Wall Street has fretted that it does not know how to value many derivative assets because they trade so rarely. We are now about to find out, assuming Lehman begins a liquidation of assets.
- The Dow 30 at a Glance
That liquidation will likely result in wider credit spreads, as well as a mark down in assets at other brokers, which will further pressure capital ratios.
So we will now likely see:
--more rate cuts
--more banking consolidation--some financial institutions like JP Morgan and Bank of America will get stronger, other mid-size banks with exposure to real estate and weaker balance sheets will get weaker;
--more "boutique" banks that de-emphasize risks.
CNBC Special Report:
Despite all the gloom, there are several pieces of good news:
--the Fed has finally drawn a line on the "moral hazard" issue by refusing to backstop Lehman;
--interest rates are likely to come down;
--the dollar is still strengthening, despite the likelihood of lower rates;
--commodity prices are still dropping;
--there is still cash on the sidelines.
Most importantly, there are efforts being made to address the most crucial issue, the lack of capital and liquidity:
--the Fed has already announced an expansion of its emergency lending program for commercial and investment banks;
--the ECB has said they will also offer additional funds;
--a consortium of banks are offering a $70 billion borrowing facility to improve liquidity.
On the two big topics this morning: AIG and Bank of America/Merrill, there is some good news, and considerable risk.
AIG: The good news here is that AIG is not a brokerage firm: they have many assets they can sell to accomplish their capital needs. There are two serious problems:
1) they can't accomplish a sale immediately, that's why they need a bridge loan. It's not clear that the Fed would be willing to make a loan on the scale they need ($40 billion or so);
2) the lowered assets values associated with Lehman's liquidation will negatively impact securities similar to those held by AIG.
These two problems are why AIG is down almost 50 percent pre-open.
Bear in mind that losses from Hurricane Ike will also affect AIG, with estimates of total losses there of $8-$18 billion (those are total losses, not just AIG exposure).
Bank of America/Merrill Lynch. Bank of America buying Merrill Lynch for .8595 shares for each Merrill Lynch share, roughly $25 at this morning's prices. No one is quite sure how this price was derived.
There are many positives:
--significant costs savings (about $7 billion, 30 percent of Merrill's expense base);
--B of A's size increases by about one-fourth, and in the process they become a top-tier investment banker with a world-class brokerage firm, along with control of 49 percent of BlackRock;
--they will be able to distribute Merrill Lynch products through a dramatically increased pipeline--the BofA branch network.
We know the risks:
--the Countrywide integration is ongoing, and the Merrill deal only increases execution risk;
--Merrill's considerable risky assets have not gone away;
--BofA's own issues with loan losses.
This was a strong merger that would have made some sense even absent the current crisis, despite the fact that it was done under duress and for a price far lower than would have been considered even a few months ago.
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