Pain Continues on Wall Street as Lehman Goes Bankrupt, and Merrill Sold to BofA

Focus now shifts to brewing crisis at both AIG and Washington Mutual.

September 15, 2008, 12:59 PM

Sept. 15, 2008— -- Wall Street had its worst day more than six years after hectic and historic weekend brought the quick demise of two of America's oldest and best-known investment banks.

Stocks dropped dramatically -- with the Dow closing down 504.48 points -- after 158-year-old brokerage firm Lehman Brothers filed for bankruptcy this morning and the other Wall Street stalwart, Merrill Lynch, was sold to Bank of America for $50 billion.

The Dow's fall of 4.42 percent today was the worst single day for the index since July of 2002. The other major indexes also had a miserable day with the NASDAQ falling 3.6 percent and the S&P 500 falling 4.69 percent.

But it could have been much worse. Given the turmoil in the financial world, today could have easily been a repeat of Black Monday, the day in October 1987 when the Dow lost 22.6 percent of its value. Government and Wall Street leaders worked through the weekend to try to avoid another crash.

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Lehman Brothers didn't fare as well. After filing for bankruptcy, its stock lost virtually all of its remaining value, falling 94.3 percent today. Shares of the company which were trading around 65 just a year ago, closed today at 0.21.

Merrill Lynch's stock was up throughout the day but ended virtually unchanged.

The downfall of these two titans shows just how far and deep the financial crisis has spread and that nobody -- no matter how big and powerful he or she is -- is immune from the turmoil.

Focus on Wall Street has now shifted to American International Group, or AIG, the world's largest insurance company, which has now gone to the government for emergency funds as it struggles to stay alive.

Also, many analysts are worried about the health of Washington Mutual, the country's largest savings and loan. The company's stock has plummeted as investors worry that the bank has too many bad mortgages and loans on its books.

AIG's stock lost more than 60 percent of its value today and Washington Mutual saw its shares plummet 26.7 percent.

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No Government Bailout

From the start of this weekend's discussions, the government made it clear that it was drawing a line in the sand about taxpayer-backed bailouts. In March, the Bush administration supported -- and gave financial backing to -- the sale of Bear Stearns to J.P.Morgan Chase. And last week it bailed out mortgage giants Fannie Mae and Freddie Mac.

But when it came to Lehman, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke were explicit at the start of the weekend: There is no political will for yet another government bailout.

Speaking at the White House this afternoon, Paulson said that it will be some time until we see the bottom of the financial crisis.

But he remained confident that the situation would improve "in months as opposed to years."

Paulson said he "never once" considered it appropriate to use taxpayer dollars to help save Lehman, which he considered a different situation than Bear Stearns.

"I don't ever take it lightly to put the taxpayer on the line to protect an institution," Paulson said.

Now, he said, the market has to "work off the past excesses."

President Bush that "in the short run, adjustments in the financial markets can be painful" but tried to calm the news today saying in the long run he is confident the markets are "flexible and resilient."

"I know Americans are concerned about the adjustments that are taking place in our financial markets," Bush said in the Rose Garden. "At the White House and throughout my administration we're focused on them, and we're working to reduce disruptions and minimize the impact of these financial market developments on the broader economy."

Wall Street Optimism?

The new government message -- that investors had to live with their own decisions and risks -- left some on Wall Street happy and even a bit optimistic despite the groundswell actions.

Throughout the weekend, Lehman was courted by Bank of America and British bank Barclays. But both backed down without the government's protection and after further reviewing their options.

That left Lehman with only one other option: enter bankruptcy before the market opened. This morning Lehman did just that, filing for Chapter 11 bankruptcy in the Southern District of New York. The company plans to continue operations as the court liquidates its assets.

To further try to shore up the financial system, 10 banks and securities firms independently have set up a $70 billion fund to provide necessary money to help struggling financial firms that threaten stock markets around the globe. Each bank will contribute $7 billion and loans to participating banks can be up to one-third of the total fund size.

A New Banking Superpower

Bank of America didn't just fade into the sidelines after walking away from saving Lehman. Instead, the giant bank set its sights on Merrill Lynch. In a rushed deal, scraped together in just one weekend, Bank of America ended up purchasing Merrill Lynch in an all-stock transaction worth about $50 billion.

The deal was a preventive measure, aiming at shoring up Merrill and stripping any doubt about the firm's heath or future.

Ken Lewis, CEO of Bank of America, said there was no pressure from regulators to make the deal. Lewis also said that Merrill would have been able to continue independently but that his bank decided to act before somebody else decided to make a bid for Merrill.

"As we weighted everything we said it is better to seize on this opportunity as we see it at the moment as opposed to trying to catch the very bottom and possibly not catching it at all," Lewis said during a conference call this morning.

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Bank of America has more deposits than any other U.S. bank, and Merrill is the world's largest brokerage. Together, they will form a massive banking empire, offering a wide range of products and challenging Citigroup's dominance as king of the U.S. banking sector.

The demise of Bear, Lehman and Merrill also leaves just J.P.Morgan Chase and Goldman Sachs as the two remaining independent Wall Street investment banks.

The Lurking Financial Storm

The nation's financial turmoil extends well beyond Wall Street, and all eyes are now on insurance giant AIG.

Like nearly every other corner of the economy, AIG is also suffering from the subprime housing meltdown. It sold numerous contracts insuring others against subprime losses. When those losses became a reality, AIG had to pay out more than expected.

The company reported losses of more than $13 billion for the first half of the year. Its stock has sunk nearly 80 percent since January.

To stay afloat, the company is looking for $40 billion in emergency funds, possibly from the Federal Reserve, and plans to sell off some assets. The insurer has already raised $20 billion in fresh capital this year.

All of this is aimed at preventing a credit-rating downgrade that would make it more costly to borrow and only compound the already-weakened firm's health.

Is Your Savings Account Safe?

It has not been a good year for banks. So far, 11 banks have failed and had to be taken over by the Federal Deposit Insurance Corp., or FDIC, the largest being IndyMac.

To put that in perspective, there are nearly 8,500 banks nationwide covered by the FDIC.

But all it takes is one big failure to throw the system into turmoil. So far -- with the exception of IndyMac -- this year's failures have been small, regional banks with minimal impact on the overall economy.

Now, there is concern about the future of Washington Mutual, which holds many mortgages that are expected to fail. The largest savings and loan has seen a doubling of defaults and has many outstanding adjustable-rate mortgages that are due to reset to a higher, harder-to-pay rate shortly.

In July, the bank reported a $3.3 billion loss for the second quarter. Since April, the bank's share price has plummeted about 75 percent from $13.15 to around $2 today.

If Washington Mutual goes under, most customers would be protected by the FDIC insurance. But such a failure could wipe out the remaining balance in the bank-funded FDIC insurance pot. If that were to happen, the FDIC would turn to the U.S. Treasury for more cash to protect depositors. Individuals with money in troubled banks would, for the most part, be safe but taxpayers could end up footing the bill to protect those deposits.

Bank Deposit Insurance

The FDIC protects deposit accounts including checking and savings accounts, money market deposit accounts and certificates of deposit up to the federal limit. The insurance does not cover products such as stocks, bonds or mutual funds, even if they are sold by your bank.

The basic insurance protects up to $100,000 in deposits at each institution for each kind of ownership category. That means one individual could be insured for up to $100,000 for a single account and another $100,000 in a joint account with a spouse or somebody else.

There is also a separate $250,000 insurance limit for various kinds of retirement accounts, including IRAs, Section 457 plans and Keogh plans.

The kind of account or bank branch makes no difference when calculating the insurance limit. The insured amount is not doubled by opening both a checking and savings account at a single bank or opening accounts at separate branches of the same bank.