US stocks to open down 2-3% on news of Lehman bankruptcy
Stock futures reacted poorly to the news that Lehman would not be purchased either by Barclays Bank or Bank of America and would instead enter bankruptcy. In a surprise development, Bank of America announced instead that it would purchase Merrill Lynch. Investors had hoped that the US Treasury would enable the sale of Lehman by guaranteeing a certain level of losses. In March, the sale of Bear Stearns to JP Morgan was facilitated by a $29 billion guarantee. However, the Treasury apparently felt that the risk of a Lehman bankruptcy was not the same as Bear Stearns, so elected not to provide the guarantee.
Lehman, Merrill Lynch follow Fannie Mae, Freddie Mac into History Books
How could these firms, with histories running back 153 years in the case of Lehman, all disappear in under a week? Like many hedge funds that disappeared in recent weeks, these firms followed the "aggressively leveraged one-way bet" strategy. On the assumption that real estate prices would rise indefinitely, these firms borrowed cash to buy mortgage based loans. In a rising real estate market, outsized profits could be obtained; in a falling real estate market, however, capital is vaporized. By last week, losses for Fannie Mae, Freddie Mac and Lehman exceeded their capital base. Merrill Lynch is in slightly better shape, but with real estate prices projected to fall through 2009, management elected to sell now rather than follow Lehman into bankruptcy.
Fannie Mae and Freddie Mac are in the business of buying loans, but how did Lehman and Merrill end up in similar circumstances. Over the last decade, the core businesses of broker-dealers became ever less profitable. Commission income from stock trading is negligible and copy-catting of investments products drove the margins of most offerings to zero. Many broker-dealers boosted the capital allocated to proprietary trading, including, unfortunately, the mortgage groups. Goldman Sachs and Morgan Stanley are in similar circumstances, but, so far, have avoided the losses that took out Bear Stearns, Lehman and Merrill. The big five is now the big two.