On the positive side, 10 major investment banks have come together to provide a $70 billion lending facility to ensure there is enough liquidity to allow LehmanÆs subprime-related assets to be unwound in an orderly manner, and the Federal Reserve has increased its Treasury lending facility to $200 billion from $175 billion.
Even so, the market was yesterday bracing for a further liquidity crunch that could lead to more write-downs by the major investment banks. Investors also worried about the counterparty risk resulting from a winding up of Lehman, which is one of the most highly leveraged players on Wall Street and still has about $45 billion worth of residential and commercial mortgage-backed securities on its books. The 158-year old firm filed for bankruptcy early Monday after investors lost confidence in its assets, listing $613 billion in debt and $639 billion in assets.
And while some commentators suggested that the events of this weekend were a step in the right direction û particularly BoAÆs acquisition of Merrill at a premium to market value û and should help to stabilise the situation in the medium term, the initial reaction was one of rising risk aversion towards the financial sector. Half-way through last nightÆs trading session on Wall Street, LehmanÆs share price had plunged 90% to less than 25 cents, insurance company AIG was down about 45% and the countryÆs fourth largest bank, Wachovia, which was surrounded by rumours about the need for a capital injection, had dropped about 22%.
The fact that the US Federal Reserve was willing to allow a major US investment bank to collapse sent shockwaves through the entire system, as market participants started speculating on who might be next. However, the real question is not why the US decided against using taxpayer dollars to shore up a private bank, but why Lehman Brothers, led by chairman and CEO Richard Fuld, hadnÆt more aggressively tried to reduce its overall leverage and mortgage exposure and to re-capitalise its balance sheet since the subprime-induced credit crunch took hold more than 12 months ago. In fact, while other investment banks have taken turns to shock the market with larger-than-expected write-downs and sizeable capital injections from third parties, including several sovereign wealth funds, Lehman has done almost the opposite by trying to convince the market, verbally and with the help of a bit of creative accounting, that its house was in good shape.
In a written comment about the firmÆs first quarter earnings in mid-March, which showed a net profit of $489 million and contained only $1.8 billion of negative mark-to-market adjustments, Fuld said: ôIn what remains a challenging operating environment, our results reflect the value of our continued commitment to building a diversified platform and our focus on managing risk and maintaining a strong capital and liquidity position. This strategy has allowed us to support our clients through these difficult and volatile markets, while continuing to build and strengthen our global franchise for our shareholders.ö
And only two weeks ago, LehmanÆs Asia CEO Glenn Schiffman was boasting to the Hong Kong media at a Lehman cocktail event about how well the bank was doing both in Asia and worldwide, which in hindsight certainly leaves much to be desired in terms of transparency.
There are also unconfirmed rumours that talks with Korea Development Bank collapsed because Fuld was unrealistic in his price expectations. But it is equally likely that the government-controlled Korean investment firm may have just got nervous about what it was taking on. There is also the view that KDB was never a credible buyer as it doesnÆt have a strong enough balance sheet to provide Lehman with the capital it needed.
By contrast MerrillÆs chairman and CEO, John Thain, has emerged from the situation looking like a canny negotiator, having grasped an opportunity to raise additional capital in July and now having negotiated a premium to market on the Bank of America takeover. However, it wasnÆt clear last night whether there will be a role for him at the enlarged Bank of America franchise.
The Lehman bankruptcy news did not come out of the blue though. In fact, several commentators said after the bank reported a preliminary third quarter loss of $3.9 billion last week that this was a likely outcome û unless it could find a last-minute buyer. The shortfall was well above forecasts and caused largely by a net $5.6 billion of write-downs of real estate assets. But even more worrying, according to the commentators, was the fact that the bank had failed to secure a much needed capital injection and that the strategic initiatives it announced to reduce its mortgage exposure were still quite preliminary in nature.
Specifically, the market was sceptical towards LehmanÆs plan to move $25 billion to $30 billion of commercial real estate assets into a separate publically traded entity, as the breakout of these assets appeared to be primarily a way for the bank to avoid accounting for them on a mark-to-market basis û thus pushing potential further losses into the future. The new entity was to be funded by $5 billion to $7.5 billion of equity provided by the bank.
Other measures announced last week included the sale of $4 billion worth of UK residential assets to Blackrock and a reduction in annual dividends by 93% to 5 cents per share. The bank also said that it planned to sell 55% of its investment management arm, which comprises Neuberger Berman as well as its private equity and wealth management divisions. However, it did not have a buyer at the time, making the announcement seem more of a wish than a concrete plan of action.
The scepticism was obvious by the fact that LehmanÆs share price fell another 50% on Thursday and Friday on the back of the earnings release, taking the total loss in the past six months to more than 90%.
A remaining concern for the market is that the events over the past weekend have not addressed one of the key issues, namely what is the real value of the real estate-linked assets that are still plaguing the books of some major investment banks? This is what appears to have ultimately toppled a last-minute rescue of Lehman as potential buyers worried that these assets may have a negative value that could exceed the franchise value of the entire bank.
Until someone sells these assets and gets an official market value on them, there is no way of knowing whether the market has actually bottomed out, says one observer. The problem with doing that, of course, is that the banks will have to account for any realised losses on their books. In late July, Merrill agreed to sell collateralised debt obligations with a face value of $30.6 billion to an affiliate of US private equity firm Lone Star Funds at a price of $6.7 billion, equalling 22 cents for every dollar. However, Merrill also provided financing to cover 75% of the purchase price, meaning Lone StarÆs real exposure is only 5 cents to the dollar.
Over the weekend, the last two remaining suitors for Lehman û Barclays and Bank of America û both walked away from the bank after the US Federal Reserve refused to provide a guarantee that would protect them against further trading losses by Lehman following an acquisition, forcing the bank to announce on Sunday its intention to file for Chapter 11.
Hours later, BoA surprised the market by saying that it will instead buy Merrill Lynch in an all-share deal valued at about $50 billion, or 1.8 times its stated tangible book value. Before the shares started trading on Monday, the deal translated into $29 per Merrill share, a premium of 70% over its close of $17.05 on Friday. BoAÆs share price dropped about 15% in the first hour of trading yesterday, though, reducing the value of the deal. BoA said it will exchange 0.8595 of its own shares for each Merrill Lynch common share.
Asked in a televised press conference about the rationale of the acquisition, BoAÆs chairman and CEO Ken Lewis stressed the fact that the combined entity will be the largest brokerage in the world with more than 20,000 financial advisers and $2.5 trillion in client assets û a business that it might have taken a decade to build organically. After the acquisition, which needs the approval of shareholders at both banks, Bank of America will also be the number one underwriter of global high-yield debt and the third largest underwriter of global equity.
Lehman BrothersÆs said in an announcement that it would file a Chapter 11 petition to protect its assets and maximise value. Its US subsidiaries and affiliates, including the broker-dealer units and the investment management arm, would not be included in the bankruptcy, it said. Lehman also said early Monday that it would file a ôvariety of first-day motions that will allow it to continue to manage operations in the ordinary course. Those motions include requests to make wage and salary payments and continue other benefits to its employees.ö Few details were available as of last night, however.
Staff at Lehman Brothers in Tokyo and Hong Kong, where offices were closed on Monday for Respect for the Aged Day and the Mid-autumn Lunar Festival respectively, have been told to report for work as usual today and one member of staff says the hope is that another bank might be interested in taking on part of the bank and its staff under a Chapter 11 restructuring. Such a takeover could include the investment banking and sales operations, which are still functioning businesses, the staff member says.
Another long-term employee expressed disappointment that the Federal Reserve was willing to help bail out Bear Stearns earlier this year and Fannie Mae and Freddie Mac only last week, but left Lehman out to dry. ôWe are the sacrificial lamb,ö the employee says.
Perhaps, but it is worth noting that it wasnÆt a liquidity issue that toppled Lehman and therefore a rescue operation similar to that put in place when JPMorgan bought Bear Stearns would have had little effect. Lehman needed long-term capital and a credible valuation of its mortgage assets that would enable a potential buyer to properly value the rest of the business û without that, a bailout was simply too risky. One can also argue that by focusing on keeping up appearances and perhaps holding out for a higher price, rather than to deal with the situation head on, Lehman and its top management missed any chance they may have had in the past year to significantly reduce the exposure to toxic assets on its books and to re-capitalise its balance sheet.
Either way, it doesnÆt change the outcome for LehmanÆs 25,900 employees who currently do not know whether they will have a job by the end of the week.
Meanwhile, the market has turned its focus to tonightÆs interest rate decision by the Fed and now thinks there is a 75% probability of another quarter-point rate cut to prevent a further melt-down in the stock markets. This compares sharply to the 80% probability, as indicated by the Federal Funds futures before the weekend, that the Fed would leave rates unchanged at 2%. Also today, Goldman Sachs will report third quarter earnings, followed by Morgan Stanley tomorrow.