Crisis on Wall Street as
Lehman Totters, Merrill Seeks Buyer, AIG Hunts for Cash

U.S. Opts to Avoid Lehman Rescue,
Stirring a Momentous Weekend for American Finance;
Traders Brace for a Chaotic Monday

CARRICK MOLLENKAMP, SUSANNE CRAIG & SERENA NG
Wall Street Journal 15sep2008

The American financial system was shaken to its core on Sunday. Lehman Brothers Holdings Inc. faced the prospect of liquidation and Merrill Lynch & Co. was close to a deal to sell itself to Bank of America Corp.

The U.S. government, which bailed out Fannie Mae and Freddie Mac a week ago and orchestrated the sale of Bear Stearns Cos. to J.P. Morgan & Co. earlier this year, drew a line in the sand with Lehman. It refused to provide a financial backstop to potential buyers.

Without such support, Barclays PLC and Bank of America, the two most interested buyers, walked away. On Sunday night, Bank of America was close to striking a deal to buy Merrill Lynch for about $44 billion, or $29 a share. Lehman was working on a possible bankruptcy filing.

As worries spread across Wall Street that Lehman wouldn't survive, brokerage firms, hedge funds and other traders moved to disentangle themselves from trades with Lehman. When hopes of a potential sale dimmed, a quiet Sunday on Wall Street turned into a mad rush. Executives and traders hurried to their offices or worked their phones to unwind outstanding contracts with Lehman and to gauge their overall exposure.

A sense of foreboding gripped the Street as top executives feared collateral damage from a Lehman liquidation. Attention turned to Merrill Lynch, which boasts the largest force of retail brokers, and to American International Group Inc., the insurance giant. Both firms have seen their stocks get hammered, and their managements spent the weekend trying to come up with plans to reassure the markets.

"Monday will be a day of reckoning for the financial markets," said Carlos Mendez, senior managing director of ICP Capital, a boutique investment firm in New York. On Sunday, he said, "it was like a fire alarm went off and people ran in all directions."

AIG executives spent the weekend trying to raise cash, either from asset sales or a capital infusion from private-equity firms, or both. AIG executives were meeting with regulators to see if they could transfer capital from some of its subsidiaries to the holding company.

Merrill, whose retail brokerage force is the largest in the country and is known as the "thundering herd," quietly engaged in discussions with Bank of America, whose retail bank branches stretch coast to coast. Wall Street executives said the Federal Reserve may be involved in orchestrating the sale, figuring that it was "better to save the relatively healthy patient instead of the dying one," said a lawyer involved in the discussions.

"We are in uncharted waters here," said a top executive of a big bank. "If Merrill can pull off a deal this weekend, that would certainly help."

The U.S. dollar, which had strengthened in the past few weeks, fell against all four of its major rivals on Sunday — the euro, the Swiss franc, the U.K. pound and the Japanese yen.

Some executives involved in the Lehman discussions held out hope that an 11th-hour reprieve would materialize. Under one scenario aimed at limiting the ripple effects of Lehman's demise, a group of about 15 banks were in discussions Sunday to pool about $100 billion, which would be used to buy assets of the battered securities firm, according to one person familiar with the situation. Details were being finalized Sunday night. One possibility is that the Federal Reserve will support the move by opening its wholesale-borrowing window and relaxing collateral requirements for borrowers.

Lehman, a 158-year-old firm that started as an Alabama cotton brokerage, and Merrill, known by its trademark bull logo, have been pillars of Wall Street for much of the last century. With the demise this spring of Bear Stearns, three of the Street's five major independent brokers could end up disappearing, leaving only Goldman Sachs and Morgan Stanley.

"We have never seen anything like this," said analyst Glenn Schorr, who covers the investment banks for UBS AG. "There have been tough situations like Long-Term Capital Management and the crash of 1987, but the problem here is there is leverage in the securities under the microscope and in the banks that own them. And to try and unwind it all at once creates a one-way market where there are only sellers, and no buyers."

The convulsions could lead to even tighter credit, higher borrowing costs and moribund capital markets, as securities firms and commercial banks try to further limit risk and preserve capital. Those moves could cause the U.S. economy to slow further.

The future of about 25,000 employees at Lehman and an additional 60,000 at Merrill is up in the air. Lehman's work force already has shrunk by about 3,000 in the past year. If the firm essentially goes out of business, most of the remaining employees are likely to lose their jobs. That would deal another blow to New York City's economy, resulting in lower tax revenues on personal income, real-estate transactions and corporate income.

The damage on Wall Street is the latest consequence of a storm that began last year with the sharp decline in American housing prices and losses on loans and other assets tied to home values. Massive capital infusions have failed to stem write-offs and losses, and financial firms are running out of options to escape the damage.

Regulators and others were preparing for a chaotic Monday. The New York Stock Exchange prepared contingency plans over the weekend to reassign the approximately 200 blue-chip stocks that Lehman's specialist unit trades, according to people familiar with the matter. If Lehman is forced into liquidation, the exchange will likely transfer the stocks to one or more of the remaining specialist firms, most likely using the same technology and staff that currently trade the stocks.

Dozens of Wall Street desks have trades with Lehman. As word spread that the Barclays deal was falling apart, worries that the company could be thrown into bankruptcy mounted, and traders labored to get out of those over-the-counter contracts.

At approximately 2:30 p.m., government officials hosted a call, and a trading session was opened to ease fears. One trader said it was agreed that other brokers would pick up contracts that trading desks have with Lehman. If Lehman does open on Monday, the deals struck on Sunday, often at a worse price, would be void. "It is utter chaos here," the trader said.

Credit-derivative traders at many Wall Street firms were told to come to work immediately. With many trading desks open, investors rushed to buy credit-default swaps tied to other brokerages and corporations, sending the cost of protection on investment banks such as Goldman Sachs and others sharply higher.

In a statement Sunday, the International Swaps and Derivatives Association, a trade group whose members include many large dealers, said a "netting trading session" which took place between 2 p.m. and 6 p.m. on Sunday to allow Lehman's counterparties to offset their derivatives positions against each other.

"The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy filing," it said. It added that trades conducted during this period "are contingent on a bankruptcy filing on or before 11:59 p.m. New York time" on Sunday. If no filing takes place, the trades will be canceled, ISDA said.

Many Wall Street firms concluded that a liquidation of Lehman's assets likely would proceed in an orderly fashion, people familiar with the situation said. That means other firms could quickly buy real estate, securities and other investments, preventing the assets from flooding the market. Because of that, these people said, some participants in the New York Fed talks decided that liquidation was no worse an option than selling Lehman to a buyer such as Barclays PLC.

"There will be an orderly wind down," said one banker involved in the matter. "This was the default option. It happens when you have no buyer."

The outside firms decided that instead of making guarantees for Barclays or some purchaser of Lehman, they would prefer to pool their resources and buy the assets themselves, taking on the risks and carrying costs, along with the possibility of profiting down the road.

Those firms would likely then buy assets such as mortgage-backed securities, leveraged loans, private-equity positions and investments in real estate or hedge funds.

—Aaron Lucchetti, Jeffrey McCracken and David Enrich contributed to this article.

source: 14sep2008