When Titans Fall

The world's biggest bankruptcy, Lehman Brothers (LEH), American International Group (AIG) asking the Federal Reserve for help, Bank of America (BAC) buying Merrill Lynch (MER), and the world markets selling off, with the US stock market desperately fighting to hold fast.

It seems like the crisis gripping Wall Street should be a kitchen-sink event, one that has led to the most dramatic reshaping of the financial sector ever.

But is the worst really done, or will there be more heartache for investors in the coming months?

Answer: It's not over yet.

A group of global banks and securities firms announced a $70 bn loan program that financial companies can tap to help ease a credit shortage that threatens global financial markets.

Also, the Federal Reserve, in an extraordinary move, has dramatically widened its lending facilities, allowing banks to post equity as collateral, and suspended rules stopping banks from using ordinary deposits to back their investment banking units.

But the Lehman Chapter 11 bankruptcy will ignite a wave of massive writedowns as it sets a new mark-to-market pricetag for troubled assets held by publicly traded commercial and investment banks around the country, depending on the assets' exposures.

American International Group, the world's biggest insurer, a company with a $1 tn balance sheet, is in serious danger. Not out of the woods either is Citigroup (C).

And investors in Bank of America will experience acid reflux for quarters to come as the bank digests both Merrill Lynch and Countrywide Financial.

The dramatic events come on the heels of the U.S. government's seizure and backing of mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE), a move that added $1.6 tn of their operating debt to the government's budget.

The hope is that the U.S. government will reduce the two giants' $3.7 tn in mortgage guarantees and financings (a total $5.3 tn book of business when you add in the two companies' borrowings). The two mortgage giants also have $3.3 tn in off-balance sheet hedges. 

However, when you read through the details of the new rescue plan, it gives these two behemoths anywhere from five to 10 years to pare back their book of business--think a Congress of the future has the intestinal fortitude to pare them back?

And now, the government may need to bail out Washington Mutual (WM), which could potentially cost taxpayers $24 bn in mortgage guarantees from the government to get a takeover done, according to Richard Bove, an analyst at Ladenburg Thalmann & Co.

Meanwhile, Morgan Stanley (MS) and Goldman Sachs (GS) are set to report what are expected to be weak third-quarter results--Goldman tomorrow and Morgan Stanley on Wednesday--as the third quarter is historically tough on the financials. 

The Subprime Crisis Gone Viral

Since the subprime crisis went viral in August 2007, financial companies around the globe have taken more than $510 bn of writedowns and have raised $354 bn. That compares to the $600 bn inflation-adjusted cost of the S&L crises of the late ‘80s early ‘90s.

The writedowns arose from a drunken daisy chain of paper kryptonite in the form of bad credit derivatives that have vaporized profits earned during the housing bubble and now sit as landfill in investment portfolios around the globe.

Wall Street thought it had outfoxed shockingly lax mortgage-lending standards, because it wrongfully believed the risk from its securitization machine would ultimately would be passed along, sold on to a third party via their paper.

Investment banks also went so far as to set up off-balance-sheet accounting--through structured investment vehicles--in order to take on more risk and boost profits. Ironically, the derivatives were meant to offload risk and disperse it throughout the system, but those derivatives are now blowing up in their faces.

Nearly a dozen chief executives of financial companies have either been forced out or left their jobs. Some 100,000 workers in the sector have been laid off, with more to come.

The markets have rarely seen a crisis like this one, a seven on the financial Richter scale that comes due to an unwinding of a decade of excess, one analyst said. And in a slap to deregulatory forces, there have been 137 financial crises around the globe of all stripes since the ‘80s--versus just nine from the ‘50s to the ‘70s, according to economists at the University of Maryland.

Amidst a firestorm of criticism, the U.S. government has stepped in to save the financial system, leading to criticism of moral hazard, whereby private profiteers increasingly raid the public purse of taxpayer money to bail themselves out. 

The United States of Bailouts

The after-the-fact refereeing of a free market that has turned into a free-for-all has raised criticisms that the Treasury Dept. and the Federal Reserve look like a chaotic pell mell fire brigade hosing down crises with taxpayer money, as the Washington Post calls it, leading to accusations in this election year that the country is turning into the United States of Bailouts.

The Federal Reserve, with the blessing of the Treasury Dept., orchestrated a shotgun wedding between the nearly dead Bear Stearns and JPMorgan Chase (JPM).

The Treasury has signed off on a rescue plan amounting to at least $200 bn to save mortgage finance giants Fannie Mae and Freddie Mac, leading to criticism that exotic, complex--and enriching--derivatives now have the same rights to the US Treasury as plain-vanilla Treasury bonds and notes.

Treasury's rescue of Fannie Mae and Freddie Mac has come under notably withering criticism, but analysts say it was necessary. An outright bankruptcy of the two would have triggered bankruptcy clauses in derivatives contracts worldwide.

Some $200 bn and $300 bn in credit-default swaps on Fannie Mae and Freddie Mac respectively are now outstanding today. Just a 5% default would have triggered $25 bn total in writedowns worldwide. Fitch Ratings estimates Fannie Mae or and Freddie Mac are referenced in about 30% of synthetic collateralized debt obligations it rates.

Also, the Federal Reserve has slashed interest rates in one of the most rapid successions in its history, and has expanded its lending facilities beyond commercial banks to Wall Street, letting investment banks now even use the asset-backed securities they mint on their own as collateral for Fed borrowings.

It's hoped that moral hazard has been reduced with the Chapter 11 bankruptcy of Lehman Brothers, as 22,500 people there will lose their jobs.

But in the process, the "Fed has debased its balance sheet," notes Bove of Ladenburg Thalmann. At one time 85% plus of its assets were backed by items such as gold holdings and Treasuries, Bove observes, but "this is now down to about 45%," he says, adding, "The Fed can still buy as many assets as it wants by printing money. This will be very inflationary but the Fed will do this anyway hoping to pull the money out of the system at some later date."

Federal Reserve and Treasury officials have been parked at Wall Street firms since March, netting information about the risk exposures on Wall Street firms and at banks from potentially toxic derivatives and credit securities.

But the problems are not over.

The markets remain in the fever grip of a vicious cycle all tied to a housing market that has yet to find the bottom. Separate from that, it is hard to call the bottom of this crisis based on past history with problem loans, since in the turndown of the early 1990s, problem loans didn't stop rising until nearly a year after the financials bottomed in November of 1991.

The Risks Remain

Derivatives--collateralized debt obligations, credit default swaps, mortgage-backed securities, and commercial real estate securities--sit at the center of the wealth destruction at Lehman, Bear Stearns, and Fannie Mae and Freddie Mac and the rest of Wall Street.

Their notional value worldwide amounts to $62 tn. Derivatives were supposed to pass along risk throughout the system, thereby lessening the impact of bad bets, though Warren Buffett warned they were really "weapons of mass destruction" in his 2002 letter to Berkshire Hathaway (BRK.A) investors.

American International Group in the Bulls' Eye

AIG, the world's biggest insurer, now needs to raise $40 bn, by some estimates, to avoid a credit-rating downgrade.

It has been frantically unloading businesses and selling off assets, but now faces a severe crisis as the private equity crowd, Kohlberg Kravis Roberts and TPG, has pulled out of any financing since the U.S. Treasury has balked at providing a financial backstop to any deal.  

AIG asked the Federal Reserve for a $40 bn bridge loan after rejecting an offer from private equity shop J.C. Flowers that would have given the buyout firm an option to acquire the whole company, the New York Times said, citing an unidentified person. Reports indicate AIG may get access to the Fed's borrowing window in an "extreme liquidity scare."

Also, New York State governor David Paterson said at a press conference the state will let AIG use $20 bn in assets as collateral held by its units to help it stay afloat, in essence borrowing from itself.

AIG chief executive officer Robert Willumstad is under pressure to raise funds after posting losses amounting to $18.5 bn over the last three quarters from toxic derivatives.

Who Gets Hurt When A Titan Falls

Lehman Brothers, founded in 1850, has endured two World Wars, the Great Depression, and a near collapse in the ‘80s and ‘90s as well as the $4.2 bn flameout of Long-Term Capital Management in 1998.

But its role as one of the biggest underwriters of mortgage-backed securities, and its purblind unwillingness to abandon this toxic profit machine, proved to be its undoing.

Specifically, the fourth largest investment firm couldn't unload $33 bn of bad commercial real-estate assets and $13 bn in sour residential mortgages. That the "bad bank" structure talked about over the weekend would suddenly house $85 bn in bad assets, double what was previously thought, added to the deep uncertainty. Lehman also at one point had $738 bn in derivatives contracts, a notional value. Their fair market value amounted to $36.8 bn.

Now a bankruptcy liquidation could trigger massive writedowns across Wall Street, as Lehman will provide a new "mark to market" price tag for similar assets. Lehman is also deeply ensconced in the huge market for credit-default swaps, where it is a top-10 player.

With more than $610 bn in debt and $639 bn in assets, its Chapter 11 bankruptcy filing is one of the largest on record, surpassing the collapse of Drexel Burnham Lambert in 1990 and WorldCom's bankruptcy in 2002.

Lehman's shares had lost 94% of their value over the last year, and the collapse came after Barclays PLC (BCS) and Bank of America could not get the U.S. Treasury to guarantee the open ended risks on Lehman's trading desks while a deal was being consummated. 

Now Lehman bondholders await to see if they can get about 60 cents on the dollar in the bankruptcy, according to CreditSights. The filing is by Lehman's holding company and does not involve any of its subsidiaries. Estimates have it that Lehman owes its 10 largest unsecured creditors more than $157 bn including debts to bondholders totaling $155 bn.

Citigroup and the Bank of New York Mellon (BK) are among trustees for bondholders, and Lehman owes the two about $155 bn. Under securities law, Lehman must separate out its securities from its cash. Its accounts are insured by the Securities Investor Protection Corp. SIPC is expected to appoint a trustee to liquidate the business and protect its customers.  

Merrill Lynch Saves Itself-BofA at Risk

Bank of America (BAC) is set to become the world's biggest bank, toppling JPMorgan Chase from that post, once it completes in the first quarter of 2009 its estimated $50 bn purchase of Merrill Lynch (Bank of America is swapping its stock, so the overall value will change with the rise and fall of BofA's stock, down sharply in premarket, Fox Business news director Ray Hennessey notes).

The Merrill purchase comes less than a year after BofA chief executive Ken Lewis, frustrated by subprime trading losses, told analysts on a conference call, "I've had all the fun I can stand in investment banking'' and vowed to scale back the unit. However, Lewis does want to expand, and he could not grow the bank via acquisitions of other banks due to rules prohibiting one bank from owning 10% or more of the country's deposits.

BofA is buying Merrill at a price that is over half of what Merrill was worth a year ago. 

Recently, Merrill's balance sheet topped $966 bn in assets and $931 bn in liabilities. Merrill's assets are worth more than $40 a share, says Citigroup, with the wealth management unit housing the retail brokerage unit alone worth $16 a share. Merrill's 49% stake in BlackRock (BLK), the New York-based money-management company, was worth about $23 bn recently or an estimated $22 a share.

But Merrill Lynch's stock plunged to record lows last week, to $17 a share, and absorbing Merrill comes with huge risks.

Analysts expected at least $3 bn more in losses in its upcoming quarter. Oppenheimer & Co. analyst Meredith Whitney has estimated Merrill would record a $6.87 bn loss for the third quarter. Merrill had the highest ratio of "problem assets" subject to write-downs to capital of the top three independent securities firms, says Fox-Pitt, Kelton. Analysts were already betting it would have to write down another $3 bn or more in the third quarter beyond what it had announced in July.

Since the credit crisis began in the summer of 2007, Merrill has booked more than $45 billion in write-downs, wiping out its profit earned during the housing bubble. It has laid off 4,000 workers, with more expected to come in the merger.  

To shore up its bottom line, chief executive John Thain, who is being commended for treating his firm's problems with alacrity, and is expected to depart in the merger with a $9 mn payout, sold Merrill's $4.4 bn stake in Bloomberg, the financial news and data service. Merrill also raised about $12 bn in equity and capital raises, and unloaded $30 bn in toxic real estate securities for cents on the dollar.

In the deal, Bank of America gets Merrill's 17,000 brokers and becomes the country's biggest player in wealth management, adding to its position as the largest issuer of credit cards, home equity loans and auto loans. It is still digesting the $2.5 bn takeover in January of Countrywide Financial, the troubled mortgage lender that has been under firing for adding to the subprime excesses with bad loans.   

On the analysts' conference call this morning, as reported by Fox Business's Ken Sweet, BofA's Lewis noted "we were in no man's land for our investment banking operations. It has been frustrating, having stops and go's. This just changes that. The fact we have the breadth of products we have now is just an incredible combination. I like it again. "

Both Lewis and Thain noted the combination would have "nominal exposure to Lehman," and that Lewis is "comfortable" with Merrill's accounting for its worst assets, specifically, the marks Merrill has made to its collateralized debt obligations, noting BofA has had similar marks.

Lewis noted that "we have clearly have had a historical knowledge of Merrill Lynch over the years. We did have an advisor... [with] extensive knowledge of the company. It's not that we don't have a significant knowledge about the asset classes that are of concern." Lewis added that he parked "45 people from our bank at Merrill over the weekend."

And when asked by a UBS analyst, "Why pay $29 a share for Merrill?" Lewis replied: "It's an obvious good question. You can think of several scenarios, the more likely that Merrill Lynch had the liquidity and capacity to see this through, more likely and not they would have seen this through and come through on the other side. But others might have had the opportunity to invest in Merrill. We could have rolled the dice and got it a lower price."

But Lewis added: "The long-term possibilities were so overwhelming we didn't want to roll the dice." He added that BofA is expected to book $2 billion in restructuring charges, cutting its regulatory tier one capital by about a quarter of a point.

The takeover ends 94 years of independence for Merrill and gives Charlotte, N.C.-based Bank of America a sales force with 16,690 brokers who manage $1.6 tn for customers, reports indicate.

The Merrill takeover would be the largest in the financial-services industry this year, data compiled by Bloomberg show. It's the fifth-largest transaction since Bank of America bought FleetBoston Financial Corp. in 2003 for about $48 bn in 2003, reports indicate.

Bank of America has 68,000 commercial customers and millions of account holders who could benefit from Merrill's investment services, bank analyst Bove notes. "Plus, Bank of America's capital allows it to hold on to questionable Merrill assets without selling them immediately into the market," he says, adding, "If these were normal times this deal would be viewed as a huge success for both companies. This may not be the case in the next few days as the markets sort out the implication of the Lehman bankruptcy filing but longer term the deal will be recognized for the success that it is."

Citigroup on the Defense

Citigroup is moving rapidly to assure the markets that it is in strong condition, Ladenburg Thalmann's Bove says. "The company is unclear about the impact of marks on its securities holdings but has provided a raft of data to support its contention that not only is it in solid position but that it has enough excess to provide funds to the Fed's new liquidity facility," Bove says. In a research report, Bove provides a compendium of quotes from Citigroup:

"... we reduced assets by $99 bn, with approximately 2/3rds driven by a reduction of legacy assets. Consumer loans are down by almost $26 bn, corporate loans were down by $17 bn and trading account assets were down by $73 bn. To date, the pattern of reducing assets and deleveraging the balance sheet has continued through this point in the third quarter.

"...Over the past 10 months, we have raised $49.7 bn in Tier 1 eligible capital from a wide range of investor types around the world in various equity categories. ... As of the second quarter, our Tier 1 capital ratio stood at 8.7%, which is well in excess of the "well-capitalized" minimums.

"...As of the second quarter, Citigroup had a deposit base of approximately $800 bn that was diversified across products and regions with more than two-thirds of it outside the U.S. This diversification, including deep access to international deposits, provides us with an important stable and low-cost source of funding.

"..As of the second quarter, we had increased our structural liquidity of equity, long-term debt and deposits by $119 bn over a 12-month time period and we have been net sellers of significant amounts of funds into the unsecured wholesale funding markets, up to and including the end of last week.

"...To date, we have extended the maturity profile of our Citigroup Senior unsecured borrowings to a weighted average maturity of seven years. We have also reduced our commercial paper program to $31.9 bn and have extended maturity to 54 days. Our reserve of cash and highly liquid securities, which stood at $65 bn at the end of the second quarter, and is essentially the same today, is up from $24 bn at year-end 2007."

Bove expects more writedowns, but at the moment he sees no need to change his earnings estimates for Citigroup and has kept his recommendation on the stock.