And so the venerable Lehman Brothers passes from the scene at the age of 158. When the sun rises in the morning, we will see how Wall Street deals with this development. Of course, many people were expecting this, and undoubtedly made contingency plans. By Friday, it seemed that a Sunday night announcement was almost a sure thing. After all, we went through this once before with Bear Stearns. Yet, even though this was possibility for the past few weeks and months, it is now reality.
It is interesting that Bank of America, which as of Friday many people were expecting to buy Lehman, took a pass on that deal and is instead buying the troubled (and storied) Merrill Lynch. How's that for misdirection?
But that's not all. Showing once again that bad things do indeed come in threes, the insurance giant AIG is also in need of assistance.
With these three companies in such dire straits, the Federal Reserve did what it could... quoting in part:
The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.
"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "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."
"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.
The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) 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. Previously, PDCF collateral had been limited to investment-grade debt securities.
The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.
By expanding the types of collateral accepted, the Fed addressing the need for liquidity by immediately expanding the quantity available. At this point, that is what is needed (as opposed to any action on interest rates).
Justin Fox has a pretty good summary:
We'll learn much more about the exact chain of events over the coming days and weeks and months, but the basics go something like this: New York Fed boss Tim Geithner (and his pals from Washington) tried to figure out some way to avert the failure of Lehman Brothers without offering any kind of federal guarantee. But nobody wanted to buy Lehman without help from Uncle Sam, so it looks like Lehman will go under. Which meant Merrill Lynch would take over Lehman's spot as Most Obviously Troubled Investment Bank. So Merrill sold out to Bank of America at $29 a share ($44 billion total). Which is an awful lot less than the $97 a share Merrill was selling for a year-and-a-half ago, but also a lot more than nothing.
So on Monday we'll get to see what the failure of an investment bank with $600 billion in assets looks like. And more important, we'll get to see if the obviously deeply flawed American financial system will be able to retain the confidence of the foreign lenders and investors who keep it going.
One crucial thing to remember in all of this is that none of the experts on Wall Street have any real idea of what they're dealing with. What has worked for the past quarter century or so has stopped working. And nobody knows what American financial institutions are going to look like going forward. Probably a lot more like the universal banks of Continental Europe. But anybody who says they know for sure is lying.
Want to read a little history about the last time something like this happened? Here's what the NY Times had to say about Drexel Burnham Lambert in 1990. It reads a lot like today's news, right down to the weekend meetings. Just replace "junk bonds" with "subprime mortgages".
There are some differences, of course. The biggest difference is that there are still so many firms in similar condition that there is no guarantee that this crisis is over. I think that Fox is right in saying that "anyone who says they know [what American financial institutions will look like after this] for sure is lying." But I am confident that the system will get through this very troubling time.
As this Wall Street Journal piece by Justin Lahart points out, there needs to be quick and decisive action to prevent something like what happened in Japan during the 1990s. The sooner everybody confronts that reality, the quicker we can get back to business. It is good to get the "unwinding" process started as soon as possible. Make sure that the smaller firms don't become collateral damage from counterparty risk, and let the consolidation result in the inevitable (but probably only short-to-medium run) shrinkage of the sector.
Every time one of these trouble firms is finally taken aside and shown the handwriting on the wall, we take one more step toward the day when someone gets to write one pretty massive after-action report. And of course, now that the extent of the damage to these three firms has been revealed, the rush is on to find who is next. Until the answer to that question is "no one", there will be more rough days ahead. I don't think we're there yet.
John Jansen has some excellent commentary and I'm sure will be adding more in the morning. He is quite worried about how all of this will end.
Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.
Very true. On a related topic, Tyler Cowen opines in the NY Times:
There is a misconception that President Bush's years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.
But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That's dysfunctional governance, not laissez-faire.
Blame enough to go around, to be sure. Like I said, it's going to be some after-action report.
Mark Thoma has a good collection of links for your morning reading as well.
Buckle up. It could be an interesting day.
UPDATE: Here's one more comment on the AIG situation. First the Wall Street Journal:
During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.
Which prompted Yves Smith of Naked Capitalism to say:
That is not going to endear them to the Fed, turning down a deal, particularly when Merrill did the right thing and sold itself to avert a possible systemic event. This is brassy and risks overplaying their hand. If I were the powers that be, I'd tell them to stuff it and take the deal.
Indeed. I think the Fed is really trying to limit the taxpayers' exposure on this one. If AIG turns down a deal, it gives others license to do so. I don't like where that leads.
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