I was expecting another one of Henry Paulson’s Sunday brunch emergency deals, but it looks like the deal with Lehman Brothers (NYSE:LEH) has hit a snag:
The fate of Lehman Brothers Holdings Inc.’s darkened early Sunday afternoon with Barclays PLC, the sole remaining bidder for the 158-year-old Wall Street firm, telling federal regulators that it is walking away from a transaction, people familiar with the matter say.
The situation was rapidly evolving, and it’s possible Barclays or another bidder would emerge to save Lehman before markets opened Monday. But with the government balking at putting any taxpayer money at risk for Lehman, the likelihood of a transaction was dimming. That would leave an orderly liquidation as the most likely scenario, a dramatic outcome for a once-powerful firm…
The main stumbling block for any Barclays deal is a reluctance by U.S. regulators to financially back an acquisition or the creation of a so-called “bad bank” to wind down Lehman’s assets.
Barclays Walks from Lehman Deal; Likelihood for Transaction Narrows (WSJ)
As of this weekend, there were only two serious bidders for Lehman Brothers. Barclays (NYSE:BCS) and Bank of America (NYSE:BOA). Bank of America also chose to walk because there would be no federal financing involved.
The lack of a deal makes the risks high for everyone on Wall Street. Earlier this week on Charlie Rose, Robert Rubin (of Citigroup and Goldman Sachs fame) described the situation best:
RUBIN: Well, three things I don’t know. One of them is what the circumstances are and whether they really are in that serious a situation. Number two, whether they are so interconnected — you say too big to fail, I think the standard now has become too interconnected, or the issue has become too interconnected to fail. That`s after all the problem in Bear Stearns. My instinct is if that Bear Stearns was too interconnected to fail, the probability is that Lehman is.
If that’s the case, then the policy makers have to make this very complicated judgment of whether to intervene or not intervene, and the argument against intervening always is that in a market-based economy, failures should be rewarded with failure and success with reward. But on the other hand, the systemic risks of allowing these interconnected institutions to fail are such that I think as you weigh and balance all this, there are times when government is going to have to intervene. Then the practicalities of how do you do it can become very complicated.
Lehman Brothers does indeed pose a systemic risk for the rest of Wall Street.
A disorderly unwind of Lehman’s derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets — such as commercial real estate — could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.
The possible merger between Bank of America and Merrill Lynch (NYSE:MER) seems to stem from the fact that anyone who held similar assets will be in a world of pain tomorrow as banks may have to further mark down toxic assets if Lehman liquidates. It’s a fact that Merrill holds more of these types of assets than even Lehman, so they may be forced into a shotgun marriage because capital raising will be difficult. EDIT: WSJ is reporting a deal at $26 per share for BoA-Merrill Lynch
In order to dampen any kind of blow that a liquidation might have with derivatives, the International Swaps and Derivatives Association announced that they’ll arrange to net any transactions involving Lehman Brothers. In a statement released today they say:
ISDA confirms a netting trading session will take place between 2 pm and 4 pm New York time for OTC derivatives. Product classes involved are credit, equity, rates, FX and commodity derivatives. The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holding Inc. bankruptcy filing. Trades are contingent on a bankruptcy filing at or before 11:59 pm New York time, Sunday, September 14, 2008. If there is no filing, the trades cease to exist. These trades are subject to a protocol which is being distributed by ISDA (International Swaps and Derivatives Association). Traders should execute the protocol and return to ISDA
ISDA Statement on Lehman Brothers Bankruptcy Trades: Full Text (Bloomberg)
Netting would be the right course of action to take. Doing so would not only lower systemic risk on Wall Street, but also the capital requirements needed by banks to service such contracts. To give you an idea of how it works, look at the image posted below.
Netting would help reduce some of the risk stemming from Lehman liquidation. The amount of capital needed would be based upon the economic position that results from the outcome of each contract, rather than the amounts stated in the actual contracts. This means less capital will be needed on both ends of the deal, which should be helpful if Lehman goes bankrupt. The ISDA’s actions will probably help, but not enough to create a good day for stocks tomorrow. It might be a good time to monitor your watch lists for any high quality companies that you’ve been hoping will be on sale.
