From the October 2008 issue of Investment Advisor • Subscribe!

Wall Street Stunned

Merrill sold, Lehman bankrupt as many wonder who's next

Wall Street is not what it used to be, for good or ill. Culminating (at least for the moment) a months-long period of market volatility and uncertainty spawned by the credit/housing crisis and punctuated by a Federal government-engineered bailout of Bear Stearns at the end of March and a Federal takeover of Fannie Mae and Freddie Mac on September 7, on September 15 two marquee names in financial services ceased to exist. Following a busy weekend in New York in which various government and corporate enterprises worked to shore up multiple corporate linchpins in the American financial system, Bank of America announced on Monday, September 15 that it would acquire Merrill Lynch & Co. for $50 billion in stock, a deal that would create the largest brokerage firm in the world, with some 20,000 brokers (assuming they all have jobs once the transaction closes in the first quarter of 2009), and $2.5 trillion in client assets. The acquisition includes Merrill's 50% stake in BlackRock.

The other major casualty of the September weekend was Lehman Brothers Holdings, which after a desperate search aided by the government was not as fortunate in finding a suitor willing to assume its risks, leading the company to announce Sept. 15 that it will file for Chapter 11 bankruptcy protection, "in order to protect its assets and maximize value." The company said all its broker/dealers will continue to operate, as will its asset management arm Neuberger Berman, though it said that it "exploring" the sale of both those operations.

The SEC quickly announced September 15 that retail customers of Lehman Brothers will be protected during the winding down, and that SEC staff will oversee the "orderly transfer of customer assets to one or more SIPC-insured brokerage firms."

What Does It Mean for Clients?

Harold Evensky, chairman of the wealth management firm Evensky & Katz in Coral Gables, Florida, admitted that the turn of events was "unique in that we haven't seen failures like this, but we've been through some other terrible experiences in the past," particularly the 1973-74 market downturn and the savings and loan failures of the 1980s.

"To the extent there is a silver lining, the markets have been driven by uncertainty [as of late], so this is going to wash a lot of it out." In the case of Lehman, the Fed and other large financial institutions had the resources to step in but they decided to pass, notes Evensky, which means they didn't perceive its failure as something that would devastate the markets. Evensky believes that the turmoil in the market "still all comes down to subprime and the credit [crisis] and to leverage." He says there is still "a huge amount of leverage in the credit markets and this is an unwinding."

As for the danger to clients, "in the short term it's not a risk for investors," but "I think we're going to continue to see some volatility."

Lous Stanasolovich of Legend Financial Advisors in Pittsburgh agrees that there will be more volatility in the short term and financial stocks will suffer. "We are short on financial stocks already for our more aggressive portfolios." The effects will be felt overseas too, he argues, saying that "we are seeing a lot of countries lowering interest rates, which means they are very concerned about a global recession...I think emerging market equities will have a lot of problems going forward, at least over the next three to four months."

What will this mean for the shrinking number of Wall Street brokerage firms? Jefferson Harralson, a research analyst who covers banks at Keefe, Bruyette & Woods, believes the broker/dealer model "is going towards where a large balance sheet and core funding is crucial; we've seen that, now, twice. We're the only country in the world that has the broker/dealer separate from the larger bank. The volatility we're experiencing is proving to be too much for the broker/dealer model."

So will there be more acquisitions for Bank of America? Harralson argues that "after buying Countrywide and now following up so quickly with the Merrill Lynch deal, [Bank of America] will retrench now for a period of time." So are there other banks that might be in a position to do more deals? Harralson demurs, "Very, very few. Most banks have their own issues with credit and most banks are relatively thin on capital. You have a JPMorgan out there that's positioned relatively well but it has already bought Bear Stearns."

Speculation in mid-September on which would be the next giant to stumble focused on AIG and Washington Mutual. Gary Shilling, the bearish Forbes columnist and long-time Investment Advisor asset allocation panel member, said "AIG seems to be on the ropes. Beyond that, all we know is that this thing is very contagious. Wall Street is really just one big glorified confidence game. I don't mean that in a crooked sense, but it does depend on the confidence of all the players in terms of whose paper they're willing to accept. Obviously, when confidence is lost, the particular firm that's the object of that confidence loss is finished."

Bob Andres, chief investment strategist for Portfolio Management Consultants, put it more bluntly. "You don't solve the problem until you solve the housing mortgage-backed securities problem," he says. "What we're doing here, unfortunately, is focusing in on the symptoms of the problem and not the problem."

Additional reporting by Kathleen M. McBride, Melanie Waddell, and Kara P. Stapleton.

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