Lehman has filed for Chapter 11 bankruptcy
Louis Lanzano/AP

Lehman Brothers, Merrill Lynch Gobbled by Market

September 15, 2008 05:04 PM
by Anne Szustek
With Bank of America buying troubled Wall Street firm Merrill Lynch and uninterested banks letting Lehman fall to bankruptcy, the sub-prime mortgage crisis continues to claim victims.

Lehman, Merrill No More

No journalistic clichés can capture the perverse market effects from Merrill’s $50 billion sale to BoA and the end of 158-year-old investment bank Lehman Brothers. “Mother Merrill” was worth some $100 billion last year. On Feb. 2, 2007, Lehman’s price-per-share peaked at

But now, more than $613 billion in debt, Lehman has filed for Chapter 11 bankruptcy. Unlike Chapter 11 bankruptcy filings for companies in other sectors, because Lehman is a financial firm, federal law stipulates that it will not be able to reorganize.

As of midday Monday, Lehman stock hovered in the range of 20 cents per share. Toward the end of last week it was believed that the investment bank was to have its assets liquidated, which would parallel Chapter 7 bankruptcy proceedings.

British bank Barclays, who was believed to be a prime contender to inject Lehman with a fresh dose of capital this past weekend, pulled out of talks on Sunday after it announced it couldn’t obtain financial backing from Wall Street firms or the U.S. government to hedge against Lehman’s losses. And Bank of America, another top contender as a partner for Lehman, opted for Merrill instead.

Federal Reserve Chair Ben Bernanke and Treasury Secretary Henry Paulson told Lehman that the U.S. government would be happy to arrange a partnership for the now-erstwhile bank—but not at the expense of taxpayers, as could very well be the case after mortgage companies Fannie Mae and Freddie Mac were taken into Treasury control last week.

“It’s a return to pure capitalism, the survival of the fittest—the government can’t and won’t bail everybody out,” Justin Urquhardt Stewart, investment manager at London firm 7 Investment Management, told Reuters.
As for Merrill’s ordeal, the $50 billion all-stock deal was a bargain for Charlotte, N.C.-based Bank of America, despite it valuing Merrill at about $12 above its price per share at Friday’s close. A source close to the negotiations told the International Herald Tribune that BoA CEO Kenneth Lewis had approached Merrill Lynch earlier in the summer; however Merrill CEO John Thain snubbed the proposal.

Background: The sub-prime mortgage crisis and the downfall of Lehman and Merrill

The beginning of the end for Lehman and Merrill, as has been the case with much of the financial industry, was the sub-prime crisis. Merrill Lynch replaced CEO Stan O’Neal last October after the bank posted third-quarter 2007 losses of $2.3 billion and $8.4 billion in debts incurred by failed credit and mortgage-related investments—its worst-ever showing in the bank’s then 92-year history. In April, Merrill Lynch announced more than $6.5 billion in write-downs and plans to cut at least 2,900 jobs, to the dismay of shareholders.

Lehman has slashed more than 6,000 positions since June 2007, and was gearing up for another 1,500 job cuts August 26.

The investment bank’s woes have roots in the sub-prime mortgage crisis. Lehman closed its subprime lender BNC Mortgage in June 2007, saying in a press release that the market “necessitated a substantial reduction in its resources and capacity in the subprime space.” It slashed 1,200 jobs, had a goodwill write-down of $27 million and accepted an after-tax charge of $25 million. Earlier that summer, Lehman rolled together its nonprime lending unit Aurora Loan Services, which concentrated on Alt-A loans, into BNC.

Opinion & Analysis: Mergers, bankruptcies and deleveraging

Those holding bonds from Lehman could get some 60 cents for each dollar if the bank gets liquidated, CreditSights analysts told Among Lehman’s over $600 billion in debts are $157 billion due to its 10 largest unsecured creditors, of which $155 billion is owed to bondholders.

Financial players knew that a Lehman failure was a likely outcome, however.

“We expect the financial markets to be under unprecedented strain over the next several days as players respond to outsized industry deleveraging,” or cutting back on debt, Oppenheimer analyst Meredith Whitney wrote in a report quoted by the Chicago Tribune.

Less access to loans could spell a greater credit crunch for both businesses and consumers alike. As for consumers, the FDIC insures accounts up to $100,000, and investment retirement accounts held at FDIC-backed institutions are covered for up to $250,000.

Major business players in need of fast capital like the struggling bank Washington Mutual have more reason for alarm.

WaMu’s mortgage-backed losses are a rash on the company’s balance sheets. A WaMu spokesperson emphasized to ABC News a Monday report from credit rating agency Standard & Poor’s “strong regulatory capital cushion.” The same report downgraded WaMu’s credit rating from “stable” to “negative.”

This, on top of the precedent set by Lehman’s scurrying to find capital as late as Sunday, makes for a grim outlook for WaMu. “Anytime that one of these institutions either fails or it does a bunch of things and does not get ‘better’ in the eyes of the stock market, psychologically it does some damage to the other weak sisters,” Douglas McIntyre, founder of financial news site, told ABC News.

Certainly a turnaround in the housing market would speed up WaMu’s convalescence, as would a dose of cash from a foreign sovereign-wealth fund. The Abu Dhabi Investment Authority gave Citigroup a $7.5 billion boost in November 2007.

And Chinese SWF Safe committed to a $2.5 billion stake in private equity fund TPG in July. WaMu should know—TPG agreed to inject $7 billion of capital into the flailing bank in July.
As for other banks, given the shaky state of the financial sector, WaMu doesn’t have a line of suitors in waiting. FAS 157, a new rule instituted by the U.S. Financial Accounting Standards Board, could send them searching for partnerships elsewhere. Set to become effective in December, FAS 157 stipulates that any major write-downs to assets that have gone unaccounted on balance sheets must be noted on accounts following a merger or acquisition. Seeking Alpha’s Edward Harrison writes that the regulation could dissuade regional banks from buying into larger thrifts such as WaMu.

“With loans fetching their greatest discounts since the Great Depression, it sharply reduces the value of a target’s assets,” Harrison quotes Columbia Business School instructor Robert Willens as saying. “That will force an acquirer to raise additional capital in this very difficult environment.”

At least three possible buyers have shied away from investing in WaMu or National City Bank, based in Cleveland, because of the rule, said two bankers involved in the negotiations.

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