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The 14-month old credit crisis is clearly in its most dramatic phase.  Last weekend, the U.S.government took over Fannie Mae (FNM) and Freddie Mac (FRE), in a transaction that essentially wiped out the common stockholders.  The ultimate fate of these two entities has not been determined, and the cost to U.S. taxpayers is unknown, but the Treasury's take-over of Fannie and Freddie, which own or guarantee over $5 trillion of mortgages, surely ranks as one of the most significant financial events in decades.

The events of this past weekend, while not as momentous, are perhaps more startling.  In the past 24 hours, Lehman Brothers (LEH), a major investment bank with a  158-year history, filed for bankruptcy after the U.S. government opted (thankfully!) to let a big institution fail rather than commit taxpayer funds to arrange another bailout of a fully private financial institution (as it did in the Bear Stearns (NYSE:BSC) transaction).

Moreover, Merrill Lynch (MER) and AIG (NYSE:AIG), the two other large financial firms in the eye of the financial hurricane, made major announcements yesterday. Merrill announced that it is being acquired by Bank of America (NYSE:BAC) at a nice premium over Friday's depressed closing price.  AIG announced that it is being forced to restructure and raise $40 billion of capital to shore up its balance sheet, which has been decimated as a resulted of insurance written against mortgage defaults.  AIG's stock is down nearly 50% this morning to $6.50 (versus a 52-week high of $70.13) after tumbling 45% last week.

Going into the weekend, the outcome Wall Street was expecting was a buyout of Lehman Brothers.  Instead, it got a Lehman bankruptcy, a buyout of Merrill and increased pressure on AIG.  These developments have intensified fears of a financial panic.  In early trading, the S&P 500 is down 30-50 points and is trading just above the major support level of 1200 reached in mid-July. 

The yield on the 10-year Treasury bond is down 20 basis points to 3.5% on flight-to-safety buying.  Oil prices are down another $5, and have broken below $100/barrel. The major volatility that we have seen in all asset markets in recent weeks appears to be accelerating in the short term. 

This week we will witness the repercussions of Lehman's bankruptcy filing.  Recall that when the Fed and the Treasury bailed out Bear Stearns in March, the action was justified as a necessary evil to avert major dislocations in the financial markets and the economy due to chain reactions in the derivatives markets and the potential for further destabilizing mark-downs in the prices of distressed assets. 

While there may be a short-term panic in the financial markets, it is difficult to see how the broad economy will be damaged by the collapse of a highly leveraged investment bank.  Lehman's balance sheet has assets with a stated value of $600 billion, against stockholders equity of $20 billion (30 to 1 leverage!).   As one of the analysts we follow put it:

"Would Microsoft stop selling software if Lehman collapsed? Would Intel stop selling computer chips? Would Exxon Mobil stop selling oil? Would people stop shopping at Wal-Mart? Would farmers stop buying fertilizer from Potash Corp. and tractors from John Deere?"

Thankfully, the Fed and Treasury realized the enormous "moral hazard" involved in using taxpayer funds to bail out private financial institutions and decided to let Lehman Brothers fail. We are optimistic that Lehman's bankruptcy will not have any lasting negative effects on the economy or the markets for that matter.  From our vantage point, the events we are witnessing are necessary, and ultimately healthy, steps to correct the excesses of the bubble in credit and Wall Street finance generally.

Source: Lehman's Collapse: Broader Economic Damage Unlikely