Investors face the Lehman bankruptcy, the sale of Merrill Lynch to Bank of America, and a possible restructuring of AIG.
Wall Street expected to spend today trying to contain the damage caused by news of Lehman Brothers’ bankruptcy, as the fourth-largest investment bank was unable to find a loan. buyer for its disastrous balance sheet.
And that’s not all. There’s the difficult sale of Merrill Lynch to Bank of America for around $50 billion, and a sweeping restructuring plan for American International Group (AIG), the insurance giant that has become a major player in securities and derivatives. related to mortgage loans.
Many bond market traders haven’t even had a weekend. An additional emergency session took place on Sunday afternoon for trading in credit default swaps, a kind of derivative product. The session was held “to reduce the risks associated with a Lehman bankruptcy,” according to a notice published by the International Swaps & Derivatives Association. The transactions were dependent on Lehman filing for bankruptcy at midnight. The companies have also called on employees to reconsider their positions vis-à-vis Lehman.
THE PAULSON POLICY TEST
The day faced the fallout of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke’s decision to let Lehman fail rather than have it taken over by another bank in a government-backed market. Paulson and Bernanke made it clear this summer that they reluctantly arranged the March acquisition of Bear Stearns by JPMorgan Chase. They feared that allowing Bear Stearns to fail would throw Wall Street into chaos. Indeed, Bear had countless credit derivative contracts against many other banks and hedge funds. Now, regulators have apparently decided that Wall Street has had time to master its risks with Lehman. The solvency of the New York firm has been in question since the beginning of this year and serious doubts have weighed on it for several weeks. The Lehman warnings, six months after Bear was nicely sold off, gave Wall Street time to prepare for the collapse of a major investment bank.
Regulators would like to believe that Wall Street has had enough time to anticipate and prepare. Injections of cash into troubled companies, while preserving financial institutions and mitigating short-term danger, are widely seen as encouraging managers and investors to take on more and more risk, telling themselves that their losses will be covered.
Regulators have likely also felt the other influences that lead them not to save Lehman. Merrill and AIG shares fell last week, along with Lehman stock, following the government’s takeover of giants Fannie Mae and Freddie Mac. Shares of Washington Mutual also depreciated sharply. In other words, things could get much more expensive for the government, even if it doesn’t subsidize a buyer for Lehman.
PREFERRED SHARES IN THE GARBAGE
The plunge in prices of Merrill and AIG has highlighted the possibility that the market has realized that the two institutions are bearing further losses on mortgage loans. Worse still, if Merrill and AIG have lost a lot of funds, Wall Street has fewer options to replace capital since the Fannie and Freddie deal. The terms of the government’s takeover of Fannie and Freddie wiped out the value of their preferred shares.
Until now, preferred shares have been an excellent tool for bold investors wishing to inject new capital into a company in need of rehabilitation. Trades in Fannie and Freddie indicated that these preferred investors could lose big to common stock investors in the event of emergency buyouts. Both Merrill and AIG raised new capital earlier this year by issuing securities similar to preferred shares. Lehman has also raised capital through these preferred investors, who are now likely to be severely weakened by bankruptcy. So now massive preferred stock issues may not be able to fill holes in balance sheets that may be caused by further losses.
After a bad week, a work weekend, and a frenetic Monday, Wall Street can only wish the credit crunch had peaked.