Massive Shifts on Wall St.

By Heather Landy and Neil Irwin
Washington Post Staff Writers
Monday, September 15, 2008

NEW YORK, Sept. 15 -- Lehman Brothers announced early Monday morning that it will file for bankruptcy, becoming the largest financial firm to fail in the global credit crisis, after federal officials refused to help other companies buy the venerable investment bank by putting up taxpayer money as a guarantee.

The failure of the nation's fourth-largest investment firm offers a profound test of the global financial system, and government and private officials had been bracing Sunday night for an upheaval in a range of financial markets that have never before experienced the bankruptcy of such a large player. To keep cash flowing normally through these markets, the Federal Reserve announced new lending procedures, while 10 major banks combined to create a new $70 billion fund.

After a marathon series of negotiations over the weekend, Federal Reserve and the Treasury stepped aside to allow a wrenching transformation of Wall Street to proceed. After galloping to the rescue of other major financial institutions in recent months, the federal government drew the line with Lehman Brothers, ignoring pleas from would-be buyers of the company who insisted on receiving federal backing for its troubled assets.

Leaders of the Federal Reserve and Treasury Department decided that Lehman was unlike the investment bank Bear Stearns, whose sudden collapse in March threatened the world financial system, or Fannie Mae and Freddie Mac, whose potential insolvency did the same.

In betting that Lehman could be allowed to fail without catastrophic consequences, New York Federal Reserve President Timothy F. Geithner, Fed Chairman Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. were making it clear that struggling financial firms cannot count on a bailout.

The decision not to intervene carries the risk that the ripples of Lehman's failure will prove impossible to contain. What worries regulators and Wall Street is a massive, multitrillion-dollar lattice of interlocking financial instruments known as derivatives. The most worrisome to bankers are "credit default swaps," in essence a form of insurance against corporate failures. If the financial firms themselves fail, the value of the insurance they have written will be tested as never before.

So would the market for "triparty repo" -- a form of debt that funds all sorts of financial firms and is held in the money market mutual funds of ordinary Americans -- which is also looking at potential losses from the Lehman bankruptcy.

It was that fear that led the Fed specifically to broaden the types of collateral it will accept at its lending window for investment banks, so that cash can keep flowing through the repo market. Even with that move, they are were steadying themselves for a tumultuous week in that market.

The steps the Fed announced last night, Bernanke said in a statement, "are intended to mitigate the potential risks and disruptions to markets."

"Bankruptcy is a perfectly natural thing, but you hope that the firm is in a position so that it can be an orderly bankruptcy and not cause other problems," said Susan Phillips, dean of the George Washington University School of Business and a former Federal Reserve governor.

Government officials drew a sharp contrast with the threat posed by the difficulties of Bear Stearns. In that situation, in March, Fed and Treasury leaders were convinced that its abrupt demise would have caused extensive damage across the financial system resulting in economic distress in the United States and beyond. For that reason, senior federal officials strongly encouraged J.P. Morgan Chase to buy Bear Stearns and backed $29 billion worth of its risky assets to make the deal happen.

Several firms, especially Bank of America and the British bank Barclays, wanted control of Lehman's investment banking and asset management businesses. However, they wanted no part of billions in shaky real estate and other investments on Lehman's books, and wanted either taxpayers or other financial firms to assume part of that risk.

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