Financial markets tumbled around the world during the week following the ‘Black Sunday’ for the US investment banking industry in which the third-largest investment bank, Merrill Lynch, wa
Financial markets tumbled around the world during the week following the ‘Black Sunday’ for the US investment banking industry in which the third-largest investment bank, Merrill Lynch, was sold off to Bank of America for what was widely seen as a bargain price and the fourth largest, Lehman Brothers, slid into bankruptcy after the US authorities refused to back a potential industry rescue with public money.
Coming just weeks after the bailout by the US government of the country’s giant mortgage providers, Freddie Mac and Fannie Mae, the eclipse of Merrill and Lehman, six months after the demise of Bear Stearns, brought home to market participants worldwide that the fallout from the collapse of the sub-prime US mortgage market, the credit squeeze and the problems in determining the value of ‘toxic’ real estate-backed securities is far from over.
The hedge fund industry, already battered by falling financial markets and tighter restrictions on borrowing, faces further uncertainty with the application for bankruptcy protection by Lehman and the acquisition of Merrill, both significant prime brokerage players, and continuing worries about the continued viability of the business model of the top remaining independent players, Goldman Sachs and Morgan Stanley, as the latter looks actively for a merger partner with an ample deposit base.
The gravity of the situation became apparent when the US government was obliged to step in to rescue American International Group, the world’s biggest insurer, with a USD85bn liquidity cushion that effectively makes AIG an 80 per cent-owned subsidiary of the Federal Reserve Bank of New York. The insurer appears to have been saved from Lehman’s fate by the vast web of derivatives contracts it maintained with counterparties across the financial industry, especially credit default swaps; the authorities feared a complete market collapse if AIG defaulted.
In the UK, some institutions found themselves losing confidence while others went hunting bargains. Lloyds TSB saw competition rules waived to allow it to carry out the GBP12bn acquisition of mortgage bank HBOS, which was beginning to see investor and counterparty confidence ebb in tandem with its share price. The UK government had lined up a reluctant HSBC as its second choice if Lloyds had baulked at the deal; and some of the latter’s shareholders remain far from happy at a transaction that will create a bulked-up institution that has been dubbed ‘Bank of Britain’.
Until last weekend, there were hopes that Lehman might have been rescued, if not as an independent entity, with Bank of America and UK-based Barclays in the running to bid, but the optimism evaporated on Sunday morning as Charlotte, North-Carolina-based BoA struck a deal instead with Merrill Lynch, while Barclays withdrew once it became evident it could not obtain shareholders’ approval in time. Nevertheless, the UK bank resurfaced days later to pick up Lehman’s US investment banking business for a song.
Merrill Lynch was acquired in an all-share transaction valuing the largest US brokerage firm at USD50bn. The price offered by Bank of America of USD29 a share was almost USD12 a share higher than last Friday’s closing price, but less than half of its peak share price over the past 12 months.
The petition filed by Lehman Brothers Holdings under Chapter 11 of the US Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York does not affect the bank’s investment management subsidiary, Neuberger Berman, which was up for sale along with the rest of Lehman’s investment management operations, including its substantial private equity business. A cluster of private equity groups are in the running to buy the investment business. In the meantime, Neuberger Berman and Lehman Brothers Asset Management continue to conduct ‘business as usual’.
The implications of Lehman’s Chapter 11 filing are not yet clear for hedge fund clients of the firm’s Capital Markets Prime Services business, which employs more than 600 professionals in the US, Europe, Middle East and Asia-Pacific region, and which provides financing, fixed income and equity prime brokerage, futures, research and strategic transactions. However, many fund manager clients appear to have emulated GLG Partners and moved their business over the past few days and weeks.
The authorities on both sides of the Atlantic have shored up the financial sector by easing the rules on central banking borrowing and by pumping in liquidity in a desperate attempt to prevent the money markets from seizing up completely. The US Federal Reserve made it easier for financial institutions to obtain emergency liquidity, extending the range of securities they can use to obtain loans to include equities, and said it would increase the volume of Treasury securities it auctions under one of its regular lending programmes. After first saying that a similar loan facility for financial institutions would close on schedule this month, the Bank of England changed tack and extended it for a further three months.
The rescue of AIG followed unsuccessful attempts to raise financing from the private sector, and the future of the giant business remains uncertain, Its new masters are reported to be considering dismembering the group by selling off its (mostly solvent and profitable) operating subsidiaries.
However, AIG’s problems have already caused one casualty, the exchange-traded commodity products marketed by ETF Securities, more than 100 of which were backed by matching contracts from AIG Financial Products Corporation and guaranteed by the parent group. After some institutions stopped making markets in AIG-backed ETCs on Monday, the London Stock Exchange suspended electronic execution of trades. As the week drew toward a close, the question on the lips of most financial industry professions was not ‘Is it over?’ but ‘Who’s next?’
