Lehman and Merrill falls

The inevitable finally happened as Lehaman Brothers files for Chapter 11 bankruptcy protection. In another stunning development, iconic brokerage firm Merrill Lynch became the latest victim of the deepening sub-prime mortgage triggered financial crisis, as it announced selling itself to Bank of America for roughly $50 billion. Insurance giant American Insurance Group (AIG) appears set to follow suit, as it has sought a $40 billion lifeline from the Federal Reserve, without which the company may have only days to survive.

Lehman, a 158 year old firm, will be the largest failure of an investment bank since the collapse of Drexel Burnham Lambert 18 years ago. Because of the harsher treatment that federal bankruptcy law applies to financial-services firms, Lehman cannot hope to reorganize and survive.

Merrill Lynch, founded in 1914 and one of the first Wall Street firms to go public as early as 1971, has so far taken more than $45 billion in write downs on its mortgage investments. Merrill moved aggressively into the mortgage market and became one of the top issuers of investment vehicles linked to subprime mortgages and other risky forms of debt. It has been the largest brokerage house in America and its purchase will make Bank of America the biggest brokerage house and consumer banking franchise. Merrill’s brokers would be combined with Bank of America’s smaller group of wealth advisers into an entity called Merrill Lynch Wealth Management.

The crisis management has also gone into overdrive with a group of 10 banks that includes JPMorgan Chase, Goldman Sachs and Citigroup gathering a $70 billion fund to help ensure market liquidity by lending to those in trouble. Central Banks across the world have responded to the ripple effect on the global financial system by injecting fresh doses of liquidity to the credit starved markets. The European Central Bank distributed 30 billion euros to major banks, and the Bank of England issued £5 billion, or about $9 billion in loans. The Federal Reserve said it would accept a broader array of collateral, including stocks, in exchange for large loans to securities firms.

Barry Ritholtz has an excellent summary of the lessons learnt from the ongoing crisis. His concerns about the moral hazard unleashed by all these bailouts are very real, and the global and especially American financial market may take a long time to recover from it. If your company is big enough to bring down the entire financial system, then you have a license to throw caution to the winds in your investments and lendings! As they say, "If you owe $100 you have a problem, but if you owe $100 bn everyone else has a problem"!

With financial institutions falling like nine pins, there emerges an excellent opportunity for enterprising hedge funds - short the shares of these firms!