As some of you may or may not know, I work at one of the large banks here in New York City. The past week has been one of the most frenetic and chaotic in Wall Street's history, and I wanted to share some of my thoughts about what has been going on. Even though I'm not involved in the part of the trading floor that has seen the most action this week - that would be people who trade financial stocks or CDS (credit default swaps) on those same companies, as well as virtually any interest-rate product - it's enough to give one perspective when they go to work and are living history (and this is history, even if it ain't the good kind) each day.
Simply put, it comes down to this: no one saw the abrupt collapse of Lehman Brothers coming - especially filing for bankruptcy - or, even worse, the de facto bankruptcy of AIG (and yes, that's what it is - not nationalization). What's worse?
No one knows what is going to happen next.
Lehman Brothers' story is similar to that of Bear Stearns, except that it should have played out differently. Bear Stearns collapsed before any of the lending facilities the Federal Reserve had put into place came online; its lack of liquidity was real. One thing to understand about any bank that has an investment banking component to it: they use leverage, and lots of it. If you aren't able to have access to cash, your liquidity will dry up faster than water in the desert, and you are finished. That's why Bear Stearns was gone within a week of it first reporting it had serious trouble. That's the same thing that happened to Lehman, although it was furthermore hurt by its extensive holdings in real estate mortgages, which, whether they be commercial or residential, are pretty much worth shit at the moment. Without access to funding - and with impending credit downgrades furthering the need for Lehman to put up even more collateral to take out loans - they had no choice but to call it quits. It's not surprising that Bank of America and Barclays refused to buy them outright, given the toxicity of Lehman's balance sheet. While Barclays eventually bought most of Lehman's investment bank, it did so at a fire-sale price - and without any of the 'bad' assets that Lehman still holds onto.
I suppose it's time to mention why credit agencies are playing yet another harmful role in these times. First, they were castigated for rating highly complex securitized instruments - whether they be CDOs of virtually any kind, CDO squareds, CLOs, CMBS, ABS, MBS, etc. - at much higher ratings than their underlying assets were worth in quality. Now, when they downgrade firms' credit scores, it forces them to put up much more in collateral in order to access the funding they need. It also jacks up the interest rates further, which, given widening spreads, makes it much more expensive. While they are doing their jobs correctly, the credit agencies certainly aren't making life easier for anyone.
Merrill Lynch's forced sale to Bank of America was effectively a foretold event once it became clear Lehman wasn't going to make it to this past Monday as an independent entity. They were next on the hit list, and given that their balance sheet is far worse than either Goldman Sachs' or Morgan Stanley's (now the only two independent investment banks left on the Street), John Thain did the right thing in selling out. That being said, he shouldn't be hailed for much of anything; Merrill's stock took a brutal hit during his short tenure at the helm, and Thain doesn't deserve the widespread kudos that he's been getting. Bank of America is now the biggest financial firm in the world - even larger than Citigroup - but given that they've acquired two firms steeped in problems stemming from the mortgage crisis (Countrywide, and now Merrill), Ken Lewis' task is no easy one. If he pulls it off, though, he will be remembered as the next Sandy Weill (the man who put together Citigroup in its current form).
AIG - well, no one really saw it coming. They've been losing money left and right, but it's hard to imagine the world's largest insurance firm having no cash whatsoever. In the end, though, the government loaning $85 billion was the last recourse. The idea that the private sector would give them that much money was ludicrous given how little access to credit there is. That said, don't think that AIG is going to come out of this as the financial behemoth that it became under Hank Greenberg. Given that the firm is getting charged an absurdly high interest rate of around 11-11.5% on its 'loan', it's effectively a race against the clock to sell off the individual parts of AIG to repay it. That's why it's more like a bankruptcy than a true nationalization; the government has no intention of running the largest firm in the private insurance markets. If AIG is forced to come back for more cash before it can pay off its loan, then there's going to be another episode of handwringing - and we lucky taxpayers may get to foot more of the bill. Oh, and the shareholders? They got screwed by the government taking an 80% stake in the company. The stock isn't worth the paper it's printed on; I don't know why anyone would buy it at this point.
That brings us to today: where do we go from here? Talking with various people, it's clear that no one - not even the best and brightest of us - have the faintest clue. Despite reporting relatively strong earnings, Morgan Stanley took a beating today, and it could very well end up that this weekend, it's their turn to get forced into a shotgun marriage with a bank that has deposits to backstop any losses. And if they fall - which seems quite likely, given they're already talking to other banks about a potential deal - what becomes of Goldman Sachs? They'll be the last man standing, and they are, bar none, the best of the best in the business - but will they make it out? Credit default swaps, which are effectively insurance against any defaults on a firm's debt, are trading at incredibly high spreads for both firms, which doesn't bode well.
And what of non-investment bank firms? It's pretty clear that Washington Mutual is the next one to go; they've cleared up an agreement they have with TPG, a private equity firm, that allows them to sell themselves at a fire-sale price. It brings into question the solvency of other firms, and given that the FDIC is severely undercapitalized relative to the size of banking deposits around the country, there's no telling what could happen next. We all hope things will get better, but when you watch on your Bloomberg and see the markets absolutely tank in the last hour of trading - for no particular reason at all - you have to think that the worst is yet to come. The Fed's special $30 billion auction of 76-day T-Bills is worrisome, as it means that they may be having trouble keeping up their funding of the lending facilities after the huge AIG deal.
In the end, there is not a lot of good news on the horizon. I'd be prepared for a lot more bad news...with no real end in sight, at least in the near future.
[Update]: A lot of people are commenting on the 'no one saw it coming' line, and that's probably somewhat hyperbolic. That being said, I think it's hard - or at least it was - to conceptualize a firm going underwater because it had no money. These banks deal in billions of dollars a day, and it's hard to imagine that the funds may simply not be there anymore. And while you hear rumbles about firms potentially going under, it creeps up out of nowhere. Lehman survived several months of whispering about its capital position until it deteriorated so rapidly at the end of last week that it reached the end of the line. Merrill came out of nowhere, in my opinion. AIG was a similar situation to Lehman - they were having problems, but it was pretty shocking to hear David Paterson on TV Monday saying that they had 1 day to find $75 billion, or they were bankrupt.