No Bailout for Lehman: Fed Awakens to Bond Market Crash Risk

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 |  About: Lehman Brothers Holdings Inc. (LEH)
by: Nadeem Walayat

My commentary on Friday closed with expectations that the weekend would see the world's formerly fourth largest investment bank, Lehman's Brothers (LEH), taken over by one or a consortium of bidders at mere peanuts of its former valuation, further sweetened by a healthy subsidy from the US government / central bank.

However, the noises emanating from Hank Paulson at the US Treasury department over the weekend were of having drawn a line against an effective bailout of the bankrupt investment bank;  this will not live up to bidder expectations of providing tens of billions of tax payers' money so as to enable a relatively risk free takeover by other banks. This therefore results in suitors such as Barclays in advanced talks, declaring their withdrawal from a possible weekend bid for the bank and indicating that Lehman's is now heading directly towards bankruptcy (Editor's note: See updates on LEH here).

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Lehman's, which survived the 1929 crash and September 11th (having offices in the World Trade Center), was taken down by its exposure to Tulip backed securities through huge positions in the over-the-counter derivatives market at huge leverage. The bank has been teetering on the brink since March of this year, following Bear Stearns' (NYSE:BSC) collapse. Its decimated stock price has lost some 94% of its value, reflecting the bank's true financial state as it prepares to disappear into the history books.

However, the bank is not alone, as competing banks righacross the globe have their own derivatives and tulip backed black holes to contend with, comprising of assets originally booked at several hundreds of billions with true real market valuations of perhaps less than 30%; therefore, the stream of continuing huge losses amongst virtually all large financial institutions on a quarter to quarter basis are claiming more bankruptcies in the future.

US Treasury Drawing A Line?

After the huge unprecedented bailout and de facto nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), which effectively saw the US take on and give Treasury Bond status to $5 trillion of Fannie and Freddie debt so as to prevent foreign investor panic; in the process devaluing the whole US Treasury Bond market with the likelihood that the eventual losses to the tax payer would be far above the $25 billion indicated at the time, using the UK Northern Rock example, implying losses of as high as $500 billions. In the interests of self preservation, the US Treasury (effectively) said "NO, we are NOT going to risk the collapse of the US Treasury Bond market as foreign investors reappraise the credit worthiness of of US Treasury Bonds and therefore the US dollar in the face of a stream of bailouts of $30+billion dollars per week!"

However, this decision would not have been taken lightly, as it now leaves the financial markets facing a huge crisis due to Lehman being in default on its derivatives exposures, which impacts its counter parties. Lehman's exposure is put at over $200 billion, which now risks a cascade of failures rippling throughout the financial markets as the financial system adjusts to the increased risk of default amongst Lehman's counter parties.

Is This The End Of Bailouts?

I doubt it, as the apparent action NOT to bailout Lehman's is actually a panic move; under normal circumstances, the US Treasury and Fed WOULD bailout Lehman, but in the current climate, it is more likely that the US government will have to start bailing out other distressed industries in some shape or form, such as airlines, insurers and auto manufacturers, though probably not going so far as to nationalize them but rather to make huge loans available to corporations, much as the Japanese government did during the early 1990s, which resulted in Japan's Great Depression.

It is already being reported that Bank of America (NYSE:BAC) is eagerly sniffing around Merrill Lynch (MER) as a better candidate to takeover following Lehman's bankruptcy; will they get a sweetener form the US Fed? Despite announcements of no tax payers money, they probably will. (Editor's note: See updates on MER and BAC here).

Whilst the focus is on the US, the bailouts and unprecedented loans being made available to financial intuitions is not just limited to the US Fed. Central banks  across the globe will be flooding the markets Monday in an attempt to prevent a cascade of failures amongst banks that have already lost their capital bases over the last 12 months and therefore are teetering over the edge.

Meanwhile the architect of the whole crisis, through a series of blunders which includes cutting and keeping US interest rates at 1% for several years and therefore igniting the derivatives bubble as investors and financial institutions took on far more risk so as to generate returns, was again doing the rounds on US media such as the ABC network, stating

We will see other major financial firms fail, but it did not need to be a problem. It depends on how it is handled and how the liquidations take place, And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers.

What Does This Mean For Investments?

The short-term response will be an immediate bloodbath on the equity markets Monday morning; with Asian markets already sharply lower in the order of 4%, will we witness a crash? Probably a crashette in the region of 4 to 5% , that more importantly threatens a trend towards a possible break of the July lows right across the world's stock markets. Once those support levels go, then that will signal the NEXT LEG of the BEAR MARKET, as both investors and deleveraging distressed financials continue to liquidate assets in the face of increased counter party risk and potential losses.

Expect scared money to flow into traditional safe havens such as gold and precious metals; however, the problem with the US Dollar as a safe haven is the risks associated by a potential stream of bailouts; nevertheless, as the world's other economies continue to crumble, the US Dollar will be seen as a relative safe haven of sorts.

Summary

In conclusion, we are witnessing panic moves by the US government and world  central banks on literally an hourly basis in the face of a potential wave of bank failures; as I have pointed out several times over the last 6 months, most of the big western worlds banks are bankrupt, insolvent, and the only thing thing that will keep them afloat is a flood of taxpayer money with all of the economic consequences associated with running huge budget deficits at the same time as the credit markets contract, which implies economic depression.

Update:

  • Lehman said it intends to file for protection under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York.
  • Bank of America buys Merrill Lynch for $29 a share at a value of $50 billion. As Merrill rushed to prevent itself following Lehman's path to bankruptcy.