Buyout of Merrill and Bankruptcy of Lehman Heightens Worry of U.S. Credit Crisis Pain Still to Come

By William Patalon III
And Jennifer Yousfi
Money Morning Editors

After a weekend in which the deepening U.S credit crisis sent one top investment bank to bankruptcy court and a second into the arms of a “White Knight” suitor, U.S. stocks yesterday (Monday) recorded their worst day since the 9/11 terrorists attacks seven years ago. Indeed, the Dow Jones Industrial Average plunged more than 504 points, its biggest one-day point decline since Sept. 17, 2001 – the day the markets reopened for trading after the attacks on New York and Washington.

Wall Street entered last weekend anticipating a government bailout of Lehman Brothers Holdings Inc. (LEH), but exited with Merrill Lynch & Co. Inc. (MER) agreeing to sell itself to Bank of America Corp. (BAC) for nearly $50 billion – and with Lehman announcing it will seek bankruptcy in a bid to avoid a total liquidation after it was unable to find a buyer.

American International Group Inc. (AIG) – the largest U.S. insurer by assets – saw its stock price plunge by 61% yesterday and is now seeking to prop itself up with $70 billion to $75 billion in loans arranged by Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM), sources told Bloomberg News late yesterday. Wall Street's biggest firms are collaborating in the hope they can avoid a failure at AIG, which sold investors protection on $441 billion of fixed-income assets – $57.8 billion of which were tied to the subprime mortgages that kicked off this crisis, Bloomberg said.

And shares of Washington Mutual Inc. (WM) – the nation’s largest savings-and-loan institution – dropped nearly 27% as its debt was cut to junk-bond status.

“The tectonic plates beneath the world financial system are shifting, and there is going to be a new financial world order that will be born of this,” Peter Kenny, managing director at Knight Capital Group Inc. (NITE), the New Jersey-based brokerage firm that handles $4 trillion in stock transactions a year, told Bloomberg. “It's an ugly and painful process.”

Investors worldwide took a beating.

At yesterday’s close in New York, the blue-chip Dow was down 504.48 points, or 4.42%, to finish the session at 10,917.51. The tech-laden Nasdaq Composite Index shed 73.74 points, or 3.26%, to close at 2,187.53. And the broader Standard & Poor’s 500 Index skidded 58.74 points, or 4.69%, to close at 1,192.96.

All sectors were down, with energy sector (down 6.84%), financial services (down 6.81%) and the basic materials sector (down 6.60%) enduring the largest declines.

Asian markets were closed yesterday. The FTSEurofirst 300 index of blue-chip European shares fell 3.6% to close at 1,119.94 points, its lowest close since July 16. Other European bourses were down, with the Paris-based CAC40, London’s FTSE 100, Madrid’s IBEX 35 and the Frankfurt-based DAX all posting losses.

Late last night, Wall Street leaders were still huddled in a series of meetings that started Friday night at the urging of the Bush Administration.

Many experts now fear that the U.S. financial sector faces a “crisis of confidence,” a potentially devastating psychological impasse from which there’s no easy escape. The stunning-and-sweeping moves, which are permanently reshaping the U.S. financial sector, are the latest chapter in a financial crisis that has resulted in hundreds of billions of dollars in losses – ostensibly due to bad real-estate loans, The New York Times reported.

“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I’ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm The Blackstone Group LP (BX), who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration – and whose new foundation is sponsoring the documentary, IOUSA, which warns of the looming U.S. government debt crisis.

In a move that mirrored the step taken by hedge fund Long-Term Capital Management 10 years ago this week, 10 major banks will create an emergency fund of $70 billion to $100 billion that financial institutions can use to protect themselves from the fallout of Lehman’s collapse. And the Fed expanded the emergency loan program it created for Wall Street banks, a move that The Times and other media outlets concluded will increase what each U.S. taxpayer will owe as a result of this crisis.

But it remains to be seen whether the sale of Merrill Lynch, the “controlled demise” of Lehman and the intervention into the fate of other key U.S. financial giants will be enough to keep the broader U.S. economy from getting swept into a stagflationary recession.

Let’s take a look at the key players in this saga, and see what role they’re playing, or how they are being affected.

And Then There Were Two: Bank of America Bulks Up

The five New York-based securities firms that dominated Wall Street have been reduced to two: Goldman Sachs Group Inc. and Morgan Stanley (MS). Both firms will report a profit decline for the third quarter – but unlike Merrill Lynch and Lehman, Goldman and Morgan Stanley have remained profitable throughout the year.

“I think highly of Morgan Stanley and Goldman Sachs, so I expect them to ride this out,” Roger Altman – the CEO of investment banker Evercore Partners Inc. (EVR) and a former deputy treasury secretary – said during an interview on CNBC. “But as to whether we've seen the last of this crisis, I think the answer to that is clearly: ‘No.’ And exactly where it goes from here and how it unfolds, I'm unsure.”

But how did it get this far?

The financial-sector convulsions that started in the summer of 2007 already have eliminated The Bear Stearns Cos., which in March was forced into a government-supported, cut-price sale to JPMorgan Chase & Co. A week ago, the U.S. Treasury Department took control of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) – placing them into a conservatorship – after concerns that foreign central banks would stop buying our bonds actually forced the government’s hand [For a full report on that dilemma, take a look at our report, Foreign Bondholders - and not the U.S. Mortgage Market - Drove the Fannie/Freddie Bailout].

Fed and U.S. Treasury officials met in an emergency session as Barclays PLC (ADR: BCS), the U.K.'s third-largest bank, and Bank of America abandoned talks to acquire Lehman after failing to win government guarantees against losses. The companies were considered leading candidates to acquire the 158-year-old investment bank after record losses erased 94% of its stock value this year.

The first in a series of weekend meetings began at 6 p.m. Friday at the Federal Reserve building in Lower Manhattan. The Fed called the emergency session. U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. attended, as did key banking-industry executives.

Because the central bank and the Treasury had already intervened with the “shotgun” marriage of Bear Stearns and JPMorgan – underwriting $29 billion in assets as part of the deal – and with the conservatorship for Fannie and Freddie, most observers expected the financial sector’s dynamic duo to work their magic yet again.

But it was not to be.

News reports say that the bankers were told that – this time around – the government would not bail out Lehman and that Wall Street had to solve its own problems. Lehman’s stock plunged last week, as worries about its financial condition escalated. When counterparties became wary of doing business with Lehman, its ability to survive as a standalone company in that form was all but over.

Without the safety net of government backing, Lehman sought a buyer, focusing on Barclays and Bank of America. But Barclay’s abandoned talks to acquire Lehman after failing to win government guarantees against losses for the big British bank.

That’s where the takeover talks took an odd turn. Although Merrill and Lehman are both investment banks – Merrill focuses on the brokerage business while Lehman keys on the institutional portion of the market – both firms made an ill-fated foray into real-estate-related investments.

Understanding that global investors would lump Merrill in with the other troubled companies as the crisis worsened, new CEO John A. Thain began buyout talks with Bank of America CEO Kenneth D. Lewis, published reports state. One person briefed on the negotiations said Thain had rebuffed Bank of America when it approached Merrill earlier this summer. But understanding how a Lehman bankruptcy would whipsaw the markets, Thain realized a deal was the best answer this time around, The Times reported.

Bank of America will swap 0.8595 shares of its stock for each Merrill share. That works out to $29 a share, based on Bank of America's closing price of $33.74 on Friday.

“A merger between Merrill and Bank of America is a good idea,” Richard Bove, an analyst at Ladenberg Thalmann & Co. in Lutz, Fla., told Bloomberg. “If Lehman fails, the next bank to be attacked would be Merrill. They are attempting to forestall that attack by linking with Bank of America.”

Bank of America – often referred to as BofA – may end up as the new big kid on the block in the U.S. financial-services sector. Earlier this year, Bank of America agreed to buy troubled mortgage lender Countrywide Financial Corp. – in a $4 billion all-stock deal that would make BofA the largest mortgage lender and loan provider in the U.S. market.

Some top experts like BofA’s bargain-hunting strategy.

“My bet is that Ken Lewis has made a very wise investment,” Saturnino S. Fanlo, CEO of KKR Financial Holdings LLC (KFN), told a reporter. “I believe over time it will prove to be a great decision.”

Debt-rating firm Standard & Poor's Inc. cut its long-term counterparty credit rating on Bank of America Corp. to AA- from AA and the credit ratings on the holding company were put on CreditWatch with “negative implications,” Bloomberg said late yesterday. Moody Corp.’s (MCO) Moody’s Investors Service unit also is reviewing BofA’s debt for purposes of cutting the rating.

But that doesn’t faze Lewis, the BofA CEO.

“Acquiring one of the premier wealth management, capital markets, and advisory companies is a great opportunity for our shareholders,” Lewis, 61, said in the statement.

Lehman: The Loser in the Weekend Buyout Sweepstakes

During its 158-year run, Lehman had navigated through such rough waters as the Internet bubble, the savings-and-loan crisis and even the Great Depression. But that record of survival ended when it failed to reel in BofA as a White Knight, Lehman filed the biggest Chapter 11 bankruptcy petition in history, listing more than $613 billion in debt. It filed the petition in U.S. Bankruptcy Court in Manhattan.

That makes Lehman’s failure the largest of any investment bank since the collapse of Drexel Burnham Lambert 18 years ago, The Associated Press reported.

 “There is likely to be a domino effect as other firms and individuals who relied on Lehman for financing feel the effects of its meltdown,” Charles “Chuck” Tatelbaum, a bankruptcy lawyer with the Florida office of the law firm Adorno & Yoss and former editor of the American Bankruptcy Institute Journal. “The whole thing is frankly frightening for the U.S. economy.”

After its shares were decimated last week and the loss of its investment-grade credit rating loomed, Lehman, with help from the U.S. Federal Reserve and Treasury Department, was desperate to negotiate a white knight bid. But when last-minute weekend negotiations with Barclays and Bank of America could not produce a private-sector suitor, Lehman had no choice but to file for Chapter 11 bankruptcy protection before the market opened for the week.

News of the bankruptcy filing was the final death knell for Lehman shares. The stock dropped another $3.46 yesterday, a decline of 95%, to close at $0.19 in New York.

Moody’s Investors Service had threatened a ratings downgrade if Lehman could not come up with a stronger financial partner to bolster its liquidity. Without an investment-grade credit rating, Lehman’s trading partners would have been unwilling to assume settlement risk. And Lehman wouldn’t have been able to last long in an environment where all of its trades needed to be pre-funded. The threat of the downgrade forced Lehman’s hand, shutting the doors of one of the oldest firms on Wall Street.

Filing for bankruptcy could mean a quick sale of the stocks, bonds and derivatives in Lehman's portfolio, according to Oppenheimer & Co. (OPY) analyst Meredith Whitney, Bloomberg reported.

“Due to the liquidation of unprecedented scale, we expect a broad-based decline in marks on asset values,” Whitney wrote in a report. That “will force the other brokers to mark down their assets accordingly, and therefore pressure all capital ratios.”

Flooding the market with billions of dollars in securities for sale when the market is already feeling immense pressure in the financial sector is going to put even more downward pressure on share prices.

“Bankruptcy severs all counterparty contracts, and therein lies the systemic risk,” David Kotok, chief investment officer of Vineland, N.J.-based Cumberland Advisors Inc., which manages $1 billion, told Bloomberg. “This would be the first time we've tested how much damage will be done by a bankruptcy.”

According to Bloomberg data, Lehman owes more than $157 billion to its 10 largest unsecured creditors, which includes $155 billion in bondholders’ assets. 

Lehman’s top creditors include several Asian banks. Tokyo-based Aozora Bank Ltd. (PINK: AOZOF) is the largest single creditor listed in the bankruptcy filing and is owed $463 million for a bank loan, Bloomberg reported. Mizuho Corporate Bank Ltd. (ADR: MFG) is owed $382 million, while a Hong Kong-based Citigroup Inc. (C) unit is owed an estimated $275 million, according to the filing.

Lehman plans to move forward with CEO Richard S. Fuld Jr.’s plans to sell its investment management arm, Neuberger Berman Management Inc. Top bidders include the private-equity firms of Bain Capital LLC, Clayton Dubilier & Rice Inc. and Hellman & Friedman LLC, according to unnamed sources close to the negotiations. Fuld is hoping for a speedy deal to maximize value.

As the fallout from Lehman’s bankruptcy continues to unfold, global financial firms, which have already taken more than $510 billion in credit-related losses and write-downs to date, have to prepare for an even bumpier ride.

“No one, currently working on Wall Street, has ever experienced a credit event like the one we are currently facing,” Bernstein Research analyst Brad Hintz, a former Lehman chief financial officer, wrote in a note to investors earlier this month, MarketWatch reported. “The credit events the market has lived through since 1980 ... appear like ripples in a pond compared to the plunge we are currently experiencing.”

Fed Policymakers to Take a Stand?

As the news of Lehman’s bankruptcy filing roiled the financial markets, the U.S. Federal Reserve announced emergency measures designed to smooth volatility. Once such move includes having the Fed increase its loan program – buy widening the types of collateral available for loans.

“The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets,” Fed Chairman Ben S. Bernanke said yesterday.

Speaking just ahead of the regularly scheduled meeting of the policymaking Federal Open Market Committee (FOMC) that is set for today (Tuesday), Bernanke outlined a plan designed to pump liquidity into the capital markets after U.S. Interbank lending rates zoomed to 6%, three times the Fed’s 2.0% target. It was the widest margin over the Fed’s target in more than a decade, and stems from the fact that – as the markets grow even more risk-averse – banks are holding onto capital and demanding a premium for lending.

After the central bank pumped $70 billion in temporary cash reserves into the capital markets system, the rate lowered to 4%, according to Bloomberg data.

It had been widely anticipated that the FOMC would vote to hold its key interest rate steady at 2.0% when it meets today. But with the collapse of Lehman Brothers, Fed Funds futures traded on the Chicago Board of Trade are pricing in an almost 72% chance of a quarter-point reduction in the benchmark Federal Funds rate.

Prior to Lehman’s Monday morning bankruptcy filing, futures indicated only a 12% chance of such a cut.

Paul Mortimer Lee, economist at France’s BNP Paribas SA (OTC ADR: BNPQY), said the Fed would either cut rates by a half-percentage point or signal that a rate cut could come soon, MarketWatch reported.

“So, in short, they either talk dovish or act and talk dovish,” Lee wrote in a research memo to clients.

The Fed has also expanded the types of securities that can be pledged for collateral at the Primary Dealer Credit Facility. Previously, the PDCF had been limited to investment-grade securities. Now collateral “has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks,” the Fed statement said.

On Sept. 12, the effective Fed funds rate was 2.1%, only 10 basis points above the Federal Reserve’s target rate. If the Fed’s emergency measures do not have their intended affect, it could force the FOMC’s hand into making a rate cut.

“If the Fed Funds rate closes high today, I would be really worried as it would mean that there really is no money out there to be lent,” Stan Jonas, who trades interest-rate derivatives at Axiom Management Partners LLC in New York, told Bloomberg.

AIG – Looking for Love in All the Wrong Places?

While Wall Street is still reeling from the collapse of Lehman Bros., an even bigger crisis could be brewing at American International Group. AIG shares have shed more than 75% of their value in the past week. The firm has taken $18.5 billion in losses in the past three quarters and could face as much as $30 billion in write-downs at the current quarter’s close, thanks to derivative contracts backing $57.8 billion in subprime mortgage securities, Bloomberg reported.

Yesterday, AIG’s stock shed $7.38, a 61% decline to close at $4.76.

AIG CEO Robert B. Willumstad, 62, has been scrambling to come up with an additional $40 billion in capital to shore up the insurance giant’s liquidity position, but due in part to the Lehman collapse, has been unable to find a lender. 
“AIG has intrinsic value and has options as long as it can get over this immediate liquidity hump,” David Havens, a UBS AG (UBS) credit analyst told Bloomberg. “It is more important for the government to step in and help AIG than it was with Lehman.''

A member of the blue-chip Dow Jones Industrial Average index since 2004, AIG has a market capitalization of $12.8 billion, even with the recent plunge in its share price.

The diversified insurance-and-asset-management firm is much bigger than Lehman, with $110 billion in annual sales last year and an employee roster of 116,000 people, reported. And an AIG failure would impact many more average consumers than the Lehman debacle, as some of AIG’s biggest units include commercial life insurance and retirement planning.

Eric Dinallo, the New York State insurance superintendent, along with representatives from the U.S. Treasury Department and representatives from the New York Federal Reserve, met with AIG management yesterday to try to find a solution to the ailing insurance giants capital woes.

AIG has received special permission from the state government of New York to move $20 billion in capital from various subsidiaries to its parent company. Several news outlets reported that AIG was also seeking a $40 billion bridge loan from the Federal Reserve; but Paulson, the treasury secretary, was adamant that such a loan was not to be an option, Bloomberg reported.

What is going right now in New York has got nothing to do with any bridge loan from the government,” Paulson said at a press conference yesterday. “What's going on in New York is a private sector effort, again, focused on dealing with an important issue that's, I think, important for the financial system to work on right now.”

“We are working through a difficult time in our financial markets right now,” Paulson added. “The American people can remain confident in the soundness and resilience of our financial system. Our banking system is a safe and sound one.” [For an analysis of how the central banks around the world are responding to the current crisis, please click here. The story appears elsewhere in today’s issue of Money Morning.]

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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