MarketView for September 15

Summary

  

Wall Street sent shock waves through the business world on Monday, as the major equity indexes saw their worst day in seven years as one of the Street’s most venerable investment banks declared bankruptcy and another was forced into a merger. It was by far the most stomach-churning single day since a financial crisis began to bubble up from billions of dollars in rotten mortgage loans that have crippled the balance sheets of one bank after another and landed mortgage giants Fannie Mae and Freddie Mac under the control of the federal government.

 

The Dow Jones industrial average lost more than 500 points, more than 4 percent, its steepest point drop since the day the stock market reopened after the Sept. 11, 2001, attacks. About $700 billion evaporated from retirement plans, government pension funds and other investment portfolios.

 

The carnage capped a tumultuous 24 hours that saw Lehman Brothers, an investment bank that predates the Civil War and weathered the Great Depression, file the largest bankruptcy in American history. A second storied investment bank, Merrill Lynch, fled into the arms of Bank of America in what will be a $50 billion dollar stock only transaction.

 

As a result, Bank of America will become a financial giant rivaling Citigroup, the largest U.S. bank in terms of assets. Bank of America has the most deposits of any domestic bank, while Merrill Lynch is the world's largest and most widely recognized brokerage.

 

"It was an opportunity of a lifetime," said Ken Lewis, Bank of America's chairman and CEO.

Lewis said at a news conference with John Thain, Merrill's chief executive. The two put the deal together in 48 hours, while they were taking part in marathon discussions at the New York Federal Reserve over the weekend to save Lehman Brothers.

 

In Washington, Treasury Secretary Henry Paulson, who refused to toss a financial lifeline to Lehman, was unapologetic as the Bush administration signaled strongly that Wall Street shouldn't expect more rescues from Washington. Paulson said he "never once" considered it appropriate to put taxpayer money at risk to resolve the problems at Lehman Brothers, which is saddled with $60 billion worth of soured real estate holdings.

 

Meanwhile, Lehman workers brought gym bags, shopping totes and Lehman travel bags to cart home personal files and pictures from their desks at the company's midtown Manhattan headquarters.

 

Unfortunately, the carnage is far from over. American Insurance Group, the world's largest insurer, was fighting for its very survival as New York Gov. David Paterson moved to allow the company to tap one of its subsidiaries for an emergency loan to stay above water.

 

"AIG still remains financially sound," Paterson said, even as the company's stock tumbled almost 60 percent. Almost $20 billion was wiped off AIG's balance sheet on Monday.

 

Six months ago, Paulson moved to prevent the collapse of Bear Stearns, brokering a deal for JP Morgan Chase to buy the firm at a fire-sale price with Federal Reserve backing. Earlier this month, he stepped in to help the government seize Fannie and Freddie in hopes of reversing the housing and credit crises.

 

The Dow industrials dropped 504 points, the sixth-largest point drop ever and the worst since the average fell 684 points on the first day of trading after the Sept. 11 terror attacks.

 

It is probable that the Lehman bankruptcy will trigger even tighter credit, making it more difficult for everyone from large companies to small businesses to American homebuyers to borrow money.

 

The failure of Lehman and probable job losses at Merrill are also a blow to the New York City economy, which is still trying to absorb a blow from shrunken tax revenues after the collapse of Bear Stearns in March. The city and its outlying suburbs rely heavily on taxes paid by workers in the financial services industry.

 

In marathon sessions Friday night, Saturday and Sunday, government officials and the chief executives of major domestic and foreign banks huddled at the New York Fed's fortress-like building in downtown Manhattan, trying to work out a way to save Lehman.

 

They failed at that. But a group of the 10 largest banks and investment banks formed a $70 billion pool that banks or brokerages can tap to cover short-term funding needs.

 

There were also worries that Lehman's problems would infect other financial companies and spread to global stock markets, further harming both our domestic economy and economies worldwide.

 

So what is the Fed going to do next? It meets on Tuesday to decide interest rate policy and is widely expected to keep rates at 2 percent, although a minority believes it could lower them to soothe Wall Street's frazzled nerves.

 

The financial turbulence could also further derail consumer confidence in the economy just as stores prepare for the critical holiday shopping season. The upheaval in the financial system also means that those consumers with marginal credit history will have an even harder time getting loans, cutting into consumer spending.

 

The Administration’s answer was that the American people should remain confident in the "soundness and resilience in the American financial system," Paulson told reporters at the White House.

 

Republican presidential nominee Sen. John McCain assailed "greed and corruption" on Wall Street and promised to clean it up, while his Democratic opponent, Sen. Barack Obama, blamed White House policies and said his opponent would only deliver more of the same.

 

Obama called it "the most serious financial crisis since the Great Depression." McCain declared in a new TV ad that "our economy is in crisis" and that only he and his running mate,could fix it. McCain also told voters in Jacksonville, Fla., "The fundamentals of our economy are strong."

 

With Lehman and Merrill out of the picture, three of the top five domestic investment banks will have departed the scene inside of six months.

 

AIG Struggles To Survive

 

American International Group struggled for survival a day after a financial tsunami swept away investment bank Lehman Brothers and forced the sale of rival Merrill Lynch in the largest financial industry shake-up since the Great Depression. Its stock dropped 61 percent on Monday and its precipitous decline has led ratings agencies to threaten downgrades that could force it to post more collateral and nullify insurance contracts.

 

The Federal Reserve has hired investment bank Morgan Stanley to review options for AIG, which has lost some 90 percent of its value so far this year and is putting pressure on Goldman Sachs and JP Morgan Chase to offer up a short-term $70 billion dollar loan to AIG. JPMorgan is a financial advisor to AIG.  Meanwhile, weekend talks between billionaire investor Warren Buffett and AIG had ended with no deal.

 

Meanwhile, AIG will be allowed to use $20 billion of assets held by its subsidiaries to provide cash needed for the troubled insurer to stay in business, New York Gov. David Paterson said Monday. Paterson asked New York state insurance regulators to essentially allow New York-based AIG to provide itself with a bridge loan.

 

The governor has also asked the head of New York's insurance department to talk with federal regulators about providing an additional bridge loan to AIG. "AIG still remains financially sound," Paterson said. The move will allow AIG to use those assets as collateral to borrow cash to fund its day-to-day operations, Paterson explained.

 

A state insurance commissioner's priority is to protect the policyholder, and that includes making it very difficult for an insurer to access the funds that are used to pay claims. AIG could face significant claims from Hurricanes Ike and Gustav. Furthermore, AIG has been battered over the past year by billions of dollars of losses tied to deterioration in the mortgage and credit markets.

 

Shares of AIG fell $7.38, or 60.8 percent, to close at $4.76 Monday. They had been down as much as 71 percent to $3.50 before Paterson's comments.

 

On Friday, Standard & Poor's warned that it could cut AIG's credit rating by one to three notches because of concerns that AIG will have difficulty accessing capital in the short term. AIG is in a precarious position, in part, because of a potential downgrade to its credit ratings and how that would affect its portfolio of financial instruments known as credit default swaps. The swaps are essentially insurance coverage to protect investors against defaulting bonds or debt.

For the three quarters ended in June, AIG lost about $25 billion in the value of credit default swaps.

 

As a seller of the swaps, investors go to AIG to insure bonds or debt they hold. As part of those swaps, AIG must maintain certain credit ratings. If AIG's ratings are cut, the insurer must put up more collateral or repay the contracts. The credit ratings clause is essentially a hedge against failure by AIG to pay out any claims on the swaps.

 

AIG estimated a one-notch downgrade by both S&P and Moody’s Investors Service would force it to post $13.3 billion in extra collateral to cover swaps, according to a regulatory filing.

 

The potential need for that extra capital puts a constraint on AIG's day-to-day liquidity position, which is why it has been seeking new financing or capital investments. AIG had worked with New York officials through the weekend to shore up capital after rating agencies threatened downgrades. AIG has said it is exploring all options to help bolster a balance sheet battered by a downturn in the credit and mortgage markets.

 

Paulson Says He Is Prepared To Act

 

Treasury Secretary Henry Paulson said on Monday the U.S. financial system remained sound despite current stresses and said he was prepared to take further actions if necessary to maintain stability.

 

In a briefing at the White House after the past weekend's crisis meetings in New York over the fate of Lehman Brothers, Paulson said a correction in housing markets remained a key challenge. He also noted the government acted to take over mortgage finance companies Fannie Mae and Freddie Mac to reduce turmoil.

 

"I'm committed to working with regulators here and abroad, as well as policymakers in Congress, to take additional necessary steps to maintain the stability and orderliness of our financial markets," Paulson said without elaborating.

 

Over the weekend, Paulson participated with top officials of the New York Federal Reserve Bank and the SEC in efforts to find a suitor for investment bank Lehman Brothers but refused to commit taxpayer funds to any rescue.

 

In the end, Lehman's holding company parent filed for bankruptcy. But other financial institutions are struggling, including insurer American International Group, which was meeting in New York with the New York Fed.

 

Paulson was asked about reports that AIG wanted an emergency loan to help it through its troubles.

 

"What is going on right now in New York has got nothing to do with any bridge loan from the government," he replied. "What's going on in New York is a private sector effort, again, focused on dealing with an important issue that's, I think, important that the financial system work on right now, and there's not more I can say than that.”