Wall Street's Category 5

Two hurricanes hit America this weekend - one in Galveston and the other in lower Manhattan - both of which have caused billions of dollars in damage.  The financial landscape has been rearranged as much as the sandbars in the gulf have been.  Lehman Brothers (LEH), a firm dating back to before the Civil War is gone, bankrupt, kaput.  Merrill Lynch (MER) was pressured by the Fed to put it up for sale to Bank of America (BAC - Analyst Report), but was able to negotiate an extremely generous price of $29 a share, a huge premium from the $17.05 price they closed at on Friday. 

While the strategic rationale for BAC to buy MER is pretty obvious - it weds the biggest retail bank to the biggest retail brokerage firm - what possessed BAC to pony up that sort of price is far from obvious.  They could have had LEH for maybe $0.05 a share if they wanted it.  If they had waited a week they could have probably picked up MER for $10 a share.  I would not be shocked to find out that there was some sort of inducement from the government for them to step up the price, so there would be some "good news" for the markets today. 

Meanwhile, it appears that the biggest insurance company, AIG (AIG - Snapshot Report) in the world turned down capital-raising offers from several private equity firms and is now going hat in hand to the Fed. 

Apparently the rule of law means nothing on Wall Street now.  There is NOTHING in the Federal Reserve Act that would allow a non-Depository financial institution that is not even a Primary Dealer (and even that is stretching it big-time - but was the basis the Fed was part of the Bear Stearns [BSC] bailout/shotgun wedding) to have access to the Fed window, and certainly not to the tune of $40 billion which is reportedly what they are looking for. 

This is crazy. There is no Fed window anymore.  A window implies that it is something that could be open and shut, so that access to it could be controlled.  This is no window, it is a gaping hole in the side of the wall.  To the extent it is still a window, it is like all the windows of the J.P. Morgan Tower in Houston. 

There is much to look at and explore.  Ten major banks have each come up with $7 billion to fund something that looks like a second, private Fed window.  As I write this the Dow is down 300 points.  If we close at these levels, count it as a victory. 

People thought that the demise of BSC was then end of the credit crisis, it was not.  Then the conservatorship of Fannie Mae (FNM - Snapshot Report) and Freddie Mac (FRE - Analyst Report) was going to be the bell that rings signaling the end of the credit crunch (big financial crunches have historically come to a climax when someone or something big goes under, like Continental Illinois Bank, Mexico, LTCM). 

I doubt this is the end, either; there is still much more trouble ahead.  In the meantime, hunker down and for God’s sake make sure you do not have more than $100,000 in any single bank.  There are going to be a lot of bank failures still, and the FDIC insurance fund is running dangerously low. 

It appears that the next domino to fall may be Washington Mutual (WM - Snapshot Report).  Its insured deposits alone far exceed the size of the FDIC fund.  If it goes under there will have to be an emergency infusion of funds from the Fed or the Treasury.  If that didn’t happen, then the next bank failure would result in insured depositors not getting their money back.  That would lead to a run on virtually every bank in the country - shades of 1931. 

Thus, I am very confident that such an infusion would be made.  But - oh what the heck, what’s another $100 billion or so added to the budget deficit?  Dick Cheney assures us that deficits don’t matter anyway.

On a macro-level, what is going on is a massive deleveraging.  Deleveraging is by its very nature deflationary.  Money goes to money heaven when it happens.  The Fed is trying to offset this by pumping as much liquidity into the system it can.  Under normal times that is how you go about creating inflation. 

Once upon a time, only depository institutions, plain old-fashioned commercial banks were allowed to borrow from the Fed, and then only using T-Notes or T-Bills as collateral.  Then Investment banks were allowed in, and the collateral was expanded to Agency debt.  Now it appears that even insurance companies can go to the window and use any investment-grade debt (and we know just how on top of things the Rating agencies have been about quickly reflecting the true financial conditions </sarcasm>) as collateral. 

Heck, they are now even allowing equities to be used as collateral.  What is next, a beanie baby collection as collateral?  Down that road leads to hyperinflation (i.e. the United States of Zimbabwe).  Theoretically, it would be possible to precisely offset the deflation with this induced inflation, resulting in stable prices.  However, with the lags inherent in monetary policy even in the best of times (usually 6-9 months) and incomplete data collection, that will not be easy. 

The best comparison I can make is that the Fed will have to thread a needle while sitting in a car going 70 mph down a poorly maintained dirt road, and they only get one chance.  Stay away from the Financials.  This is not over, folks.

Read the full analyst report on LEH

Read the full analyst report on MER

Read the full analyst report on BAC

Read the full analyst report on AIG

Read the full analyst report on FRE

Read the full analyst report on WM