Wall Street Deleveraging

In a stunning and unprecedented series of events on Sunday, 158 year old Wall Street firm Lehman Brothers (LEH:NYSE) is expected to file for bankruptcy this morning after an unsuccessful effort to find a buyer while The Federal Reserve ordered the sale of Merrill Lynch (MER:NYSE) to mega bank Bank of America (BAC:NYSE).

Compounding the negativity, top insurer American International Group (AIG:NYSE) is in a frantic search for capital as it scrambles to head off a downgrade, which would create a need for additional capital to match reserve requirements. In yet another unprecedented move, AIG has reportedly turned to the FED to inquire about the FED potentially bridging a loan from some private equity firms, of which KKR has been mentioned.
Lehman has been rumored to be teetering since the collapse of Bear Stearns. Since the FED’s moves after Bear, including opening up the discount window, one would think Lehman had ample opportunity to find a way out, potentially by attracting a buyer. Perhaps, after the Bear Stearns deal the FED orchestrated and the bailout of Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE) due to implicit guarantees of the federal government, Lehman thought the FED would ultimately rescue them, but thankfully the FED drew a line in the sand here. Lehman had issues with their books as accurately indentified by David Einhorn of Greenlight Capital Management back in April, and this no doubt cautioned potenital investors.

The FED move with Bear Stearns can be argued, but I think the deal was a good one and did ease systemic risk and a potentially massive stock market selloff. Since then, through open market operations, the FED has been active in offering outlets for these firms to get assistance, even if there is a stigma associated with getting help at the discount window. Lehman failed to operate successfully during this time while the short selling vultures were swooping in and now is left without options.

Merrill, staring in the face of Lehman dying, was helped by the FED in realizing their days were numbered as the short sellers likely had Merrill in their sights. The FED dictated the sale to BAC at a premium per Merrill’s close on Friday, which is puzzling. Could a deal have been struck to not prosecute former Countrywide executives now part of BAC as part of the sub prime market collapse should BAC be of assistance here?

Although we have had some nice rallies, particularly a few months ago, we are still in a bear market and the financials are a complete disaster. Expect a very negative and volatile day on the corner of Wall and Broad as the market continues to wring out the excesses. It is possible capitulation could occur today for those following a technical analysis of the market. Short sellers, with their punching bag Lehman facing chapter 11, will no doubt look for their next target, which is likely Washington Mutual (WM:NYSE).

A consortium of securities firms and global banks have reportedly formed an alliance of some 70 billion to provide some sort of backstop as the unwinding and balancing of credit swaps today could be quite tricky with Lehman out. Treasury Secretary Henry Paulson pleaded with Wall Street to help their own, rather than the federal government doing it, and this is a step in that direction. It will limit the damage the short sellers can do if nothing else.

Although the housing crisis created by sub prime lending is the major catalyst to this downdraft, this has turned into a credit issue and a swift and smothering tightening of available consumer credit, thus contracting our consumer driven economy. Since over 50% of homes are owned outright and with over 92% of loans performing as instructed, it should be clear the banks overleveraged themselves through exotic mechanisms to squeeze out some extra cash while extending their leverage well beyond prudent levels. The most damaging aspect of this is that many of these institutions have no idea the level of losses on the balance sheet, and without that knowledge it is virtually impossible to accurately forecast the total losses or the length of the issues.

I welcome these poorly managed financial firms taking the hit. I do recognize the FED may have to act with taxpayer dollars, as they did with Fannie and Freddie, to prohibit far greater expenses and losses which could have a very serious effect on the overall economy.

We crank out dive bombing this morning at the bell, and although you should rarely fight the tape, I am not sure the financial wreckage has very much to do with the prospect of Coca Cola (KO:NYSE). Opportunities will exists that will require further review.