 bankruptcy filing. When a firm files for bankruptcy, all contracts that it has had with trading partners — and the number can be huge — would usually terminate. Lehman reportedly had about 2 million open contracts.

Add to the sheer number of contracts the possibility of incomplete documentation, or plain error. Then throw in operational risks and problems of logistics.

All this triggers a complex chain of events.

The net value of an individual financial contract between a counterparty and a distressed firm may be settled if the contract specifies the amount. If it is the counterparty that owes the amount, it must pay it to the bankruptcy trustee. This means an immediate — and possibly large — cash outlay for the non-defaulting party. If the distressed firm owes the amount, then the counterparty must supply documentary proof to the bankruptcy trustee and await payment.

If the counterparty holds collateral to secure its exposure, then the collateral must be sold to cover the amount due.

If the contract was used as a hedge, its termination exposes the counterparty to its underlying risk. The counterparty must then enter into new contracts to re-hedge itself to avoid additional risk. In general, hedging must be done on a contract-by-contract basis, with limited scope for retrieving net value.

Because this process is complex and time-consuming, the amount of losses sustained may not be certain for some time.

The Chapter 11 filing may also trigger contracts concerning the firm itself. For example, Lehman’s bankruptcy filing would have required settlement of credit default swap contracts that, in effect, insured some of the investment bank’s debt. If a Lehman counterparty held these contracts as hedges, they would ease its losses. In all cases, settlements would create potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehman’s debt, for example, came to about $365 billion.

A firm’s bankruptcy affects other parties through “contagion.” Counterparties that had dealings with the distressed firm either face losses or suffer cash outflows as they meet termination payments. They may face additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality, possibly leading to a fall in their share prices and increases in their borrowing costs. If credit ratings are affected, margin calls may be the result, further threatening solvency.

The overall market is also affected. Greater volatility in asset prices may reflect liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity falls as the number of counterparties drops. Credit becomes scarce, limiting firms’ ability to deal with each other.

Uncertainty over the fallout of a company going under can cause trading in the inter-bank lending market to freeze up. That, in turn, further increases volatility and exposes weaker firms to failure.

Bankruptcy proceedings inevitably accelerate the need to deal with assets that are difficult to value or are illiquid. In resolving the matter, trustees and administrators, acting in the best interest of creditors, can adversely affect the overall market.

And because bankruptcy law is jurisdiction-specific, different sets of trustees and administrators have to grapple with how to best manage the assets of a firm to settle with its creditors. In the case of Lehman, there are already disputes about transfers, totalling $8 billion, made between the investment bank’s London office and those in the United States.

They may also differ in their approaches to dealing with assets. The U.S. trustee in the Lehman bankruptcy indicated that “time was of essence” in dealing with the bank’s assets. In contrast, the British administrator anticipated a long drawn-out affair. All this creates uncertainty about the effect of Lehman’s demise on its creditors and the overall market.

Assets held in a fiduciary capacity can become entangled in this mess. Where Lehman acted as their prime broker, hedge funds and other asset managers face potentially lengthy delays in recovering their investment. About $45 billion in assets, and $20 billion in short positions, are affected. Here’s another problem: Though unable to deal with their assets, legal owners may face margin calls if the value of their positions deteriorates.

A bankruptcy filing can thus reveal the complex networks that tie together all participants in modern financial markets. The chains of risk can spread problems from distressed financial institutions to weak ones, and can ultimately affect even strong firms seemingly remote from the problem.

Assume Bank A, a sound financial institution, has large hedges with Bank B, another sound institution. If a counterparty to Bank B has difficulties, its resulting losses may imperil Bank B, which, in turn, might affect Bank A.

The risk spreads through direct losses, liquidity calls, funding problems or uncertainty. Confidence in the financial system is undermined and financial transactions grind to a halt. It’s a contagion that resembles a hungry wolf pack systematically hunting down the weakest prey in a herd.

Understanding the financial system’s detailed connections, while unglamorous, is the key to anticipating the evolution of a crisis and preventing further exposure to events. It is also where long-term reform efforts should be directed.

John W. Gardner once observed: “The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water.”

Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is greatly increasing its risks.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.