NEW YORK -- Six months of pent-up anxiety over the fate of the financial system exploded into chaos on Wall Street this weekend, as the deepening credit crunch apparently put a second major Wall Street firm — Lehman Bros. — out of business and had top government officials and bankers scrambling to avert a more serious crisis.
Early Monday, Lehman leh announced plans to file for Chapter 11 bankruptcy protection.
The announce came at the end of a wild weekend, full of intense negotiations at the offices of the Federal Reserve Bank of New York, one that drove home just how difficult it will be for the nation's banks and financial institutions to return to health.
Earlier in the weekend, Lehman, one of Wall Street's oldest and most-storied investment banks that had run into trouble by investing too riskily in real estate, failed to strike a deal with a number of potential bidders.
Barclays, Britain's third-biggest bank, was the last of the potential white knights to nix a deal.
The failure to get a Lehman deal was due largely to the federal government's refusal to provide interested buyers such as Barclays with the kind of support that JPMorgan Chase received when it bought troubled investment bank Bear Stearns.
In that controversial deal, the Fed extended what amounted to a $30 billion loan to JPMorgan that reduced some of the risk. This time, the Fed put none of taxpayers' money on the line.
Late Sunday, Bank of America bac announced that it would acquire Merrill Lynch mer for $50 billion in an all-stock deal.
Plus, insurance giant AIG aig was reported by Bloomberg News to be seeking capital from buyout firms Kohlberg Kravis Roberts and J.C. Flowers. Bloomberg cited an unnamed source. Shares of both Merrill and AIG tumbled Friday as investors speculated on the next potential victims of the spreading credit crunch.
USA TODAY was unable to independently confirm that report.
"We are in a hysteria," says Richard Bove, banking analyst at Ladenburg Thalmann.
And that hysteria is creating concerns that today's market action may be turbulent.
The simple fact that the Lehman rescue didn't occur "will send shivers down the spines of investors," says Jack Ablin, chief investment officer of Harris Private Bank.
How severe is the crisis? Former Federal Reserve chairman Alan Greenspan, appearing on This Week with George Stephanopoulos, said: "It's a once-in-a-century type of financial crisis." Greenspan said he expects other financial institutions to fail.
The attempted rescue plan for Lehman — along with wider discussions with many banking leaders about shoring up the financial system — was debated in New York over the weekend in high-level meetings that began Friday and included top government officials from the Federal Reserve, Treasury and the Securities and Exchange Commission, as well as top executives from all of Wall Street's top investment banks.
The biggest stumbling block was the government's reluctance to contribute financially to a rescue package. Potential suitors wanted the government to protect them against potential losses surrounding Lehman's so-called bad bank assets. These assets include toxic real estate securities, which have a face value of about $77 billion, and about $53 billion if write-offs are taken into account.
Buyers were comfortable with buying Lehman's so-called good assets, such as its investment management division and equities business.
Questions about Lehman's ability to survive have been swirling ever since a bank run on Bear Stearns led to its demise and government-engineered shotgun marriage to JPMorgan Chase in mid-March. Lehman was deemed vulnerable because it was the smallest of the major investment banks still standing and because it had massive investments in troubled real estate and mortgage-related securities.
Lehman's hopes of remaining independent were squashed last week when talks with a sovereign wealth fund from South Korea, which was considering injecting much-needed capital into Lehman, broke down.
Lehman's hopes were dashed for good when Wall Street gave a thumbs down to a plan the firm rolled out Wednesday to try to fix its problems. The plan, which investors thought was too late, included selling a majority stake in its asset management division, slashing its dividends and spinning off toxic real estate assets.
Lehman's troubles morphed into a crisis late last week due in large part to the sharp decline of its stock price and a sharp increase in its borrowing costs.
The stock plunged 77% last week to $3.65, and its borrowing costs ballooned to 8 full percentage points above a comparable government bond. The combination of higher costs to access capital, coupled with the loss of collateral value of its stock, put Lehman in a vulnerable position.
Investors were also afraid Lehman would announce bigger losses in the quarters ahead, beyond the nearly $7 billion in write-downs it's suffered the past two quarters.
"It was a run on confidence," says Chris Whalen, managing director at Institutional Risk Analytics.
Whalen says Lehman was being hurt by fears that other financial companies will cease doing business with it.
The endgame for Lehman comes after a turbulent week on Wall Street, where the spotlight on troubled financial firms spread to a wider number of players. Jittery investors fear that the steep stock price declines in the firms could make it more difficult for them to raise capital.
It also follows on the heels of the Treasury Department's historic seizure last week of the nation's two mortgage giants, Freddie Mac and Fannie Mae. Both were reeling from bad housing investments caused by falling home prices and failed mortgages.
In that bailout, the Treasury Department committed to injecting up to $200 billion into the financially troubled giants in an effort to help stabilize the sagging real estate market. The government's plan is designed to help keep the cash spigot open for mortgages and push mortgage rates lower.
Despite massive government intervention over the past six months, fears of credit problems infecting the broader financial system are still palpable.
Wall Street is still having problems valuing toxic real estate assets, which makes big investors leery of putting more capital at risk and investing in troubled financial companies.
Financial institutions around the globe have already booked losses totaling more than $473 billion, according to Bespoke Investment Group. And while they have been able to raise more than $350 billion to offset those losses, it is getting more and more difficult for battered institutions to raise much-needed cash, notes Paul Hickey of Bespoke.
The government's decision not to put taxpayer money at risk was a departure from its prior interventions in the crisis. Debate has been raging on Wall Street as to which institutions are "too big too fail."
But in the case of Lehman, Treasury Secretary Henry Paulson has made it clear that the government did not want to use taxpayer money to rescue the firm.
Unlike in the case of Bear Stearns, the market has had ample time to prepare for troubles at Lehman. What's more, unlike Bear, Lehman has direct access to short-term funds from the Fed. When it announced the Bear deal, the Fed also created a special facility that enables investment banks for the first time to access the Fed's cash for short-term needs.
Fallout and confidence
Many critics of early government bailouts say it would be a mistake for the government to send the message that it will bail out everyone. Anthony Sabino, a law and business professor at St. Johns University, says the bailouts must stop. "The government is keeping the free in free markets," he says. "And free means free to succeed and free to fail.
"If you bail out Lehman, then you have to bail out everyone. Who's next? Does it go beyond the next financial institution? The automakers? Do you bail out Wendy's because it's not selling more burgers than Burger King?"
Critics of CEO Richard Fuld's strategy to save Lehman say he waited too long to strike a deal with a deep-pocketed suitor.
Because Lehman's banking business is geared mainly to institutional investors and not mom-and-pop investors depositing money in the bank, its fallout on Main Street is likely to be more of a confidence issue.
But the messier the company's death, the greater the effect it will have on Wall Street and Main Street.
What worries federal authorities is not the collapse of Lehman, but the effects of its possible demise on the rest of the financial system.
"They're worried about the daisy chain," says Seattle money manager William Fleckenstein. "They're worried about the problems that Lehman might create for someone who did business with Lehman."
One type of ordinary American it does affect is Lehman's roughly 25,000 employees. They got a sizable chunk of their compensation in Lehman stock. Employees reportedly own up to 25% of the shares, which on Friday closed 95% off their 52-week high. That means employees have suffered losses of $11 billion since Nov. 14, when shares traded at $67.73, their highest level in the past year.