STAFF NEWS & ANALYSIS
Lehman Brothers Faces Failure, While Merrill Lynch Is Bought
By Staff News & Analysis - September 16, 2008

The ruptured U.S. financial system was facing an unprecedented shakeup on Sunday that could lead to the failure of Lehman Brothers, the takeover of Merrill Lynch & Co Inc and big asset sales by big insurer American International Group. The developments may indicate Wall Street and Washington are accepting that massive triage is necessary in the face of the 13-month old credit crisis and destructive U.S. housing bust. "The U.S. financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey. "It's a new financial world on the verge of a complete reorganization." The focus on Sunday had initially been on whether talks between regulators and Wall Street's top bankers could lead to the sale of Lehman, which until recently was the fourth-largest U.S. investment bank. However, those talks faltered when Britain's Barclays Plc, which had appeared to be front-runner to take over Lehman — excluding its toxic mortgage-related assets — said it had pulled out of the bidding. – Reuters

Dominant Social Theme: Some win, some lose – and Wall Street will continue.

Free-Market Analysis: Because Wall Street is in such flux, this first article will focus on the proverbial "big picture." (That's why you read The Bell after all, isn't it?) In fact, whether firm X is purchased, or firm Y is "saved," is kind of beside the point at this juncture. What is really going on is that the real face of America's Wall Street is showing now. And that is the face of an extraordinary consolidation led not by Wall Street itself but by central banking and Treasury regulators. The fiction that Wall Street is a "capitalistic" entity has been stripped bare.

Uber-regulator and former Federal Reserve chairman Alan Greenspan has even apparently floated the idea of a US "government backed" mega fund to purchase the subprime mortgages that Wall Street and Europe can't seem to swallow.

To see how far we have come from anything remotely resembling a free-market system, let's take a look at the famous "bulge bracket" on Wall Street. (In common use, the term 'bulge bracket' refers loosely (in the US) to the group of investment banks considered to be the largest and most profitable in the world, as measured by various league table standings. Since the criteria for this judgment are unclear, there is often debate over which banks form part of the bulge bracket.) (Wikipedia)

Bulge bracket also means the firms that get the lion's share of underwriting deals. For this reason, bulge bracket banks in America used to refer to INVESTMENT BANKS. Now, because of the failure of so many investment banks, the definition seems to be morphing into commercial banks – both foreign and domestic – that have subsidiary underwriting firms. Citigroup sub Smith Barney, a huge retail and investment bank, is a good example of this.

Here's a recent lineup of so-called "bulge bracket" firms:

* Bank of America

* Citigroup

* Credit Suisse

* Deutsche Bank

* Goldman Sachs

* JPMorgan

* Lehman Brothers

* Merrill Lynch

* Morgan Stanley

* UBS

This is a pretty incredible lineup, actually. Hard to believe, given the way the bulge bracket used to look. And it is not through changing yet. Citigroup (Smith Barney) has had its troubles and Lehman Brothers and Merrill Lynch (as of this writing) seem on their way out. That would leave a bulge bracket list looking like this:

* Bank of America

* Citigroup

* Credit Suisse

* Deutsche Bank

* Goldman Sachs

* JPMorgan

* Morgan Stanley

* UBS

The bulge bracket used to be littered with firms that were uniquely "of Wall Street." But Salomon Brothers, Kidder Peabody, Dean Witter, Shearson, PaineWebber, Prudential and many other notable names have all either fallen by the wayside or been swallowed up by big banks in the recent past. Additionally, until fairly recently most if not all of the names of bulge bracket firms were American. But once the fallout from the subprime crisis ends (if it ever does) the list will likely include as many if not more foreign banks than American ones.

Of course, some of this was due to the relaxation of the Glass-Steagall Act which once forbade commercial banks from directly participating in Wall Street's investing and underwriting business. But the Glass-Steagall Act went the way of the Dodo in the 1990s, and there seems little doubt that the conflation between the holdings of commercial banks and Wall Street banks of "toxic" subprime paper is aggravating the latest financial crisis. Most notable in all this is the way that the curtain has fallen away from the "Great Oz" – the American Federal Reserve and its managers, including the US Treasury – that have collectively "managed" the crisis and in doing so revealed just how concentrated the US financial business has become.

An editor of a famous business magazine used to defend his lack of coverage of Wall Street by saying that the Street did tiny business compared to Main Street. This was several decades ago, of course, and Wall Street was indeed considered a kind of arcane backwater.

Times change. Gone are the funny little names. The biggest banks in the world have moved in and are dominating the bulge bracket. Take a look. Both Credit Suisse and UBS are Swiss banks – and Swiss banks are not seen in a very favorable light by America's regulators these days. So both UBS and Credit Suisse are probably on "double secret probation" as Dean Vernon Wormer of Animal House's Faber College used to say. Goldman Sachs seems to be a virtual funding arm of the US Treasury and JP Morgan and Morgan Stanley used to belong to the same firm – founded by JP Morgan himself, once the richest men in America and also the founder of modern Wall Street.

As for Citigroup, well here is some background on that large and currently troubled entity:

The history begins with the City Bank of New York, which was chartered by New York State on June 16, 1812, with $2 million of capital. Serving a group of New York merchants, the bank opened for business on September 14 of that year, and Samuel Osgood was elected as the first President of the company. The company's name was changed to The National City Bank of New York in 1865 after it joined the new U.S. national banking system, and it became the largest American bank by 1895. It became the first contributor to the Federal Reserve Bank of New York in 1913, and the following year it inaugurated the first overseas branch of a U.S. bank in Buenos Aires. The 1918 purchase of U.S. overseas bank International Banking Corporation helped it become the first American bank to surpass $1 billion in assets, and it became the largest commercial bank in the world in 1929. As it grew, the bank became a leading innovator in financial services, becoming the first major U.S. bank to offer compound interest on savings (1921); unsecured personal loans (1928); customer checking accounts (1936) and the negotiable certificate of deposit (1961). (Wikipedia)

Our fundamental point is that Wall Street as it was in the 20th century is finished. Kaput. Not only is it not a domestic American product any longer, it is not really an international one either. What it is, is a creature of the United States Government – and of Western governments in general.

Yes, no matter what happens to other individual firms overseas or in America – Merrill Lynch and Lehman Brothers, for instance – the "die has been cast." It could not have been otherwise of course, but the sight of the US government (like the UK government in week's past) so inextricably involved, day after day and week after week, month after month, in the salvaging of various financial entities makes it clear that the Western (US) form of regulatory capitalism is now nakedly exposed as "regulator's" capitalism.

After Thoughts

Of course, regulatory capitalism or even "regulator's capitalism" is not really a government affair though it seems to be. Behind government, even the US government, stand private forces that often pull regulatory levers for their benefit. What the great subprime crisis bail out does show us is how nakedly and brutally these levers are pulled when the need arises.

For a generation of Americans, for a generation of citizens around the world, the idea that American capitalism is a kind of raw and unsupervised "survival of the fittest" can be put to rest. It is no more and no less than a variant of European crony capitalism (crony socialism?) and those who once held otherwise have surely been educated by the latest events.

For at least 100 years, since the founding of the Federal Reserve in America, the United States has been far less of a "free market" than it might seem. Now, at least, the reality is evident – and the confusion about what constitutes a free market and what does not may be laid bare.

And there's worse to come, and likely more "consolidation" as well. We will leave you, dear reader with the following insights penned late last week on the aptly named "clusterstock.com".

Is Today The Day Financial System Collapses? In the next day or two, the financial markets could hit their tipping point. It is certainly not beyond the realm of the possible that Lehman (LEH) and Washington Mutual (WM) could fail. Merrill Lynch (MER) is also trading off sharply. Looking into what is now a nearly bottom-less well, a serial failure of several firms could cut the implied value of mortgage-back securities and other consumer debt instruments by 20% or 30% more than their nominal value a few weeks ago. This is not a measured failure of inherent value. It is an annihilation. Value of existing derivatives, which have not been valued by trading in the open market could face a catastrophic failure. The Fed and Treasury would have little choice other than to step in with tens of billions of dollars, or watch the banking system dissolve.

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