No Bailout for Lehman as Fed Awakens to Bond Market Crash Risk

By: Nadeem_Walayat

My Fridays commentary closed with expectations that the weekend would see the formerly worlds fourth largest investment bank, Lehman's Brothers taken over by one or a consortium of bidders at mere peanuts of its former valuation further sweetened by a healthy subsidy from the US government / central bank. However the noises emanating from Hank Paulson at the US Treasury department over the weekend of having drawn a line against an effective bailout of the bankrupt investment bank, this will not live up to bidder expectations of providing tens of billions of tax payers money so as to enable a relatively risk free takeover by other banks, this therefore results in suitors in advanced talks such as Barclays now declaring their withdrawal from a possible weekend bid for the bank and indicates that Lehman's is now heading directly towards bankruptcy.

Lehman's which survived the 1929 crash, survived Sept 11th (having offices in the World Trade Center), was taken down by its exposure to Tulip backed securities through huge positions in the over the counter derivatives market at huge leverage, the bank has been teetering on the brink since March this year following Bear Stearns collapse. Its decimated stock price having lost some 94% of its value reflects the banks true financial state as it prepares to disappear into the history books.

However the bank is not alone as competing banks right across the globe have their own derivatives and tulip backed black holes to contend with, comprising of assets originally booked at several hundreds of billions with true real market valuations of perhaps less than 30%, therefore the a stream of continuing huge losses amongst virtually all large financial institutions on a quarter to quarter basis claiming more bankruptcies in the future.

US Treasury Drawing a Line?

After the huge unprecedented bailout and de facto nationalisation of Fannie Mae and Freddie Mac, that effectively saw the US take on and give Treasury Bond status to $5 trillion of Fannie and Freddie debt so as to prevent foreign investor panic, and therefore in the process devaluing the whole US Treasury Bond Market with the likelihood that the eventual losses to the tax payer being far above the $25 billion indicated at the time, with the UK Northern Rock example implying losses of as high as $500 billions. In the interests of self preservation the US Treasury said NO., We are NOT going to risk the collapse of the US Treasury Bond market as foreign investors reappraise the credit worthiness of US Treasury Bonds and therefore the US dollar in the face of a stream of bailouts of $30+billion dollars per week!.

However, this decision would not have been taken lightly, as it now leaves the financial markets facing a huge crisis due to Lehman's now being in default on its derivatives exposures which impacts on its counter parties. Lehman exposure is put at over $200 billions which now risks a cascade of failures rippling throughout the financial markets as the financial system adjusts to the increased risk of default amongst Lehman's counter parties.

Is this the End of Bailouts ?

I doubt it, as the apparent action NOT to bailout Lehman's is actually a panic move, under normal circumstances the US Treasury and Fed WOULD bailout Lehman's but the in the current climate of the likelihood that the US government will have to start bailing out other distressed industries in some shape or form such as airlines, insurers and auto manufacturers, though probably not going so far as to nationalize them but rather to make huge loans available to corporations much as the Japanese government did during the early 1990's which resulted in Japans Great Depression.

Already it is being reported that Bank of America is eagerly sniffing around Merrill Lynch as a better candidate to takeover following Lehman's bankruptcy, will they get a sweetener form the US Fed?, despite announcements of no tax payers money, they probably will.

Whilst the focus is on the US, the bailouts and unprecedented loans being made available to financial intuitions is not just limited to the US Fed, Central banks right across the globe will be flooding the markets Monday in an attempt to prevent a cascade of failures amongst banks that have already lost their capital bases over the last 12 months and therefore are teetering over the edge.

Meanwhile the architect of the whole crisis through a series of blunders which includes cutting and keeping US Interest at 1% for several years and therefore igniting the derivatives bubble as investors and financial institutions took on far more risk so as to generate returns, was again doing the rounds on US media such as the ABC network, stating "We will see other major financial firms fail, but it did not need to be a problem. It depends on how it is handled and how the liquidations take place, And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers."

What Does this Mean for Investments ?

The short-term response will be an immediate bloodbath on the equity markets Monday morning, with asian markets already sharply lower in the order of 4%, will we witness a crash ? Probably a crashette in the region of 4 to 5% , that more importantly threatening a trend towards a possible break of the July lows right across the worlds stock markets, once those support levels go then that will signal the NEXT LEG of the STOCKS BEAR MARKET, as both investors and deleveraging distressed financial's continue to liquidate assets in the face of increased counter party risk and potential losses.

Expect scared money to flow into traditional safe havens such as gold and precious metals, however the problem with the US Dollar as a safe haven is the risks associated by a potential stream of bailouts, nevertheless as the worlds other economies continue to crumble the US Dollar will be seen as a relative safe haven of sorts.

In conclusion, we are witnessing panic moves by the US government and worlds central banks on literally an hourly basis in the face of a potential wave of bank failures as I have pointed out several times over the last 6 months that most of the big western worlds banks are bankrupt, insolvent, and the only thing thing that will keep them afloat is a flood of tax payers money with all of the economic consequences associated with running huge budget deficits at the same time as the credit markets contract, which implies economic depression.

Monday Morning Update -

• Lehman said it intends to file for protection under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York.
• Bank of America buys Merrill Lynch for $29 a share at a value of $50 billion. As Merrill rushed to prevent itself following Lehman's path to bankruptcy.

By Nadeem Walayat
http://www.marketoracle.co.uk

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Nadeem Walayat has over 20 years experience of trading, analysing and forecasting the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 150 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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