The Wall Street provided an update on the Lehman rescue efforts which were consistent with its earlier coverage, which discussed considerable impediments to a “good bank/bad bank” solution with Wall Street firms providing the capital to support the bad bank. Note this contradicts the more optimistic report from CNBC on this approach (which we viewed with some skepticism).
Barclays is keen to conclude a deal for the brokerage firm but only if there is some form of government support. From the Wall Street Journal:
Barclays PLC, the U.K.’s third-largest bank, is emerging as a leading contender for Lehman Brothers…A sale of Lehman to either Barclays or Bank of America Corp. remained dependent on government financial support…Barclays appeared to be moving more aggressively in trying to find a way to complete a deal.
That, however, would put any proposed deal at odds with the government’s reluctance to step in with funding….
Under a plan that was crystallizing Sunday, either Barclays PLC or Bank of America Corp. would buy Lehman’s “good assets”, such as its equities business, people familiar with the matter say. Lehman’s more toxic, real-estate assets would be ring-fenced into a “bad” bank that would contain about $85 billion in souring assets. The move would avert a flood of bad assets deluging the market, damaging the value of similar assets held by other banks and insurers.
On Saturday, one idea was for Wall Street firms to inject some capital into the bad bank. By Sunday morning, though, this option appeared to be losing support. Unlike when Wall Street firms stepped in to bail out hedge fund Long-Term Capital Management, today’s banks are much weaker financially. Some also are loathe to provide financial support at the same time a rival like Barclays has the potential to buy Lehman for a cheap price….
Demands by Bank of America and Barclays that the government somehow financially backstop the bad bank could be negotiating tactics during the talks. Barclays in the past has shown a discipline to not overextend on deals.
Jim Bianco e-mailed to tell us that the idea that Lehman can be wound down in an orderly fashion, with counterparties continuing to trade with it as assets are sold, is a non-starters:
Why does a deal have to be done today?Moody’s warned last Wednesday that they will downgrade Lehman if they don’t either merge of raise capital immediately.
http://www.reuters.com/article/fundsFundsNews/idUSN1047904220080910Why is a downgrade important?
“A downgrade would likely force Lehman to post additional collateral, increase short-term and long-term funding costs, and limit its ability to transact with partners which demand certain credit ratings,” Goldman Sachs Group Inc. analyst William Tanona wrote in a note today. http://www.bloomberg.com/apps/news?pid=20601087&sid=alIffXk3Sb2I&refer=homeSo, if nothing gets down, Moody’s downgrades them tomorrow and it’s over. To control the process, Lehman may file for bankruptcy tonight if nothing happens.
If Lehman does file, Moody’s has to downgrade their counter-party rating to junk. This forces everyone to stop doing business with Lehman. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buy-side accounts have fiduciary rules that bar them from doing business with a junk rated counter-party. Recall that this was the trigger that buried bear.
No way that Moody’s will agree to keep a bankrupt broker with an investment grade counter-party risk rating.
Update 11:40 AM:
Bianco’s comment suggests a narrower form of government support might work. Could the powers that be merely guarantee the actively traded counterparty exposures? You’d keep credit default swaps out of this. since there is (presumably) no good reason for firms to enter into new CDS agreements with Lehman at this juncture. But how would you draw the line between old exposures and new positions? If a simple trade date cutoff would work, that might be fine, but it isn’t hard to imagine how this could be gamed. (On further thought, the rating agency issue would be with exposure to Lehman, period, so the approach might be guaranteeing those counterparty exposures that need to be traded and/or would be subject to a quick exit).
The idea would have the advantage of giving the deal a different appearance to the public, even if the amount at risk was the sam. Paulson & Co. could stress that bondholders would take their lumps too. It would prevent rating agencies from downgrading firms that continued to trade with Lehman. In theory, the exposure ought to be less. but if this angle wasn’t already under consideration (almost certain not to have been, given Paulson’s unwilingness to consider a rescue), could a narrower backup plan be crafted on short notice?
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Guaranteed government subsidy for “bad bank” or for entire Lehman entity. Paulson/Bernanke will blink first. They don’ want to be remembered as the guys who started the great unwind, so they will throw taxpayer largesse into the mix. This deal will get done today.