`Tectonic' Shift on Wall Street as Lehman Fails, Merrill Sold
By Christine Harper
Sept. 15 (Bloomberg) -- In the biggest reshaping of the
financial industry since the Great Depression, two of Wall
Street's most storied firms, Merrill Lynch & Co. and Lehman
Brothers Holdings Inc., headed toward extinction.
New York-based Lehman, founded 158 years ago, said early today
that it filed for Chapter 11 bankruptcy protection after failing
to find a buyer. Merrill Lynch, 94 years old and also based in
New York, agreed to sell itself to Bank of America Corp. for $50
billion in an emergency deal hashed out yesterday.
``The tectonic plates beneath the world financial system are
shifting, and there is going to be a new financial world order
that will be born of this,'' said Peter Kenny, managing director
at Knight Capital Group Inc., the Jersey City, New Jersey-based
brokerage that handles about $1 trillion worth of stock
transactions a quarter. ``It's an ugly and painful process.''
The engines that powered record growth in the financial industry
over the last decade -- cheap credit and surging property values
-- have been thrust into reverse. Companies that once thrived on
making real estate loans and holding assets bought with borrowed
money are now under siege, giving the upper hand to those less
reliant on leverage and holding the fewest assets tied to
property.
The industry convulsions that started last year have already
eliminated Bear Stearns Cos., forced into a cut-price sale to
JPMorgan Chase & Co. with government support in March. A week
ago, the U.S. Treasury placed mortgage companies Fannie Mae and
Freddie Mac into conservatorship, guaranteeing their widely held
debt securities while all but erasing their equity value.
American International Group Inc., once the world's largest
insurer, is struggling to raise cash to avoid a credit-rating
downgrade that could cripple its business.
From Five to Two
The five New York-based securities firms that dominated Wall
Street have been reduced to two: Goldman Sachs Group Inc. and
Morgan Stanley. While both firms are scheduled to report a drop
in third-quarter earnings this year, their business has remained
profitable throughout 2008 -- unlike Lehman and Merrill.
``I think highly of Morgan Stanley and Goldman Sachs, so I
expect them to ride this out,'' Evercore Partners Inc. Chief
Executive Officer and Former Deputy Treasury Secretary Roger
Altman said in an interview on CNBC. ``But as to whether we've
seen the last of this crisis, I think the answer to that is
clearly no. And exactly where it goes from here and how it
unfolds, I'm unsure.''
Lehman, which employed 25,935 people at the end of August in 61
offices around the world, had a balance sheet totaling $786
billion as recently as February. Merrill Lynch, with 60,000
employees, is known for its ``thundering herd'' of financial
advisers that brought Wall Street financial products to Main
Street investors.
`Vaporized'
``I've been on Wall Street for many years, and I've never seen a
weekend like this one,'' said Michael Holland, 64, chairman and
founder of New York-based Holland & Co. ``We are unwinding what
has been years of silliness in the financial markets, and the
silliness is being vaporized as we speak, unfortunately with the
stock price of a number of companies involved in it.''
To help cushion the fallout, 10 banks created a $70 billion fund
to lend to firms that are having trouble financing their assets
in the markets. The Federal Reserve also said it will be willing
to lend money in return for a wider array of collateral
including stocks.
Still, the repercussions may be widespread.
Meredith Whitney, an analyst at Oppenheimer & Co., wrote in a
note to investors that sales of Lehman's assets will push down
the value of securities, forcing other firms to write down their
own holdings.
`Fundamentally Flawed'
Nouriel Roubini, an economics professor at New York University,
said the independent securities firm model is ``fundamentally
flawed'' and that every securities firm will need to combine
with a bank to gain a deposit base and greater access to loans
from the Federal Reserve.
Just five months ago, Lehman Brothers Chief Executive Officer
Richard Fuld, 62, was telling shareholders that ``the worst is
behind us'' in the credit contraction. As concerns escalated
about the value of Lehman's assets tied to residential and
commercial real estate, Fuld replaced Chief Financial Officer
Erin Callan and President Joseph Gregory in June.
Deteriorating markets put more pressure on the value of Lehman's
assets and the firm, unable to negotiate an investment from the
Korea Development Bank, instead tried to reassure investors last
week by revealing third-quarter results early and unveiling a
plan to sell part of its fund management unit and create a
separate unit for its real estate holdings.
Fuld's Efforts Undermined
Fuld's efforts were undermined on Sept. 10, when Moody's
Investors Service put Lehman's credit rating on review for
downgrade, noting that the firm needed a ``strategic transaction
with a stronger financial partner'' to help support its rating.
Lehman's stock fell 50 percent on Thursday, Sept. 11 and Friday,
Sept. 12 and the collapse spread to Merrill, which has reported
four consecutive quarters of losses and was expected to lose
money again this quarter.
New York Federal Reserve President Timothy Geithner called a
meeting of Wall Street's top firms starting at the Fed's
downtown headquarters that began at 6 p.m. on Friday, with a
goal of helping ease a sale of Lehman, according to people
familiar with the situation.
Suitors Walk Away
The two banks most interested in Lehman, London-based Barclays
Plc and Charlotte, North Carolina-based Bank of America, balked
at a deal unless the government would protect it from any losses
on some of the hardest-to-value assets. The government, already
shaken by criticism of its actions to support Bear Stearns,
Fannie Mae and Freddie Mac, refused to budge and tried to
persuade the CEOs of the biggest Wall Street firms to pitch in
instead.
The talks lasted through the weekend, with groups of executives
breaking off into smaller groups to discuss options and teams of
traders examining positions at every major firm. Yesterday,
Barclays, the U.K.'s third-biggest bank, dropped out, deciding
it couldn't agree on a deal so quickly without some type of
protection from losses.
As hopes dimmed for salvaging Lehman, attention turned to the
future of Merrill, Lehman's bigger rival. That business, with
its 16,690 financial advisers and nearly half of fund manager
BlackRock Inc., was more attractive to Bank of America than
Lehman could be. Merrill CEO John Thain, persuaded by the
weekend's events that a deal was necessary to avoid a loss of
confidence and a fate similar to Lehman's, entered into
negotiations with Bank of America's Ken Lewis.
The liquidation of Lehman, last year's top underwriter of bonds
backed by mortgages, is an amplified version of investment bank
Drexel Burnham Lambert Inc., which filed for bankruptcy in 1990.
Drexel made its name financing corporate takeovers in the 1980s
using junk bonds pushed by Michael Milken.
Keeping the Talent
Maintaining the confidence of the markets is only one of the
challenges for an investment bank -- the other is retaining
employees, recalled Fred Joseph, Drexel's CEO from 1985 to 1990.
``It's an awfully good business, but the assets go down in the
elevator every night,'' said Joseph, 71. ``Despite the tough
times, the Street's so small, everybody wants the really good
guys.''
A key difference with Drexel is Lehman's central role in the
over-the-counter derivatives markets, which have ballooned to
$454 trillion since Drexel was in business. A default by Lehman
on its obligations in that market could cause chain reactions
throughout the markets that have never before seen a major
financial counterparty fail to honor its obligations.
``The implications of one of the `too big to fail' institutions
being allowed to fail is incredibly difficult to grasp, but
suffice to say that a huge number of firms and securities are
going to get affected,'' said Michael Auyeung, who manages about
$500 million as chief executive officer at Pacific Mutual Fund
Bhd. in Petaling Jaya, Malaysia. ``The reach of the carnage will
be global and system-wide.''
Lehman's collapse wipes out a company that had a market value of
$45.5 billion in February 2007. Merrill's sale to Bank of
America for $29 a share, while about a 70 percent premium to
Merrill's value on Friday, compares with the company's $86
billion market capitalization in January 2007.
``It's breathtaking that we've gone from five standalone firms
to two very quickly,'' said Roy Smith, a finance professor at
New York University's Stern School of Business and a former
partner at Goldman Sachs. ``It's certainly going to cause Wall
Street to rethink the strategy.''
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