For Wall Street, fears of a market sell-off

Some hope Merrill sale will calm investors

By Floyd Norris and Vikas Bajaj
New York Times News Service / September 15, 2008
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Wall Street and the federal government played a game of chicken over the weekend, and neither side backed down, pushing Lehman Brothers toward bankruptcy and setting off worries of a worldwide sell-off when markets open today.

While some investors feared a precipitous decline in the markets today, others hoped that Bank of America's surprise announcement on yesterday that it was buying Merrill Lynch might provide enough reassurance to calm investors.

"That would be seen as very good news," Liz Ann Sonders, the chief investment strategist for Charles Schwab & Co., said of Bank of America's $50 billion or $29 a share offer, a price far higher than Merrill's close Friday but less than a third of what the stock was worth early last year, before the mortgage crisis began to damage financial firms.

With major Asian markets closed for a holiday today, the answer regarding investor response could wait until European markets open, and, after that, the US exchanges. In the Lehman talks yesterday, the government, worried about the precedents it had set in bailing out the investment bank Bear Stearns and the mortgage finance giants, Fannie Mae and Freddie Mac, wanted Wall Street to collectively take on the risk that Lehman's assets were worth far less than the firm claimed. The firms, worried about their own capital, were unwilling to do so.

Now, the risk for the financial firms is that investors would respond by trying to do exactly what they are doing - minimize their risk. If enough investors do that and choose to sell, stocks could plummet in markets around the world, thus increasing the risks rather than easing them.

"We don't want to be the first one in," said Thomas Atteberry, a partner at First Pacific Advisors, an investment firm in Los Angeles specializing in fixed income. "I would rather wait and see that there are other participants in the marketplace."

A bankruptcy filing could delay any immediate sell-off of some Lehman's assets, although those pledged to secure loans might be quickly sold by lenders. The filing could also raise concerns that other firms will be badly damaged by their exposure to Lehman, which could lead to more selling pressure.

Sonders said large-scale failures do not always lead to more carnage. "In the past when you had a crisis that resulted in a big failure, that ended up being closer to the bottom than anything else," she said. "The problem is that we have waves of these. Where does it stop is the question that is different than in the past."

Among some market participants, the wait yesterday was excruciating. There was trading in credit default swaps - contracts that allow traders to buy or sell protection against a company defaulting on its debts, and there were few willing to sell such protection.

Instead, traders said, the cost of buying protection against defaults soared, even for financial firms that are considered to be in good shape, like Morgan Stanley and Goldman Sachs.

Some even recalled the stock market crash in 1987, the biggest fall ever seen by the current generation of Wall Streeters. "This is an earth-shattering event, this is like a tectonic plate shifting event," said Thomas Priore, chief executive of Institutional Credit Partners, a hedge fund active in credit markets. "This is welcome back to Black Monday."

That day, Oct. 19, 1987, saw the Dow Jones industrial average fall more than 22 percent. It came after a week in which the index fell 9.5 percent, for the worst week since 1940, when France fell to invading German armies.

Over the weekend in 1987 before Black Monday, there was no sign of an integrated approach to the crisis, and even public bickering between US and European officials, which some argued exacerbated investor fears.

To some, talk of 1987 was overdone. "The market has already leaped ahead to the end game here," said Douglas Peta, a market strategist at J&W Seligman & Co., a brokerage firm, saying if an unwinding of Lehman's assets went well, things might not be so bad today.

Long term, he was not as optimistic. "We are in the grip of a vicious circle," Peta said, "and the only thing that to me will break that is for home prices to stop going down."

Over the weekend, the Federal Reserve Bank of New York called together the leaders of most major financial firms in an effort to get them to act collectively to stem any possible panic, but could not force a deal.

The major financial firms are in agreement that prices in many markets are ridiculously low. But they have repeatedly underestimated how much further prices could fall, particularly for mortgage-backed securities and derivatives tied to mortgage markets, and they have been surprised by how much capital they have been forced to raise.

In recent years, there was a general increase in leverage, whether among the Wall Street firms or people who bought homes with no money down. Now that is reversing.

"This rarely observed systematic debt liquidation is what confronts the US and perhaps even the global financial system at the current time," Bill Gross of Pimco, a leading money manager, said in a newsletter on his Web site before the rescue of Fannie Mae and Freddie Mac. "Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami."

Throughout this year, every move by the government to shore up the financial system - from bailing out Bear Stearns to opening the Fed's discount window to investment banks to last weekend's move to rescue Fannie and Freddie - has produced rallies in hopes the problem was finally nearing an end. But new fears have soon arisen each time.

Now the government appears to have decided that it could not keep bailing out firm after firm, and to see how the markets will handle a bankruptcy, something it was unwilling to contemplate when it helped JPMorgan Chase take over Bear Stearns.

"After committing to JPMorgan and Bear and the involvement in Fannie Mae and Freddie Mac," Peta said, "the government seems to have concluded: if you spare the rod, you spoil the investor."

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