Greetings good citizen,

Bank of America goes into the talks looking to ‘rescue’ Lehman Bros and walks our with Merrill Lynch in it’s pocket!

Um, apparently, Lehman was so toxic that nobody would touch it…so they’re getting some judge out of bed so they can file for bankruptcy tonight!

In yet another case of ‘now you see it, now you don’t’, there was a post on Paul Krugman’s blog that provided some ‘details’ of the deal…and one of those ‘details' happened to be how the Fed was ‘dropping it’s drawers’ for some of Lehman’s, um, ‘lower quality’ holdings. So yes good citizen, while the Fed didn’t ‘backstop’ the sale of Lehman, it still stuck it to the taxpayers by accepting more and, um, dirtier, securities at their ‘swap window’.

Just to prove I didn’t ‘hallucinate’ this, check out this story over at Calculated Risk. CR must have seen the same piece I did and included that information in his post…(bullet point number 4 to be precise.)

Worse, if I read it correctly, the ‘pants drop’ is ‘across the board’, so ALL of the ‘remaining’ players can, um, participate.

Do you hear that loud whooshing sound? That’s the sound your dollars being flushed down the toilet.

So we proceed with tonight’s offering:

In Frantic Day, Wall Street Banks Teeter
By ANDREW ROSS SORKIN
Published: September 14, 2008

This article was reported by Jenny Anderson, Edmund L. Andrews, Eric Dash, Michael J. de la Merced, Andrew Ross Sorkin, Louise Story and Ben White. It was written by Mr. Sorkin.

In one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America for roughly $50 billion to avert a deepening financial crisis while another prominent securities firm, Lehman Brothers, hurtled toward liquidation after it failed to find a buyer, people briefed on the deals said. [No ‘mystery here, the consensus has been saying after Lehman, Merrill was ‘next’.]

The humbling moves, which reshape the landscape of American finance, mark the latest chapter in a tumultuous year in which once-proud financial institutions have been brought to their knees as a result of tens of billions of dollars in losses because of bad mortgage finance and real estate investments.

They culminated a weekend of frantic around-the-clock negotiations, as Wall Street bankers huddled in meetings at the behest of Bush administration officials to avoid a downward spiral in the markets stemming from a crisis of confidence. [Um, it’s a bit bizarre to call the ‘solvency crisis’ a ‘crisis of confidence’. When consumers are broke and defaulting in droves, it’s a bit ludicrous to ‘put your game face on’ and pretend ‘everything is going to be fine!’.]

“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I‘ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm the Blackstone Group, who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration. [Is it beginning to look like ALL bankers are perpetually ‘astonished’?]

It remains to be seen whether the sale of Merrill, which was worth more than $100 billion during the last year, and the controlled demise of Lehman will be enough to finally turn the tide in the yearlong financial crisis that has crippled Wall Street. [Excuse me??? The global financial system is ‘melting down’ and for some bizarre reason they’re calling ‘bottom’ again while NOTHING has ‘materially changed’.]

Questions remain about how the market will react Monday, particularly to Lehman’s plan to wind down its trading operations, and whether other companies may still falter,[More on that topic in ‘part two’ of tonight’s offering.] like the American International Group, the large insurer, and Washington Mutual, the nation’s largest savings and loan. Both companies’ stocks fell precipitously last week. [There is, as of this moment, a ‘mad scramble’ to recapitalize AIG, which will apparently suffer more losses from the Lehman bankruptcy, as it took a significant hit from last week’s ‘conservatorship’ of ‘Mac & Mae’. As this story unfolds, AIG is currently refusing private capital and is instead asking for ‘government assistance’!]

Though the government only a week ago took control of the troubled mortgage finance companies Fannie Mae and Freddie Mac, investors have become increasingly nervous about the difficulties of major financial institutions to recover from their losses.

How things play out could affect the broader economy, which has been weakening steadily as the financial crisis has deepened over the last year, with unemployment increasing as the nation’s growth rate has slowed. [Despite the Bureau of Economic Analysis ‘massaging’ the GDP numbers by counting inflation as ‘income’…]

What will happen to Merrill’s 60,000 employees or Lehman’s 25,000 employees remains unclear. Worried about the unfolding crisis and its potential impact on New York City’s economy, Mayor Michael R. Bloomberg canceled a trip to California to meet with Gov. Arnold Schwarzenegger. Instead, aides said, Mr. Bloomberg spent much of the weekend working the phones, talking to federal officials and bank executives in an effort to gauge the severity of the crisis. [Mr. Bloomberg is right to be worried, without Wall Street, the Big Apple is nothing more than a middling port city with too many residents and too few jobs. If this really turns ‘sour’, we have the site of what will shortly be massive civil unrest.]

A weekend that was humbling for Lehman and Merrill Lynch and triumphant for Bank of America, based in Charlotte, N.C., began at 6 p.m. Friday in the first of a series of emergency meetings at the Federal Reserve building in Downtown Manhattan.

The meeting was called by Fed officials with Treasury Secretary Henry M. Paulson Jr. in attendance, and it included top bankers. The Treasury and Federal Reserve had already stepped in on several occasions to rescue the financial system, forcing a shotgun marriage between Bear Stearns and JPMorgan Chase this year and backstopping $29 billion worth of troubled assets — and then agreeing to bail out Fannie Mae and Freddie Mac. [Notably after the Chinese put a ‘gun’ to their head.]

The bankers were told that the government would not bail out Lehman and that it was up to Wall Street to solve its problems. Lehman’s stock tumbled sharply last week as concerns about its financial condition grew and other firms started to pull back from doing business with it, threatening its viability.

Without government backing, Lehman began trying to find a buyer, focusing on Barclays, the big British bank, and Bank of America. At the same time, other Wall Street executives grew more concerned about their own precarious situation. The fates of Merrill Lynch and Lehman Brothers would not seem to be linked; Merrill has the nation’s largest brokerage force and its name is known in towns across America, while Lehman’s main customers are big institutions. But during the credit boom both firms piled into risky real estate and ended up severely weakened, with inadequate capital and toxic assets. [Hmmn…curious that the nearly two month long negotiations with the Korean Development bank (which fell through) aren’t being seen as a ‘factor’ in this weekend’s ‘drama’.]

Knowing that investors were worried about Merrill, John A. Thain, its chief executive and an alumnus of Goldman Sachs and the New York Stock Exchange, and Kenneth D. Lewis, Bank of America’s chief executive, began negotiations. One person briefed on the negotiations said Bank of America had approached Merrill earlier in the summer but Mr. Thain had rebuffed the offer. Now, prompted by the reality that a Lehman bankruptcy would ripple through Wall Street and further cripple Merrill Lynch, the two parties proceeded with discussions.

On Sunday morning, Mr. Thain and Mr. Lewis cemented the deal. It could not be determined if Mr. Thain will play a role in the new company, but two people briefed on the negotiations said they did not expect him to stay. Merrill’s “thundering herd” of 17,000 brokers will be combined with Bank of America’s smaller group of wealth advisers and called Merrill Lynch Wealth Management.

For Bank of America, which this year bought Countrywide Financial, the troubled mortgage lender, the purchase of Merrill puts it at the pinnacle of American finance, making it the biggest brokerage house and consumer banking franchise.

Bank of America, meanwhile, eventually walked away from its talks with Lehman after the government refused to take responsibility for losses on some of Lehman’s most troubled real-estate assets [yet ended up taking them anyway!], something it agreed to do when JP Morgan Chase bought Bear Stearns to save it from a bankruptcy filing in March. [snip, insert a lot of chatter about the deals that didn’t happen.]

Lehman was expected to seek bankruptcy protection for its holding company by late Sunday evening, representing the largest failure of an investment bank since the collapse of Drexel Burnham Lambert 18 years ago, people close to the matter said. Lehman’s subsidiaries were expected to remain solvent while the firm liquidates its holdings, these people said. Under this scenario, a group of banks have tentatively agreed to provide a financial backstop to assist in an orderly winding down of the 158-year-old investment bank. Such an agreement could expose those banks to losses on Lehman’s assets.

Bart McDade, Lehman’s president, was at the Federal Reserve Bank in New York late Sunday discussing terms of Lehman’s dissolution with government officials. The Fed is expect to play a supporting role in the process by temporarily accepting lower-quality assets from banks in return for loans from the government. [The taxpayer ALMOST got away but it appears Mr. Paulson can keep his finger off the trigger of that damn ‘bazooka!’.]

Lehman’s filing is unlikely to resemble those of other companies that seek bankruptcy protection. Because of the harsher treatment that federal bankruptcy law applies to financial-services firm, Lehman cannot hope to reorganize and survive. It was not clear whether the government would appoint a trustee to supervise Lehman’s liquidation or how big the financial backstop would be.

Lehman has retained the law firm Weil, Gotshal & Manges as its bankruptcy counsel.

The collapse of Lehman is a devastating end for Richard Fuld Jr., the chief executive who has led the bank since it emerged from American Express as a public company in 1994. Mr. Fuld, who steered Lehman through near- death experiences in the past, spent the last several days in his 31st floor office in Lehman’s midtown headquarters on the phone from 6 a.m. until well past midnight trying to find save the firm, a person close to the matter said.

The weekend’s events indicate that top officials at the Federal Reserve and the Treasury will take a harder line on providing government support of troubled financial institutions.

While offering to help Wall Street organize a shotgun marriage for Lehman, both the Fed chairman, Ben S. Bernanke, and Mr. Paulson had warned that they would not put taxpayer money at risk simply to prevent a Lehman collapse. [Then promptly reversed that decision AFTER a deal WASN’T reached…]

The tough-love message was a major change in strategy, but it remained unclear until at least Friday whether the approach was real or just posturing. If the Fed was faced with the genuine risk of another market meltdown, analysts said, it would be almost duty-bound to ride to a rescue of one kind or another.

What few people anticipated was that the Treasury and Fed officials might reach for an even broader strategy.

“They were faced after Bear Stearns with the problem of where to draw the line,” said Laurence H. Meyer, a former Fed governor who is now vice chairman of Macroeconomic Advisors, a forecasting firm. “It became clear that this piecemeal, patchwork, case-by-case approach might not get the job done.”

At first glance, the new strategy by Mr. Paulson and Mr. Bernanke represents a much purer and tougher insistence that Wall Street work out its own problems without government help.

But that is only the first glance. If Bank of America acquires Merrill Lynch, its capital reserves would immediately fall below the minimum requirements for bank holding companies. Federal regulators, including the Federal Reserve, would have to show lenience for as long as it takes the capital markets to regain their confidence — which could be quite a while. [So what they really did by blessing the Merrill/BOA ‘merger’ was create a particularly ‘unstable’ financial behemoth.]

And Merrill Lynch is hardly the only troubled financial institution on the horizon. Administration officials acknowledged this week that more bank failures are inevitable, and the main protection for depositors — the Federal Deposit Insurance Corporation — is likely to exhaust the reserves it has built over the years from bank insurance premiums.

“What we need now is a systemic solution and to admit that this is an extraordinary situation,” Mr. Meyer said. Mr. Meyer said the government should go to the heart of the crisis — the mortgage market — and start buying up mortgage-backed securities in a broad rescue. [Understand good citizen, that the only ‘tools’ these clowns have to work with are more and longer-term debt. Ten-year car loans and 80 to 90 year mortgages, that’s the ‘solution’ they will devise…and if you don’t like it…walk/pay rent.]

That is similar to an approach urged by Alan Greenspan, Mr. Bernanke’s predecessor as chairman of the Federal Reserve. Mr. Greenspan, who long been a staunch opponent of government interference in the economy, said on Sunday that the Federal government might have to shore up some financial institutions.

“This is a once-in- a-half-century, probably once-in-a-century type of event,” Mr. Greenspan said in an interview on ABC. “I think the argument has got to be that there are certain types of institutions which are so fundamental to the functioning of the movement of savings into real investment in an economy that on very rare occasions -- and this is one of them -- it’s desirable to prevent them from liquidating in a sharply disruptive manner.” [Um, you need to recognize what he’s really ‘advocating’ here…he is advocating that the noose remain firmly around your neck…so the investors can continue to sodomize you at will!]

Most economists contend that bailouts are often bad economic policy, because each rescue tends to encourage “moral hazard” – the tendency of institutions and investors to take even bigger risks because they assume the government will rescue them too.

Both Mr. Paulson and Mr. Bernanke worried that they had already gone much further than they had ever wanted, first by underwriting the takeover of Bear Stearns in March and by the far bigger bailout one week ago of Fannie Mae and Freddie Mac, the giant mortgage finance companies. [And you KNOW these two Republicans would still be lavishing taxpayer money upon their ‘friends’ and party supporters…if they weren’t afraid of inciting a revolt!]

Officials noted that Lehman’s downfall posed a lower systemic threat because it had been a very visible and growing risk for months, which meant that its customers and trading partners had had months to prepare themselves.

Outside the public eye, Fed officials had acquired much more information than they had in March about the interconnections and cross-exposure to risk among Wall Street investment banks, hedge funds and traders in the vast market for credit-default swaps and other derivatives.

But James Leach, a former Republican congressman from Iowa and chairman of the House Banking committee, said the Fed and Treasury may not be able to avoid a broader rescue.

“The Fed’s historic position is to object philosophically to a rescue role but in the end to do everything in its power to avoid anything that poses systemic risk,” said Mr. Leach, now a lecturer at Harvard.

“My sense is that the systemic question will be the only question on the table if Lehman falters,” he continued. “If systemic risk is considered grave, the Fed, perhaps with Treasury playing at least an advisory role, will intervene.

And that’s the ‘big question’, isn’t it good citizen. For one opinion regarding that question we turn to the ‘expert’ on such matters; Dr. Doom.

(The following is an ‘excerpt’ of a post by Rdan over on Angry Bear. You can only get the ‘intro’ to this piece at RGE monitor, apparently Rdan has a subscription.)

Let me elaborate in much detail on these issues…

This bail-in of investors is the opposite of a bailout of investors like the one that was done in the case of Bear Stearns and Fannie and Freddie. It is thus akin to the bail-in of investors that was done in the case of LTCM in the summer of 1998 and the bail-in of the interbank creditors of Korean banks in the winter of 1997. I wrote in 2004 with Brad Setser an entire book titled “Bailouts versus Bailins: Responding to Financial Crises in Emerging Markets” that discusses these policy tradeoffs in financial crises where you have runs on the liquid liabilities of either illiquid and/or insolvent countries. Those were the international equivalent of the banks runs and financial crises that we are now seeing in the cases of Bear Stearns, Lehman and Fannie and Freddie. [We can safely add Merrill Lynch to that list as well.]

Since government bailouts put at risk public money and create moral hazard Treasury and the Fed decided that they need to draw a line somewhere after the bailouts of Bear Stearns creditors, of Fannie and Freddie and all the other actions aimed at backstopping the financial system. These actions have included the creation of the TAF, TSLF, PDCF, the use of the FHLBs to provide liquidity to distressed mortgage lenders, the provision of Treasury liquidity to the FHLBs, the outright purchase of agency MBS by the Treasury, the swapping of two thirds of the safe Treasuries of the Fed for toxic illiquid securities of banks and non banks, etc. So after having created the mother of all moral hazard with their actions (including the biggest bailout of all, i.e. the rescue of Fannie and Freddie) the Fed and Treasury are playing a chicken game with the financial system. Tim Geithner told clearly to the heads of all the major Wall Street firms that if they pull the plug on Lehman and Lehman collapses they are next in line for a run on their institutions. So if a buyer for Lehman is not found (or even if it is found and the counterparty lines are still pulled) not only Lehman will collapse but the run will extend to all of the other major broker dealers and banks that are the counterparties of Lehman.

The Fed may delude itself in thinking – as its stress models suggest – that the systemic risk of a collapse of Lehman are less serious than those of Bear Stearns: afterall Lehman is less involved into CDSs than Bear was and now both Lehman and the other major broker dealers have access to the discount window with the PDCF. A collapse of Lehman instead will have as much of a systemic effect as the collapse of Bear for many reasons: Lehman is larger than Bear was; Lehman is a major player in a variety of key financial markets; all the other major Wall Street institutions are interconnected with Lehman in dozens of different types of counterparty activities; the PDCF support of the Fed is neither unlimited nor unconditional, i.e. investors cannot assume that Lehman or any other broker dealer can borrow unlimited amounts with no conditions from the discount window. Thus, a collapse of Lehman would trigger a panic and a potential run on all sorts of other broker dealers and also on other distressed financial institutions like banks (WaMu) and insurance companies (AIG) and smaller member of the shadow financial system (distressed and highly leveraged hedge funds, etc.). [In short, good citizen, ‘doomsday’.]

The reason why Lehman is having a hard time to find a buyer is that it is most likely insolvent. If you had to mark to market the value of its illiquid and toxic assets (the $40 billion of commercial real estate assets, its remaining residential MBS and CDOs, its holdings of real estate private equity funds) Lehman is most likely insolvent (i.e. has negative net worth with liabilities well above its impaired assets). So leaving aside the potential and now dubious value of its franchise (an option to the value of a much slimmed down financial institution) no financial institution should be paying even a single penny to buy an insolvent firm. That is why all the potential suitors of Lehman (such as Bank of America and others) are waiting for the government to provide another sleazy Bear Stearns deal where the government would buy at higher than market value the toxic assets of Lehman (the commercial real estate assets for example) so as to make the net worth of the remaining institution positive and worth buying. But such action – borderline illegal in the case of Bear as pointed out by Paul Volcker – would be a scandal in the case of Lehman and severely exacerbate the moral hazard problem. [This is probably as close as you can get to calling this administration a ‘pack of thieves’ without landing in Gitmo.]

But here lies the conundrum of this Lehman crisis: no one seems to want to buy for a positive price Lehman unless there is a public subsidy (taking off their toxic assets off the firms’ balance sheet). The government cannot afford to provide the subsidy as the moral hazard problems are becoming severe. But then if on Monday no deal is done Lehman collapses and goes into Chapter 11 court and you have the beginning of a systemic financial meltdown as the run on the other broker dealers will start. Thus, what Fed and Treasury are trying to do this weekend is another 1998 LTCM bailin or Korea 1997 bailin, i.e. trying to convince all the major institutions to either support a purchase of Lehman or maintain their exposure to Lehman if no buyers is found. Can this bail-in work? It is not clear as there is a major collective action problem: you can’t only convince half a dozen major Wall Street firms to maintain their exposure to Lehman. You need also to convince all the other counterparties of Lehman (including the hedge funds and the other broker dealers and banks) not to roll off their claims and credit to Lehman. This is a much more messy collective action problem and coordination game than in the case of LTCM and Korea where the number of involved counterparties was more limited (less than 20 in each case.)

So, there you have it, Dr. Doom says there will be a ‘run’ on the ‘Shadow banking system’ starting tomorrow.

Will commodity prices gyrate like mad as ‘confused’ investors run hither and yon, seeking a ‘safe’ place to park their cash?

Not that I recommend it (for ‘practical’, not investment reasons), it will be curious to see where gold closes tomorrow.

More interesting is the fact that most Asian markets are closed today…so the already beleaguered and besieged European markets will be the first to ‘react’ to these, um, developments.

Make no mistake about it good citizen, this is not by any stretch of the imagination ‘good news’.

Will the markets rise as investors jump into equities…or will they tank due to the sudden ‘charge for the exits’ this situation portends?

Um, I’ll take a stab at making a ‘prediction’, since I turned out to be right on my call that Lehman’s most toxic assets would ‘disappear’ and they vanished right where I thought they would, onto the Fed’s balance sheet…leaving you and me on the hook for them.

In an effort to save the financial system, the Fed will knuckle under to AIG’s demand to be bailed out. AIG is holding trillions in CDS and will sink the financial system if it is not ‘rescued’.

With the Fed rapidly ‘running out of ammo’, ‘confidence’ in the US Dollar will start to drop like a stone…and with it, the dollar’s value. So look for a nasty and sudden ‘spike’ in inflation over the next few weeks.

Um, did the ‘march’ around the supermarket this afternoon and suffered the usual case of ‘sticker shock’. The price at the pump is falling (a little) but the price of food continues to rise.

This situation (to no one’s surprise) will continue to worsen and will even accelerate as the dollar starts to lose value faster due to sheer volume of taxpayer-funded bailouts.

That’s enough for the ‘near-term’. I’ll be making more predictions later.

Thanks for letting me inside your head,

Gegner

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