Wall St. scrambles as banks teeter

NEW YORK —  Transforming the face of Wall Street, two major securities firms succumbed Sunday to the country’s long-running mortgage crisis as Merrill Lynch & Co. agreed to a hastily arranged, $50-billion takeover by Bank of America Corp. and Lehman Bros. Holdings Inc. spiraled into bankruptcy.

In a bid to prevent Lehman’s collapse from setting off a chain reaction of financial ruin on Wall Street, the Federal Reserve announced late Sunday that it was easing the terms of its emergency lending to securities firms.

And a group of 10 global commercial and investment banks agreed to ante up $70 billion for a fund that any of them could access for emergency cash. The lending pool is intended to protect the participating firms from a sudden investor retreat of the kind that crushed Lehman, until only weeks ago the nation’s No. 4 securities firm.

“This is frightening as hell,” said Richard X. Bove, an analyst at Ladenburg, Thalmann & Co. “We simply have no idea what will happen [today] but we can be pretty sure that it’s not going to be positive.”

The Fed and industry announcements came after a frenzied day in which government officials and industry executives scrambled unsuccessfully to find a buyer for Lehman, then turned their attention to Merrill and insurance giant American International Group Inc., which like Lehman have recorded large mortgage-related losses.

Early today New York time, Lehman issued a statement saying it intended to file for protection under Chapter 11 of the Bankruptcy Code. The company said customers of its brokerage arm and its Neuberger Berman asset management unit could continue to trade and otherwise access their accounts.

The crumbling of Lehman and buyout of Merrill came only one week after the government committed up to $200 billion to shore up home-loan giants Fannie Mae and Freddie Mac. And it came six months after investment bank Bear Stearns Cos., the first big Wall Street victim of the housing crisis, was acquired by JPMorgan Chase & Co. with federal assistance.

After enduring withering criticism of those rescues, the Treasury Department and Federal Reserve ultimately refused to commit taxpayer money to salvaging Lehman, prompting Bank of America and British bank Barclays to withdraw from talks to acquire the 158-year-old firm.

That left investors staring at the unnerving possibility of starting the trading week with a crippled giant in their midst, a situation likely to exacerbate already tumultuous conditions.

“It’s a watershed day for Wall Street,” said Larry Tabb, head of research firm Tabb Group in Westborough, Mass.

Early signs indicated that investors were unnerved by the day’s events as U.S. stock-index futures -- essentially bets on the direction of the stock market -- tumbled more than 3% on Sunday night. Many Asian stock markets were closed today, but others fell sharply.

A few hours after the Lehman talks collapsed, Merrill, the nation’s largest brokerage, agreed to a $29-a-share buyout by Bank of America. The price is 70% more than Merrill’s closing stock price Friday but is also 70% below the stock’s all-time high of $97.53 set in January 2007.

It had been hoped that the propping up of Fannie Mae and Freddie Mac would put a floor under the sagging housing market, which in turn would patch holes in the balance sheets of banks and brokerages that hold billions of dollars in mortgage-related securities on their books. And, in fact, financial stocks on average rallied last week in the wake of the government’s move.

But investors continued to pound the stocks of Lehman, Merrill, AIG and other firms with significant exposure to the mortgage market. Lehman’s stock plunged 77%, Merrill’s sank 36% and AIG’s tumbled 46%.

The expected bankruptcy filing by Lehman would mark the demise of a firm that began as a cotton trader in 1850 and had endured several near-death blows over the years, including one caused by the meltdown of Long-Term Capital Management a decade ago.

Lehman was known as a gritty overachiever, which it displayed when its headquarters across the street from the World Trade Center were badly damaged in the September 2001 terrorist attacks. For weeks, the company operated out of hotel rooms around the city.

The company posted sizzling profits in recent years as it expanded beyond its longtime roots as a bond-trading operation.

However, like Bear Stearns, Lehman was among the most aggressive backers of the boom in high-risk mortgages early this decade.

Wall Street provided billions of dollars in funding to nonbank lenders such as Southern California’s Ameriquest Mortgage Co. and New Century Financial Corp. The lenders specialized in borrowers who had bad credit, huge debt loads or an unwillingness to document their earnings -- and often all of the above.

The Wall Street banks purchased the mortgages and used pools of the loans to back complex bonds, many of which were sold overseas. But heavy defaults beginning in late 2006 triggered the crisis that has brought some financial firms to the brink of extinction. Wall Street firms have written down the value of their mortgage-related holdings by more than $500 billion, giving many of them a need to raise capital.

Lehman’s fate was sealed last week when an expected capital infusion by a South Korean state bank failed to materialize. Lehman sought to reassure investors by hurriedly rolling out a restructuring plan to dump soured assets and sell a stake in its prized money-management unit.

The most immediate risk from a Lehman bankruptcy filing is that it could result in the unloading of its portfolio of mortgage-related assets at fire-sale prices, spurring another painful round of write-downs on Wall Street.

“That’s where the meltdown scenario comes into play and that’s not a happy one,” said Dan Alpert, managing director at Westwood Capital, a New York-based investment bank.

Large Wall Street firms have failed during past crises, such as Drexel Burnham Lambert after the insider-trading scandals of the late 1980s.

However, the crumbling of one firm -- Lehman -- and buyout of two others -- Bear and Merrill -- take the current crisis to a new level.

“It is unprecedented,” said Sam Stovall, chief investment strategist at Standard & Poor’s Corp. “When you look back to other periods of market turmoil, while you had single companies that did go out, you really didn’t have the financial community crumble like a house of cards.”

The Fed’s actions announced Sunday night are designed to ensure that short-term funding will be readily available to Wall Street firms during trading Monday and the rest of this week.

When markets are functioning normally, that kind of funding is usually provided by big institutional investors. But starting with the subprime debacle last summer, these investors have become more and more leery about providing those funds, leaving banks and financial firms without adequate amounts to function.

That leeriness is sure to increase with Lehman’s demise, which could leave companies with loans to Lehman short of cash and those that did not do business wondering about the health of the firms they have relationships with.

In the wake of the March collapse of Bear Stearns, the Fed expanded whom it would lend to from just banks to most of the country’s major financial firms. But it required borrowers to put up highly rated bonds as collateral, and generally restricted the loans to six months. No firms have borrowed under its so-called primary dealer credit facility since July.

Now, securities firms will be allowed to put up stocks and even junk bonds as collateral, making borrowing more appealing.

In addition, the Fed expanded a separate lending program, its so-called term securities lending facility, by agreeing to accept all types of highly rated bonds, not just government bonds, and increasing the amount available for lending from $175 billion to $200 billion and the frequency of auctions for the money to weekly from every two weeks.

In conjunction with the Fed action, a group of the 10 biggest financial players in the country, including Bank of America, announced that they would each contribute $7 billion to a pool from which any of the 10 can borrow funds if they run into financing problems.

Each firm would be limited to a maximum withdrawal of about $25 billion, although that amount may increase as other banks are admitted to the pool and make contributions, according to a statement issued on behalf of the group by Morgan Stanley.

In addition to Bank of America and Morgan Stanley, other companies involved are Barclays, Citigroup Inc., Credit Suisse, Deutsche Bank, Goldman Sachs Group Inc., JPMorgan, Merrill Lynch and UBS.

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walter.hamilton@latimes.com

peter.gosselin@latimes.com

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Hamilton reported from New York, Gosselin from Washington. Times staff writer E. Scott Reckard in Orange County contributed to this report.

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Investment players

Largest securities firms in the U.S., by assets in latest quarter

(In trillions)

Goldman Sachs: $1.09

Morgan Stanley: $1.03

Merrill Lynch: $0.97

Lehman Bros.: $0.64

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Sources: The companies