First Bear, Then Fannie and Freddie ... Is Lehman Next?

Sept. 9, 2008 — -- Worries about another major investment bank failure escalated Tuesday as shares in Lehman Brothers, the country's fourth largest brokerage firm, plummeted more than 40 percent.

Concerns about Lehman helped erase most of the rebound that Wall Street saw on Monday, after the Dow Jones industrial average surged more than 289 points on news that the federal government was bailing out ailing mortgage giants Fannie Mae and Freddie Mac.

On Tuesday, the Dow plunged some 280 points while the share price for Lehman Brothers Holdings Inc. dropped below $8 as investors worried about whether Lehman would be able to cover the losses it continues to sustain from its mortgage holdings.

"There's a strong suspicion in the marketplace that a lot of their assets, which are related to residential and commercial mortgages, are not worth what they're being carried on the balance sheet for," said Lawrence J. White, an economics professor at New York University's Stern School of Business. "One of these days, Lehman is going to have to recognize that."

White said that if Lehman doesn't resolve its asset problems, the government might eventually step in to shore up the bank like it did Bear Stearns. In March, the failing investment bank was purchased by JP Morgan in a $240 million deal backed by the federal government.

A Lehman spokesman declined to comment.

Lehman this year posted a second-quarter loss of nearly $3 billion. Analysts expect to see the bank report more losses when it releases its third-quarter earnings report next week.

But not everyone agrees that Lehman could be subject to a Bear Stearns-style treatment. Bear's bailout happened under "very narrow circumstances," said Peter Wallison, a senior fellow at the American Enterprise Institute, a conservative think tank.

At the time of the Bear Stearns rescue, he said, many major financial institutions were considered to be instable. If the government hadn't intervened and Bear Stearns had been allowed to fail, he said, there would have been a run on banks around the world.

Since then, Wallison said, financial institutions have made adjustments that would allow them to weather another bank failure. If Lehman did fail, he said, the same kind of domino effect would be unlikely and government intervention wouldn't be as necessary.

"I don't see a real danger in the same kind of panicky run on financial institutions," he said.

Lehman's Next Move

Lehman, meanwhile, has reportedly been considering moves to shore up its balance sheet without the U.S. government's help.

The bank had reportedly been in talks with South Korea's Korea Development Bank about the bank investing in Lehman, but hopes for a deal were dampened on Monday after a South Korean regulator urged KDB to be cautious about any such investment.

Meanwhile, there has been speculation that Lehman will reach for other lifelines, including the idea of splitting into a "good bank" and "bad bank": concentrating all of Lehman's troubled assets into a separate entity -- the "bad bank" -- that would focus solely on mitigating its losses while Lehman's healthy assets would remain in the "good bank."

White said he doesn't see that solution working out for Lehman because the bank simply doesn't have enough capital to add to a "bad bank."

He said that Lehman's best bet is to raise capital by selling Neuberger Berman, a profitable division of Lehman that manages mutual funds and private wealth.

If Lehman doesn't settle on a solution to its asset woes by the time of its third-quarter earnings report, the bank could start seeing some pressure to act from the Federal Reserve, which could threaten to stop lending money to the bank. After the Bear Stearns collapse, the Federal Reserve opened its discount lending window, once available only to commercial banks, to investment banks.

"[There are] going to be some big losses that are likely going to be announced. It might be the case that the Fed would say at that point, 'Gee, maybe we don't want to continue lending to you,'" White said.

It's unclear, however, how reliant Lehman will be on Fed loans in the future. A person familiar with the situation said that the last time Lehman borrowed from the Fed was in April and that it quickly repaid the loan.

That's a good sign for Lehman, Wallison said.

"That would suggest that they're able to finance themselves in the market," he said.

More Bank Troubles

Experts say that small government bailouts are taking place frequently these days as the Federal Deposit Insurance Corp. takes control of failing small- to midsize commercial banks that have also been hit by the nation's mortgage meltdown.

But large banks aren't off the hook either: White said that Washington Mutual, which provided more than $150 billion in home loans in 2006, might be vulnerable to an FDIC takeover.

In July, the bank reported a $3.3 billion loss for the second quarter of the year and Monday announced it was replacing its longtime CEO.

"This is a financially troubled institution right now," White said.

The bank did not immediately return a call for comment but in a statement Monday new chief executive Alan H. Fishman said he was intent on "returning the company to profitability as quickly as possible."

The FDIC, which insures deposits of up to $100,000 at commercial banks, has taken control of 11 banks this year, including, most recently, Silver State Bank in Henderson, Nev. An additional 117 unnamed banks are on the corporation's "watch list."

But some question whether the FDIC might need a bailout of sorts.

The FDIC's insurance trust fund is supported by fees charged to U.S. banks. Mark Zandi, chief economist at Moody's Economy.com, said that the FDIC will raise its fees later this year but the increase might not be enough.

"If there are too many bank failures, it could overwhelm the FDIC's financial resources to digest those failures," Zandi said.

In that case, he said, the corporation would replenish its insurance fund with a cash infusion from the Treasury Department.

A Bailout for Car Companies?

Outside the financial sector, experts say that among the most obvious prospective government bailouts is one for the U.S. auto industry.

According to published reports, the industry will lobby Congress this week for as much as $50 billion in low-cost, government-backed loans.

Zandi said that one of the arguments in support of government aid is that auto companies, which have seen consecutive quarters of sagging sales, could use the loans "to tide themselves over until business improves."

There is precedent for an auto-industry bailout: In 1980, the federal government backed $1.5 billion in loans for Chrysler, helping the company to avoid bankruptcy.

But it's unclear whether the federal government would approve a loan package for the auto industry this year. Some argue that it would be too expensive while others say that political motivations -- Michigan, a major auto industry state, is also expected to be a swing state in the presidential election -- will prompt leaders from both parties to embrace the proposal.

Richard A. D'Aveni, a professor of strategic management at the Tuck School of Business at Dartmouth College, said the major automakers might be better off going bankrupt instead of asking for government help.

"They need a chance to clear the decks and start over again," he said.