Sept. 16 (Bloomberg) -- As financial gurus kept inventing ever more sophisticated ways to buy, sell and bet on debt, they didn't notice or didn't care that they were resting ever more of the nation's economy on shakier ground.

Without taking a sober look at the riskiness of the mortgages at the heart of these transactions, without anyone regulating or monitoring this massive market, the financial- services industry persuaded Congress to protect the holders of these derivatives if worse came to worst.

Worst seems to be coming, now that Lehman Brothers Holdings Inc. is bankrupt, Merrill Lynch & Co. has been sold and American International Group Inc. is in need of propping up. Those events follow the Freddie Mac and Fannie Mae bailouts and the forced, government-backed sale of Bear Stearns Cos.

Now Lehman bondholders, employees and other creditors will learn just how poorly they rank against those involved in the very derivatives that are wreaking havoc on the economy.

While the bankruptcy court freezes Lehman assets to eventually spread among the firm's other creditors, parties to credit swaps, repurchase agreements and other derivatives can bypass the line of creditors forming at bankruptcy court.

``They can take their collateral and walk away,'' says Jay Westbrook, a bankruptcy scholar who teaches at the University of Texas law school.

They can liquidate it in the marketplace or hold onto it if they like. And they can do it without anyone watching.

In the Dark

``Have the effects of the Lehman bankruptcy on everyone else's balance sheets already been taken quietly and in the dark?'' asks Westbrook. Who knows?

That's what Congress let happen when it gave financial institutions favored status in 2005 amendments to the U.S. bankruptcy code. For swaps, repurchase agreements and the like, Congress carved out an exception to the rule that all assets are frozen, no bills paid without court permission, once a bankruptcy petition is filed.

In this case, Lehman didn't put its broker-dealers into bankruptcy, anyway, and their assets aren't subject to the automatic bankruptcy freeze imposed on the holding company's assets.

``Many of those very transactions that resulted in a loss of confidence in management are protected,'' says Jack F. Williams, a fellow at the American Bankruptcy Institute and a law professor at Georgia State University.

Unfair? You bet.

Congress bought the notion that without that favored status, the markets would lock up and the economy would suffer.

All Fall Down

``The argument always ends with, `And then we'll all go down,''', says Lynn LoPucki, a bankruptcy expert and law professor at the University of California Los Angeles and Harvard University.

He says there is some truth to the idea, as the current upheaval in the markets suggests.

``The financial sector has become more and more intertwined,'' LoPucki says. ``Everybody guarantees everybody else's debts,'' so that ``all of a sudden you have to worry not just about your own business but about everybody else's.''

It isn't likely the counter parties to these derivatives feel privileged. They raced all weekend to figure out how to get whatever value they think these things are worth, and still are.

Rewarding Weekend

And yet, that's a more rewarding way to spend a weekend than the way thousands of Lehman employees spent it, cleaning out their desks, contacting headhunters and trying to figure out how to pay next month's bills.

They, too, have a certain privilege under the bankruptcy law. To get their last paycheck, they get a ``priority'' spot in the line of creditors. But they still have to stand in line.

For all the rewriting that went on in 2005, the bankruptcy code still isn't made to handle the Lehman situation.

``Our law and our regulatory structures simply did not catch up with the transformation of our financial structures,'' Westbrook says.

Congress's next task, and that of the next president, will be to regulate the multitrillion-dollar, over-the-counter derivatives market, make it transparent and appoint regulators serious about accountability.

And then it can take another look at the bankruptcy code.

(Ann Woolner is a Bloomberg news columnist. The opinions expressed are her own.)

To contact the writer of this column: Ann Woolner in Atlanta at awoolner@bloomberg.net.

Last Updated: September 16, 2008 09:03 EDT