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Bloody Sunday: Wall Street Is Hit by Financial Tsunami

The U.S. financial system was badly shaken Sunday by the failure of Lehman Brothers , the surprise takeover of Merrill Lynch and big asset sales by major insurer American International Group.

AP

The developments indicate that chief executives on Wall Street and regulators in Washington are accepting that massive triage is necessary in the face of the 13-month old credit crisis and destructive U.S. housing bust.

"The U.S. financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey."It's a new financial world on the verge of a complete reorganization."

On Sunday, growing expectations that Lehman will become Wall Street's most high profile bankruptcy since junk bond specialist Drexel Burnham Lambert collapsed in 1990 sparked a sell-off in U.S. asset prices. Lehman's announced it was filing for bankruptcy midnight Sunday.

Both US stock futures and the dollar plunged in reaction to the turmoil on Wall Street.

Sunday's events signalled a transformation in the power structure on Wall Street with major banking groups like Bank of America ,which has agreed to buy Merrill for $50 billion,and JPMorgan Chase becoming more dominant.

Once Lehman and Merrill disappear, three of the top five U.S. investment banks would have dissolved or been bought inside six months. Bear Stearns was acquired in a fire sale by JPMorgan in March.

The focus early Sunday was on whether talks between regulators and Wall Street's top bankers would lead to the sale of Lehman, until recently the No. 4 U.S. investment bank.

THE FALL OF LEHMAN BROTHERS - A CNBC SPECIAL REPORT
THE FALL OF LEHMAN BROTHERS - A CNBC SPECIAL REPORT

Those talks faltered when Britain's Barclays, which had appeared to be front-runner to take over Lehman -- excluding its toxic mortgage-related assets -- said it had pulled out of the bidding.

That triggered expectations the investment bank was heading into bankruptcy and prompted a rare emergency trading session to allow Wall Street dealers in the $455 trillion derivatives market to reduce their exposure to the firm.

Within hours of Barclays withdrawal, Merrill agreed to be sold to Bank of America. And AIG , until recently the world's largest insurer by market value, was expected to sell off assets, including a profitable aircraft leasing arm.There were signs of attempts by banks and regulators to try to prop up market confidence.

To help provide liquidity, the Federal Reserve said it would accept a wider array of securities as collateral at its key borrowing windows.

"The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets," Fed Chairman Ben Bernanke said in a statement.

Banks Set up $70 Billion Borrowing Facility

Ten Wall Street banks have also agreed to set up a collateralized borrowing facility, and committed to fund for $7 billion each.

The banks are Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, and UBS. These banks have said they are committed to fund $7 billion each for a $70 billion collateralized borrowing facility.

The banks add that they are working together to assist in maximizing market liquidity through ongoing trading relationships, dealer credit terms and capital committed to markets. This will also facilitate the orderly resolution of OTC derivatives exposures between Lehman and its counterparties.

All ten banks say they all intend to use expanded federal reserve primary dealers credit facility this week. The banks say their actions reflect "extraordinary market environment".

Merrill, AIG and Washington Mutual, the biggest savings and loan institution -- which was the subject of conflicting reports Friday about whether it was in advanced talks for a sale to JPMorgan -- all face similar problems.

They have all held large amounts of real-estate related assets that have fallen sharply in value. Shares of all three lost more than one-third of their value last week. (Pimco's El-Erian discusses the financial fallout in the video).

The perception is that the losses they have disclosed are far from enough, and that they will have difficulty in raising new capital.

One of the catalysts for this weekend's events was the stance of U.S. Treasury Secretary Henry Paulson. He was strongly opposed to using government money in any deal aimed at resolving the Lehman crisis.

The lack of such government guarantees was the main reason Barclays decided to exit the negotiations to buy Lehman, according to a person familiar with the matter.

Emergency Sunday Trading Session

An emergency trading session was set between dealers with Lehman Brothers counterparty risk involved credit, equity, rates, foreign exchange and commodity derivatives, the International Swaps and Derivatives Association said.

"This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today's highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, CEO of Pimco, the world's biggest bond fund.

Market sources said the special session was initiated by the Federal Reserve, with the aim of reducing risk associated with a potential bankruptcy filing by Lehman Brothers.

"Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time Sunday," said the statement. "If there is no filing, the trades cease to exist."

The special session "is a way to offset the risk between the remaining large banks and insurance companies and fund managers prior to the markets opening in Asia," said Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas.

Grant is expecting a turbulent session when the U.S. markets reopen for business on Monday.

"The market is going to be spooked. People will be fearful and no one outside a very small group of people knows what Lehman going into liquidation will mean."

Lehman's bankruptcy marks an ignominious end to a once-proud firm, founded by cotton-trading German immigrants 158 years ago. It would also badly tarnish the reputation of CEO Dick Fuld, who has insisted that his firm could work through its problems to survive as an independent entity.

Former Federal Reserve Chairman Alan Greenspan said Sunday he suspected "we will see other major financial firms fail," but added that this did not need to be a problem. "It depends on how it is handled and how the liquidations take place," Greenspan told the ABC program "This Week." "And indeed we shouldn't try to protect every single institution.

The ordinary course of financial change has winners and losers." Hundreds of Lehman employees went into the office on Sunday to clear desks and pack personal belongings, according to an employee.

Many even opted to say their farewells with one last office soiree. "We are having pizza and beer," said one Lehman employee, who declined to be identified.

The news on Sunday was a huge hit to an already wounded financial jobs market, and a dent to New York's claim to be the pre-eminent world financial center.

Headhunters and consultants said the talent-flush U.S. market -- which has shed more than 100,000 financial-sector jobs this year -- must now brace for up to 50,000 more.

— Reuters contributed to this story

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