Wall Street's Perfect Storm


Investors deal with a Lehman bankruptcy, the sale of Merrill Lynch to BofA, and a possible AIG restructuring

Mondays better not get any more manic than this.

Wall Street expected to spend today trying to contain the damage from a bankruptcy filing by Lehman Brothers (LEH) after the fourth-largest investment bank failed to find a buyer for its broken balance sheet over the weekend.

And that's not all. There's the distressed sale of Merrill Lynch (MER) to Bank of America (BAC) for approximately $50 billion, and a radical restructuring plan for American International Group (AIG), the insurance giant which became a major player in mortgage-related securities and derivatives.

Many bond market traders never even got a weekend. An emergency, extra-hours trading session was held on Sunday afternoon for credit default swaps, a kind of derivative. The session was held "to reduce risk associated with a Lehman…bankruptcy," according to a notice posted by the International Swaps & Derivatives Assn. Trades were contingent on Lehman filing for bankruptcy by midnight. Firms also called in employees to review their trading positions with Lehman.

Test of Paulson Policy

The day will face the fallout from the decision by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke to let Lehman fail instead of having it taken over by another bank in a deal backed by the government. Paulson and Bernanke made it clear this summer that they had reluctantly arranged the March acquisition of failing Bear Stearns by JPMorgan Chase (JPM). They feared permitting Bear Stearns' bankruptcy would throw Wall Street into chaos because Bear had untold credit derivatives contracts in place with countless other banks and hedge funds. Now the regulators have apparently decided that Wall Street has had time to control its risks with Lehman. The New York firm's creditworthiness has been subject to question since early this year and has been in serious doubt for weeks. The warnings on Lehman and the six months since Bear was gently put down gave Wall Street time to conduct a drill for the bankruptcy by a major investment bank.

Regulators would like to believe Wall Street has had enough time for a drill. Bailouts, while saving financial institutions and easing short-term danger, are widely seen as encouraging managers and investors to take bigger and bigger risks out of confidence that their losses will be covered.

Regulators may have also felt other forces pushing them away from saving Lehman. Building in the wings have been threats of big trouble at other major institutions. Shares of Merrill and AIG tumbled last week, along with Lehman's stock, following the government's takeover of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). Shares of savings bank Washington Mutual (WM) also fell sharply. In other words, things could get plenty costly for the government even though it's not subsidizing a Lehman buyer.

Preferred Stock Trashed

The plunging prices of Merrill and AIG raised the possibility that the market had figured out that the two are harboring big new losses from mortgage-linked securities. Worse, if Merrill and AIG lost a lot of capital, Wall Street sees fewer ways to replace that capital since the Fannie and Freddie deals. Terms of the government's takeovers of Fannie and Freddie trashed the value of their preferred stock.

Until now, preferred stock has been a prime tool for daring investors to inject new capital into a company needing rehabilitation. The Fannie and Freddie deals indicated that preferred investors could lose big, along with common stock investors, in distressed takeovers. Both Merrill and AIG raised new capital early this year by issuing securities similar to preferred. Lehman also raised money from preferred investors, who are now likely to be wiped out in a bankruptcy. So now big issues of preferred securities may not be available to fill holes in balance sheets from new losses.

After a bad week, a working weekend, and a manic Monday, Wall Street can only hope the credit storm is at its worst.

Henry is a senior writer at BusinessWeek.

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