Lehman bailout better hurry, as WaMu, AIG, Merrill may be next

Lehman Races Clock; Financial Crisis Spreads

By Susanne Craig, Deborah Solomon,
Carrick Mollenkamp, and Matthew Karnitschnig
The Wall Street Journal
Saturday, September 13, 2008

http://online.wsj.com/article/SB122122951987228067.html

The crisis gripping the nation's financial system deepened, with Lehman Brothers Holdings Inc. racing to sell itself over the weekend and other major U.S. institutions scrambling to show they have the financial wherewithal to ride out the crisis.

Potential buyers of Lehman were heading toward a standoff with federal officials Friday. Firms weighing offers for the battered investment bank sought financial assistance, while Treasury Secretary Henry Paulson has been unwilling to support a government-led bailout, people familiar with the situation say. The weekend's negotiations over Lehman's fate could define the next chapter of the government's handling of the crisis.

Friday's unease spread beyond Lehman. Shares of American International Group Inc., the giant insurer, fell more than 30%. Standard & Poor's said it might lower its credit ratings on AIG because of its tumbling share price and the increasing yield on its debt instruments compared with safe government Treasurys.

Friday's share drop prompted top AIG management to consider holding a conference call for investors Monday morning to announce a series of steps, including asset sales, aimed at reassuring the market, according to a person familiar with the matter.

Merrill Lynch & Co., which boasts the largest force of retail brokers on Wall Street, saw its stock drop 12%, following a 17% drop Thursday. Washington Mutual Inc. shares fell 3.5% Friday, after the thrift released some financial projections late Thursday in hopes of reversing a week-long stock-price slide fueled by worries about its capital levels and access to cash. Speculation that WaMu could be up for sale, with J.P. Morgan Chase & Co. as a potential suitor, fanned rollercoaster trading. While the New York bank remains interested in WaMu, no talks are under way, people familiar with the situation said.

The immediate concern for Wall Street and Washington remained the fate of Lehman, with some resolution expected over the weekend. The Treasury Department and the Federal Reserve have been working with the 158-year-old Lehman to resolve its problems, including talking to potential buyers of the bank, according to people familiar with the matter. The Securities and Exchange Commission has also been working with Lehman and officials at the New York Federal Reserve to monitor the firm's financial situation.

As of Friday afternoon, Bank of America Corp. was seen as the likeliest buyer. Lehman and its investment bankers were also meeting with potential bidders including Barclays PLC of the U.K., and contacted HSBC PLC. Other parties were looking only at pieces of Lehman, with Goldman Sachs Group Inc. interested in some of the securities firm's huge real-estate portfolio.

... Walking Away?

There's a chance BofA could walk away this weekend, people familiar with the matter say. They say the bank figures that rather than buy a damaged company such as Lehman, it would prefer to bid for a Wall Street titan such as Morgan Stanley or Merrill Lynch should those firms come up for sale.

Because Lehman does business with several other Wall Street firms, a failure there could have widespread effects. It was precisely that concern that prompted the U.S. in March to orchestrate the sale of Bear Stearns Cos. to J.P. Morgan and limit the bank's exposure to bad assets on Bear's books.

Potential buyers of Lehman want a similar deal, but the Treasury Department looked unwilling on Friday to step in with financial backing. Mr. Paulson and Federal Reserve Chairman Ben Bernanke don't see a need to structure a Bear-like rescue. In large part, that's because Lehman has been able to borrow money to roll over its short-term debt by accessing the Fed's discount window, an emergency facility it extended amid the Bear bailout.

Lehman's troubles have also been well-known for a while, giving market participants "time to prepare," according to those familiar with the government's thinking. The government, which took over Freddie Mac and Fannie Mae last weekend, could face a public backlash if it continues to prop up troubled financial institutions.

But suitors such as Bank of America, worried about the risk of buying an ailing financial institution like Lehman, want the government to step in with a package similar to what was offered to J.P. Morgan when it bought Bear. Then, the federal government agreed to absorb as much as $29 billion in losses. In seeking a Lehman deal, Bank of America Chairman and Chief Executive Kenneth D. Lewis is likely to face a tough sell to investors if he doesn't secure some federal government backing.

Much remained uncertain as the Lehman negotiations headed into the weekend. It isn't clear how much wiggle room existed on both sides. But on Friday, people familiar with the matter said the federal government was unwilling to provide financial backing.

The government is nonetheless working to help facilitate a sale of the bank or come up with some other way to prevent the firm from having to file for bankruptcy. It has discussed options including helping to assemble a consortium of financial institutions to buy parts of the business, reminiscent of the 1998 rescue of hedge fund Long-Term Capital Management.

The federal rescues of Bear, Fannie, and Freddie have already been criticized from politicians on both sides of the aisle. Mr. Paulson is expected to face tough inquiries on Tuesday when he appears before the Senate Banking Committee to answer questions about the takeover of Fannie and Freddie.

With the 2008 election less than two months away, a third bailout in six months would be tough to swallow politically. Sen. Richard Shelby, an Alabama Republican, has said a private deal would be preferable to one involving government funds, reflecting growing frustration among conservatives on Capitol Hill that the Treasury is too willing to prop up ailing financial firms with taxpayer dollars.

At a town hall meeting in Dover, N.H., Sen. Barack Obama sharply criticized the government takeover of Fannie Mae and Freddie Mac.

"These folks were making money hand over fist during the boom times, taking extraordinary risks, paying huge bonuses to their CEOs. But when things started to go south, guess what? Taxpayers are suddenly expected to foot the bill," the Democratic presidential candidate said. "That is unacceptable and could have been anticipated, but somebody fell asleep at the switch."

... Two Tracks

While talks continued Friday, Lehman was working on dual tracks. On the one hand, executives were negotiating to find a buyer for the company. At the same time, the company was moving ahead on other business, with bids for a stake in the pre-announced auction for its investment-management unit due Friday night. The firm is also still planning to release its fiscal third-quarter earnings on Thursday.

Lehman's business has suffered as its stock has fallen. Hedge-fund clients of Lehman's prime brokerage business, which provides trading and lending services, have been shifting some or all of their assets to other firms, people familiar with the matter say. That's in part because some hedge-fund investors have pressured managers to reduce exposure to Lehman, these people say. They say the moves, which include clients in both U.S. and Europe, have accelerated in recent days and continued on Friday.

Over the past couple of months, some large dealers have been requiring their trading counterparties, including Lehman, to post additional collateral to back their commitments on credit-default swaps and other derivatives. Many of the firms have to post collateral to each other daily as market prices fluctuate.

Such policies are meant to limit direct losses from derivative contracts and could help cushion the impact if a large trading partner defaults. However, it is not known if most of Lehman's trading partners have made such demands and if they have collected sufficient collateral to protect themselves from significant losses in the event of a default.

For Bank of America, negotiating for some measure of federal participation in a deal is not the only hurdle. According to people familiar with the bank, there are two remaining stumbling blocks for Bank of America.

... Souring Balance Sheet

The first is the fact that the bank lacks the time to analyze the depth and extent of Lehman's souring balance sheet. The second concern is that write-downs, if high enough, could force Bank of America to raise capital, a step the bank so far is unwilling to consider, according to people familiar with the matter. Capital also might be required depending on the price of a Lehman purchase.

Bank of America's retail deposits do provide stability and the bank has a deep well of assets, such as U.S. Treasurys, it can use to quickly raise cash. But demand for capital potentially would cut into Bank of America's Tier 1 capital, which is important because it cushions against losses. By paying $21 billion in cash to buy Chicago's LaSalle Bank from Dutch bank ABN Amro Holding NV in 2007, Bank of America used precious capital.

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