Monday, September 15, 2008

Lehman Brothers - Natural Selection At Work

It finally happened, Lehman Brothers, the US investment bank, has said that it intends to file for bankruptcy protection "in order to protect its assets and maximise value".

Consequently, expect the markets to tank on the news as potential ripples spread through the markets today.

Barclays Bank and the Bank of America pulled out over the weekend after the potential buyers said they were not convinced that Lehman, which last week announced a loss of $3.9bn in just three months, would be a good buy for shareholders, a not so subtle code for 'they are in big trouble and we don't want to take it on'.

As of writing the Dow futures are down 330 points, an ominous sign for the open of the Euro bourses and, obviously, the US.

The good news, if there is any, is that a Lehman collapse could trigger a shake up of the entire US financial system which has been stuck in the economic doldrums since the mortgage crisis hit more than a year ago.

"The US financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," Peter Kenny, managing director at Knight Equity Markets in New Jersey, said.

"It's a new financial world on the verge of a complete reorganisation."

The US Federal Reserve and a banking consortium had already announced measures to offset a further credit crunch in the wake of a Lehman bankruptcy.

The consortium of 10 global commercial and investment banks had said earlier that it would provide $70bn "to help enhance liquidity and mitigate the unprecedented volatility and other challenges affecting global equity and debt markets".

Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, and UBS, said in a joint statement that they had agreed to create a "collateralised borrowing facility" of $70bn, with each bank contributing $7bn, to help ease access to credit.

"These actions reflect the extraordinary market environment," the banks said in a statement.

Emergency credit

The announcement came moments after the US Federal Reserve announced new steps to ease access to emergency credit for struggling financial companies, by broadening the collateral to be used for central bank loans.

The end of bidding for Lehman prompted a rare emergency trading session on Sunday which market sources said was initiated by the US Federal Reserve with the aim of reducing risk associated with any Lehman bankruptcy.

The lack of a government guarantee to resolve the Lehman crisis is the main reason Barclays decided to exit the negotiations, according to a person familiar with the talks.

So far this year, the government has bailed out mortgage giants Freddie Mac and Fannie Mae, and saved Lehman rival Bear Stearns from going under by extending it cheap loans and allowing its forced sale to another rival, JPMorgan Chase.

Within hours of the collapsed Lehman talks, there were already reports of talks involving the takeover of Merrill Lynch & Co and the expected sale of assets by American International Group.

Bank of America announced early on Monday that it was to buy Meryll Lynch for $80bn - creating the world's largest financial services company in the process.

Over the weekend Alan Greenspan, the former US Federal Reserve chairman, projected the failure of "other major financial firms" but added that this did not need to be a problem.

"It depends on how it is handled and how the liquidations take place," he said on US broadcaster ABC.

"And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers."

The collapse of Lehman's comes on the tail of the Fannie and Freddie 'nationalisation' and the Bear Stearns sale both of which have garnered criticism from certain quarters about tax payers dollars being used to bail out 'greedy bankers'.

While F&F was, in our opinion, a crucial move need to protect the integrity of the US financial system, a bail out of Lehman's may have been seen as the silver bullet for moral hazard. A bail out of too many of the banking institutions may have signaled that whatever problems you get yourself into the government would bail you out. This, though comforting for investors, may have paved the path to a worse financial crisis years down the road.

In our opinion, it is better to take the pain now and let this crisis run its course.

On the whole the philosophy of 'survival of the fittest' has been the key to success of the financial system for a hundred years, to give too much downside protection at this stage in the cycle could spell disaster for years to come.

Nature has a way of cleaning out the biggest users of resources in a forest by creating forest fires. After the chaos of a fire dies down new trees grow, plants that could not get enough light and whose resources were previously sucked up by big trees flourish and another forest is born.

The sad truth is that these banks that are succumbing to the fires of sub-prime gorged themselves on profits, dominated the markets and they have now slipped up. Smaller firms now have the opportunity to bask in the light and a new financial forest will be born.

Sure, it is sad to see a bank with history go, but the words of the fictional 'Gordon Gecko' from the movie 'Wall Street' should be ringing in the ears of bank executives at the moment; 'either you get it write, or you get eliminated'.


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