Lehman Brothers Collapse, Merrill Lynch Takeover and AIG Bailout

16 09 2008

The economic fallout from the initial sub prime mortgage crisis which triggered the credit crunch has come full circle and is affecting the future of some of the biggest names in the world’s financial markets.

This week meltdown has seen more turmoil in the markets with U.S. investment giant Lehman Brothers collapse and rival Merrill Lynch taken over by the Bank of America. These are further signs that the turmoil in the money markets is far from over.

The collapse of Lehman Brothers has sent a major jolt through global financial markets, as it is by far the biggest victim of the credit crisis that started in August 2007 and had been considered too big to fail.

No other financial institutions were willing to take Lehman over, while the government was not prepared to step in to save the bank. It seems this time the U.S. Government is happy to stand aside and let the market decide the outcome of this latest banking giant collapse.

Bad debt in the U.S. mortgage market has rocked the sandy foundations upon which economic growth over the last decade or so was built. Its effects are finally filtering down to what analysts call the real economy. A statistical recession – two quarters of contraction in the economy – is now likely, though for many people in the services sector it might well feel they are already in one.

In fact, the speed at which some of the supposedly strongest and most respected financial institutions have melted down is stunning. Bear Stearns disappeared almost overnight. Shareholders in Freddie Mac and Fannie Mae are virtually wiped out. WaMu is down 93%, and Wachovia, AIG, Merrill and others have suffered huge losses.

Lehman, like Bear, Fannie and Freddie, had too much leverage. Think of a homeowner with a 96% mortgage and credit card bills. If the value of the house declines only 5%, the homeowner is wiped out. The total leverage of companies like Lehman is difficult to calculate, but it is not unlike that of a highly overleveraged homeowner. Small declines in the value of its assets jeopardize its solvency.

Further, it is likely that Lehman and other financial institutions did not take a hard enough look at the value of its assets when they reported quarterly results and paid handsome bonuses in previous years. Many of these assets were complicated to value, but management always has an incentive to paint a rosy picture. Just as people deluded themselves with the value of their homes, financial institutions like Lehman deluded themselves with the value of their assets.

With Lehman, as with Fannie, Freddie and others, the meltdown has especially hit the common stockholders, while debtholders have been largely unscathed. Shareholders are at the bottom of the capital structure. Just as a bank gets its money back first when you sell your house, senior lenders get paid in full before shareholders get anything. And just as the bank is more powerful than the homeowner, lenders are more powerful than shareholders. Much of the credit is owned by other large financial institutions or foreign governments. The Fed will let you lose money, but it can’t stiff Saudi Arabia or China.

Lehman’s problems aren’t the end of the fallout from this financial meltdown. The credit crunch may not get worse, but it will not get better for a long time. The Fed has said it wants Fannie and Freddie to get smaller, and other financial institutions will keep cutting back on loans. Regulators, financial officers and investors are becoming far more diligent.

Analysts blame Lehman’s real estate holdings for causing the firm’s collapse, after it misjudged how much damage a declining housing market would do to a bank that survived the Great Depression. Lehman had a reputation for aggressive lending in South Florida, now one of the country’s worst real estate markets.

The demise of Lehman Brothers could somehow impact South Florida’s real estate industry. Among the local projects Lehman backed: Miami Beach’s new Canyon Ranch resort; Ian Schrager’s investment in the Riande hotel chain; the Donald Trump condo tower under way in Hollywood; a recent expansion at the Aventura Mall; and the Related Group’s Icon Brickell on Biscayne Bay.

There is, however, a positive development. Amid all the problems, the financial system is intact, the stock market is handling the shocks and we see a sharp decline in mortgage rates falling to the lowest level in five months. This means more affordable to those who are seeking to buy a home or refinancing their mortgage now.



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