The big news this weekend is that the saga of Lehman Brothers seems to be coming to a head. The federal government is trying to rescue the company, but there are no buyers. The only potential suitor for Lehman Brothers, Bank of America, pulled out of negotiations and purchased Merrill Lynch instead. But what does this mean exactly and why is it big news?
Lehman Brother is one of the top 10 brokerage firms in the nation. Their company provides trading services, wealth management and investment banking services. Basically, from a consumer’s standpoint, unless you had a few million dollars or more in cash you wanted a financial adviser to manage, you probably would not have heard of their company before.
Previously, Lehman Brothers owned BNC Mortgage. BNC specialized in lending money to not-so-qualified borrowers who wanted to purchase a home. These borrowers who may have had a low credit score, previous bankruptcies, or posed a high-risk of not being able to pay back the mortgage (default) were considered sub-prime borrowers. Because sub-prime borrowers were riskier to lend money to, lenders, like BNC, charged a higher rate of interest to compensate for the risk.
In a nutshell, these lenders would spread out their risk by not holding onto these mortgages. Instead, they packaged and sold these mortgages on the market (auction-rate securities/secondary market) to investors who would take the risk. Flush with the money of the investors who just bought the mortgages from the lender, BNC and others would then lend more money to more high-risk borrowers. Thus the vicious cycle continued.
A little over a year ago, these investors got nervous and stopped buying these mortgages from the lenders. Investors saw that these sub-prime borrowers were starting to default because of various reasons (slowing economy, loss of job, etc). With the money well drying up and with more borrowers unable to pay back their mortgage, lenders were stuck in the middle. With no more money to lend, and with mounting losses, lenders could not survive.
This lead to Lehman Brother’s announcement on August 22, 2007, that the company would close their BNC Mortgage division in order to try and stop their losses from continuing. In the coming year, Lehman revealed more losses from the then-shuttered BNC. Some rumors that speculated on Wall Street stated that the company had a much higher exposure to sub-prime mortgages than previous thought. In other words, Lehman could have been holding onto too many of their sub-prime mortgages or may not have been able to find investors to buy those mortgages.
Fast forward to last Wednesday (September 10, 2008), Lehman Brothers announced a $4 billion third quarter loss, bring their total loss for the year up to $6 billion. Because of their free-fall from profitability, the company pushed to sell its investment management business, or the company entirely, in order to slow down the losses. As the week continued, speculation on Wall Street ran rampant as many people were starting to anticipate the demise of Lehman Brothers
This past Friday (September 12, 2008), the Federal Reserve, Treasury Department, and several Wall Street banks met to try and rescue Lehman. Initially, the Feds hoped that either Bank of America or Britian’s Barclays Plc would be interested in purchasing the troubled brokerage firm. On Saturday (September 13, 2008), Barclays pulled out of negotiations. Today, (September 14, 2008), Bank of America announced that it would purchase Merrill Lynch instead. Merrill, although in financial trouble of its own, was better off financially (for the time-being) than Lehman.
This morning, (Sunday, September 14, 2008), the International Swap and Derivative Association announced that it would hold a rare Sunday trading session to help spread out the risk of traders selling off their derivatives (definition of derivatives) in Lehman Brothers all on Monday. Earlier this evening (Sunday, September 14, 2008), BBC News published a story confirming the inevitable: “If no new financing comes before Wall Street opens (Monday), it (Lehman Brothers) will have to seek “Chapter 11” bankruptcy protection.”
In the same story, the BBC confirmed that a group of 10 investment banks would place $70 billion into a loan program to help ease the credit shortage and to help soften the blow of each failing bank.
About two hours ago, Lehman Brothers announced they would be filing for Chapter 11 bankruptcy. Ending the life of yet another Wall Street Powerhouse. The Associate Press has reported that Lehman Brother employees are in their New York Times Square office, cleaning out their offices in anticipation of an announcement of the company shutting down Monday morning.
So where does that leave us tonight? If you’re a Lehman Brother’s employee, you may not have a job tomorrow. If you’re a Lehman Brother’s shareholder, your holdings in the company are just about worthless come opening bell Monday morning. Ordinarily, we’d be able to gauge how the US stock market would react by looking at the Asian markets (which are 12 hours ahead in time), but it is a holiday in Asia today and most markets are closed.
If you’re not related to any of this at all, this might just make you even more leery of the politicos saying that the economy is sound. We’re facing a crisis in our economy that will (note that I’m not saying might) ripple through the global economy. We’ll probably see a huge drop in all of the major indices tomorrow morning. Going forward, the severity of the situation depends on whether more banks and brokerage firms fail from this point forward.