Wall Street shaken by Lehman failure, Merrill sale

The ruptured U.S. financial system faces an unprecedented shakeup with Lehman Brothers set to file for bankruptcy, Bank of America buying Merrill Lynch, and the Federal Reserve saying for the first time it will accept stocks in exchange for cash loans.
On a black Sunday for Wall Street, 10 of the world's biggest banks also agreed to establish a $70 billion emergency fund, with any one of them able to tap up to a third of that.
And separately, troubled insurer American International Group asked the Fed for a lifeline, according to news reports.
The events, which followed three days of talks between bank CEOs and regulators at the Fed's fortress-like Manhattan building, indicate that Wall Street and Washington were accepting that massive triage is needed in the face of the credit crisis and U.S. housing bust.
"The U.S. financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey. "It's a new financial world on the verge of a complete reorganization."
Lehman will become Wall Street's most high profile bankruptcy since junk bond specialist Drexel Burnham Lambert succumbed in 1990.
"The risk of an immediate tsunami is related to the unwind of derivative and swap-related positions worldwide in the dealer, hedge fund and buying universe," said Bill Gross, chief investment officer at Pacific Investment Management Co (Pimco).
The events signalled a transformation in Wall Street's power structure with major banking groups like Bank of America Corp, which is buying Merrill Lynch, and JPMorgan Chase & Co becoming more dominant.
With Lehman and Merrill out of the picture, three of the top five U.S. investment banks have effectively departed the scene inside six months. Bear Stearns was acquired in a fire sale by JPMorgan in March.
TALKS FALTER
The focus early Sunday was on whether talks between regulators and Wall Street's top bankers would lead to the sale of Lehman, until recently the No. 4 U.S. investment bank.
Those talks faltered when Britain's Barclays Plc, which had appeared to be front-runner to take over Lehman — excluding its toxic mortgage-related assets — said it had pulled out of the bidding.
That triggered expectations the investment bank was heading into bankruptcy and prompted a rare emergency trading session to allow Wall Street dealers in the $455 trillion derivatives market to reduce their exposure to the firm.
Early on Monday, Bank of America said it had agreed to buy Merrill in an all-share deal for the equivalent of $50 billion, or $29 a share, almost $12 above Friday's closing price.
The New York Times also reported that AIG, once the world's largest insurer, had made an approach to the Federal Reserve seeking $40 billion in short-term financing.
Late on Sunday, authorities sought to prop up market confidence with announcements from regulators including the Fed and the U.S. Securities and Exchange Commission.
The Fed said it would begin accepting equities as collateral for emergency loans, and laid out a series of steps to calm markets and brace for the collapse of Lehman.
In addition to broadening the collateral it will accept from investment banks for direct Fed loans, it also said it would increase the amount of Treasury securities it auctions on a regular basis under one of its lending programs.
"The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets," Fed Chairman Ben Bernanke said in a statement.
The reaction by some market participants was lukewarm.
"The mere fact that they are forced to do this and they may still yet do some more indicates the breadth and depth of the trouble that the system is in," said V. Anantha Nageswaran at Bank Julius Baer in Singapore.
REAL ESTATE WOES
Merrill, AIG and Washington Mutual, the biggest savings and loan institution — which was the subject of conflicting reports on Friday about whether it was in advanced talks for a sale to JPMorgan — have faced similar problems.
They have held large amounts of real-estate related assets that have fallen sharply in value. Shares of all three lost more than one-third of their value last week.
An emergency trading session was set between dealers with Lehman Brothers counterparty risk involved credit, equity, rates, foreign exchange and commodity derivatives, the International Swaps and Derivatives Association said.
Market sources said the special session was initiated by the Federal Reserve, with the aim of reducing risk associated with a potential bankruptcy filing by Lehman Brothers.
Lehman collapsed under the weight of toxic assets, mainly related to real-estate, that are now worth only a fraction of their original prices.
One of the catalysts for this weekend's events was the stance of U.S. Treasury Secretary Henry Paulson, who was strongly opposed to using government money in any deal aimed at resolving the Lehman crisis.
The lack of such government guarantees was the main reason Barclays decided to exit the negotiations to buy Lehman, according to a person familiar with the matter.
So far this year, the government has sponsored rescues of Bear Stearns and mortgage lenders Freddie Mac and Fannie Mae.
The authorities didn't want to be accused of encouraging excessive risk-taking by bailing out another yet another investment bank.
But they also could not afford to let a blow-up of Lehman paralyze the financial system and deepen the credit crisis.
Hence the Fed's moves and soothing words from SEC Chairman Christopher Cox, who said the regulator will take steps to "reduce the potential for dislocations from recent events."
The SEC will take action against abusive short-selling, according to a source briefed on the matter. In late July and early August, major financial shares were protected by an emergency rule that expired on Aug. 12.
Paulson, who worked throughout the weekend in New York in the bid to find a suitor for Lehman, praised bankers for putting up the $70 billion in a special fund to provide another source of liquidity as Lehman is shuttered.
IGNOMINIOUS END
Whether it will be enough to keep markets stable is another question.
"Anyone else who has these toxic assets, if they haven't made a full confession, they better do it now," said Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel in Cincinnati, Ohio, which has $2.9 billion of assets under management.
"These assets may be hard to unwind, but they can unwind your firm. Lehman tried to deny reality until the bitter end."
The bankruptcy will mark an ignominious end to a once-proud firm, founded by cotton-trading German immigrants 158 years ago. It also badly tarnishes the reputation of CEO Dick Fuld, who had insisted that his firm could work through its problems to survive as an independent entity.
Former Federal Reserve Chairman Alan Greenspan said on Sunday he suspected "we will see other major financial firms fail," but added that this did not need to be a problem.
"It depends on how it is handled and how the liquidations take place," Greenspan told the ABC program "This Week."
"And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers."
Hundreds of Lehman employees went into the office on Sunday to clear desks and pack personal belongings, according to an employee. The news on Sunday was a huge hit to an already wounded financial jobs market, and a dent to New York's claim to be the pre-eminent world financial center.
Headhunters and consultants said the talent-flush U.S. market — which has shed more than 100,000 financial-sector jobs this year — must now brace for up to 50,000 more.