The New York Times and the Wall Street Journal provided Saturday afternoon updates on Lehman. The discussions increasingly acknowledge that a deal may not be in place by Sunday as initially hoped (understandable, given the authorities’ unwillingness to provide support and the near-impossibility of doing adequate due diligence in a few days) and have moved to fallback options. Reader Saboor alerted us to the fact that the Journal reports that Lehman had engaged Weil Gotschal, a New York law firm known for its expertise in bankruptcy (and for being tough negotiators), to prepare a filing.
The Journal has the recent and most detailed sighting. From the Wall Street Journal:
The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute.
A sense of optimism that a rescue could be arranged today dimmed …After 6 p.m., the formal meeting ended for the day with no resolution, though some participants stayed behind to continue talking….
At about 8 p.m., New York Fed President Timothy Geithner was still at the bank’s headquarters. Officials from the New York Fed and various banks were expected to continue working through the night.
Yves here. The break in discussions with the pressure of markets opening in Asia in less then 36 hours is decidedly not a good sign. It signals an impasse of some sort, with the principals retreating to their corners to consider whether they need to cross lines they had formerly considered inviolate. Back to the Journal:
Under one plan, 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. Other Wall Street firms would try to inject some capital into the bad bank to keep it afloat for a period of time so that a flood of bad assets don’t deluge the market, damaging the value of similar assets held by other banks and insurers. The banks are also looking for the government to somehow financially backstop the bad bank.
So explain to me why I as a private company with crappy assets of my own that I am worried about, provide scarce capital to fund someone else’s bad assets?
The problem, though, is getting enough banks to back that plan. While teams of bankers are working through structures, it’s clear that only a handful of banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves. Also, banks aren’t keen to see a big rival such as Barclays or Bank of America walk away with valuable assets by only paying a pittance.<.blockquote>
So basically, Plan A doesn’t work. Lehman was visibly in distress for months. The lack of planning for a possible crisis is stunning.
As of Saturday afternoon, Barclays, the U.K.’s third-largest bank in terms of market value, appeared to have more interest in pulling off a deal…Bank of America, an obvious buyer, appeared to be cooling….Of course, some of this could be the posturing …. Barclays nor Bank of America wants to buy all of Lehman without some government assistance….
Both Bank of America and Barclays remain fixated on the disposal of the bad real estate assets, and are less focused on evaluating Lehman’s investment bank, said one person involved in the due diligence process….
The real fear in the discussions, this person added, was that the fire-sale prices, or “marks” of Lehman’s real estate book could set off a cascade of problems for other Wall Street firms. If those marks were made against other banks’ portfolios, it could eventually force those firms to raise more capital, too. For firms’ considering funding the bad bank, the calculation has thus become the price of that contribution against the price of a widescale markdown….
So an impediment is that no one wants to expose where the market for dodgy commercial real estate debt is because everyone is afraid of being held to current market valuations (yes, the argument will be that Lehman is forced to sell at “fire sale” prices, that is, that a Lehman liquidation would be so large that it would artificially depress prices. But is this mere price discovery?)
“Unless something is settled, it’s going to be a bloodbath Monday,” said this person…..
Is Paulson, after all the heroics to date, really wiling to risk a disorderly liquidation? Is he assuming he can play a game of chicken and win? Why should any firm pony up for the bad bank, particularly when the firms in the best shape, and thus less irresponsible, may wind up making a larger contribution (let’s face it, if the crappy ones put up the same amount, it might be the event that will have lead them to go into a death spiral, so all you are doing is spreading rather than ring-fencing the problem). Oh, I forgot, “From each according to his abilities, to each according to his needs.”
With it unclear whether the gap between the federal government and potential buyers can be bridged, a second group at the New York Fed is focusing on the possibility that there might be no alternative to liquidating Lehman and winding down its operations in an orderly fashion.
On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.
Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank.
One person familiar with the matter said large dealers are trying to decide if they should show each other all their credit default swap trades with Lehman. Disclosing their positions could enable dealers to offset their positions with each other wherever possible. For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly.
Such moves could also help prevent individual firms from scrambling to find new counterparties to re-hedge their positions with when the markets reopen on Monday, potentially unleashing turmoil in the credit markets. They could also help facilitate an orderly wind-down of Lehman’s derivative positions, if that becomes necessary.
It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied…
As I read it, the only options are the Treasury relenting and providing some support, or plan B immediately above, which is clearly in flux, but in concept is a partial liquidation.
One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, “if they go into liquidation,” it is going to be a bad situation on Monday…..
In a Lehman bankruptcy, the firm’s brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm’s assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor’s property and aren’t exposed to the claims of the firm’s creditors.
In trying to hold firm to their no-bailout stance even while pressing for a deal, federal officials could try to pit Bank of America and Barclays against each other. But that leverage can work only if both banks stay in the discussions…..
While some executives had left the Fed meeting, those of other firms, including three carfuls of Barclays executives, remained at the Fed office past 6 p.m.
At least 20 New York Fed staffers left from another exit. They refused to say if they were done for the night.
The New York Times’ story, although now somewhat out of date, confirmed the two broad approaches discussed above, It also noted, as the Wall Street Journal did in sections we omitted, that worries about AIG, Merrill and WaMu were contributing to the time pressure. This quote was apt:
“You have to think of this like there is an epidemic going on — an epidemic of capital destruction,” said James L. Melcher, president of the hedge fund Balestra Capital, who has been bearish on the stock market.