Another One Bites The Dust

I promise I won't break out in song, but am I the only one that hears Queen's song playing constantly in their heads? Let's be honest folks, it's a killing field out there. As I write this, Lehman Brothers appears as if it won't make it past the next few days, let alone the next few hours. Barclay's just pulled out of the bidding for the distressed bank. It was basically the last bidder available for Lehman. The Journal reported that Barclay's walked away from the bidding for a variety of reasons which will be determined in the coming hours and days. One can assume that no agreement could be reached on what would be done with the billions of dollars of toxic assets that Lehman holds. It is an end similar to that of Bear Stearns, save for the fact that it wasn't directly a liquidity issue that caused Lehman to fail, but rather a lack of confidence in the bank's ability to continue its operations. Lehman didn't face the cash crunch that Bear did, as Lehman was and is able to borrow from the Fed's emergency discount window, unlike Bear. It's more a question of what the value of Lehman's $50-odd billion of illiquid assets is worth. In the summer, Merrill unloaded about $31 billion of notional debt at 22 cents on the dollar. At some price, there is a buyer for the illiquid Lehman debt. The thing is, at that price, Lehman is probably bankrupt anyway.

One of the main reasons that Barclay's likely walked away was the fact that the government lead by Treasury Secretary Hank Paulson was completely unwilling to bail out Lehman as it did with Bear, Fannie and Freddie. They refused to provide a backstop for the risky mortgages that a potential buyer would have had to assume. The moral hazard is simply too great. The coming failure of Lehman sends a powerful message to those who seek and take excessive risks. The government isn't (and shouldn't) be there to wipe up the mess that private companies take. Although the government did largely bail out Bear and Fannie and Freddie, in those cases, the shareholders were almost completely wiped out. Nevertheless, the government did enter into a catch-22 situation, in that they almost created an expectation with their previous bailouts that they would continue to bail out firms. Lehman however, seems to have been the final straw.

So what's next for Lehman? Well, it appears as if (barring some new development) the firm will file for Chapter 7 bankruptcy, and will likely be liquidated. There was an emergency trading session called today in order to unwind the credit default swaps that Lehman had entered into. It's extremely complex and will take quite a while to sort out. With respect to Lehman directly, it will probably be broken up and its assets auctioned to the highest bidder. Distressed-debt funds, private equity funds, sovereign wealth funds - these will be the types of buyers of Lehman's assets. It won't be pretty for the markets. Tomorrow will be a manic Monday for sure.

In other news, Merrill - a firm that could be potentially be next on the credit-crunch casualty list - is apparently in advanced talks to merge with Bank of America, one of the suitors rumoured to have been interested in Lehman. According to the Journal, the price for Merrill has been pegged at around $25 to $29 per share. Over the past week, Merrill's share price has fallen by 36%. This will, in my opinion, at least help stabilize the storm that is about to descend this week in the wake of Lehman's likely collapse.