Lehman has failed

"New York based Lehman Brothers, founded 158 years ago, said early today that it plans to file for Chapter 11 bankrupcy protection after failing to find a buyer", Bloomberg News

Over the past months I have argued on several occasions that Lehman Brothers would not be a second Bear Stearns. Today, I have been proven wrong. Financial markets tend to go to extremes when they find themselves under extreme circumstances. Unfortunately, that is what has happened yet again. Lehman's bankrupcy is the biggest in Wall Street's history as it has listed $613 billion of debt - more than Worldcom did in 2002.

Lehman's demise is the latest related to subprime and all the worthless asset backed securities that have surfaced Wall Street in the past twelve months. According to Bloomberg "Last year, it underwrote more mortgage backed securities than any other firm, accumulating an $85 billion portfolio, almost four times the $22.5 billion of shareholder equity Lehman had (...) ". The numbers are staggering. Ultimately, the slump in housing and the increase in mortgage delinquencies led to this weekend's round of events: crisis talks at the Treasury and Chapter 11. Despite its efforts to shore up capital which included writting off a substantial portion of its mortgage backed securities exposure, selling $6 billion in shares, raising additional equity from outside investors and, finally, planning the sale of its Neuberg Berman asset management division - Lehman's crown jewel. At the end of the day, none of this worked and the company filed for bankrupcy protection.

What happens now? There are two main crisis buffers in place.

First, insurance provided by the Securities Investor Protection Corp. It has been activated to protect customer accounts at Lehman which according to SEC guidelines must remain segregated from the bank's balance sheet. This means that brokerage clients with accounts up to a certain amount ($40 million I believe) are safe. Above this level it might not be the case. Meanwhile, the International Swaps and Derivatives Association, which includes 218 financial institutions, is already netting out trades its members individually have with Lehman. So, where's the contagion risk? It's in the "Over the Counter" mortgage backed securities market in which Lehman was a huge underwriter. All Lehman Brothers' counterparties are at risk because most likely the company will not meet its committments. That is why world equity markets are slumping today. There's a lot of uncertainty as to how badly other firms will be affected by Lehman's demise. In my opinion, hedge funds are on the front line to become the next casualties in this process. Which brings me to the second line of defence: the FED and all other major banks. Following Lehman's bankrupcy request, the FED has widened the collateral associated to interbank loans. It now accepts almost everything, including stocks, as collateral banks provide in return for the loans they apply for. Last but not least, a consortium of private banks has also pledged $70 billion to provide addittional liquidity to the system.

In sum, the financial sector is on high alert. However, some experts argue that we are now in unchartered territory.