Lehman, Merrill: What We Are Likely To See On Street

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.

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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:

--tighter credit

--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.

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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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