Investors Feel The Pain of Lehman Bros. Collapse

Wall Street lost more than 500 points Monday reacting to the bankruptcy of Lehman Brothers and the sale of Merrill Lynch. It was the worst loss since the Sept. 11, 2001, attacks. Adding to the misery is insurance giant American Insurance Group, which is facing serious trouble.

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RENEE MONTAGNE, host:

This is Morning Edition from NPR News. Good morning, I'm Renee Montagne.

STEVE INSKEEP, host:

And I'm Steve Inskeep. We're spending a good deal of this morning trying to figure out one thing. It's the economy; what's going wrong, what the candidates will do about it, and in a moment, how much we really need to worry. In this part of the program, we begin with the Wall Street firms whose trouble knocked more than 500 points off the Dow Jones Industrials yesterday. Lehman Brothers is bankrupt, the giant insurance company AIG is in trouble, and federal officials are trying to figure out what to do. Here's NPR's Chris Arnold.

CHRIS ARNOLD: Yesterday afternoon with the stock market down around 300 points and falling, Treasury secretary Henry Paulson was trying to see the glass half full. Given the collapse of another major Wall Street investment bank over its exposure to bad mortgage loans, Paulson seemed to be saying things could be a lot worse.

Secretary HENRY PAULSON (Treasury Department): We're not going to move through this in a straight line. There are going to be some real rough spots along the road, but I believe we're making progress. And when I look at the way the markets are performing today, I think it's a testament to the way the financial industry has come together.

ARNOLD: A couple of hours later, though, things looked even uglier with the Dow down 504 points. Some investors were worried that the government wasn't doing more to help. Paulson's been wearing a different hat these days. When Bear Stearns and then Fannie Mae and Freddie Mac were in trouble, Paulson rode to the rescue with saddlebags full of money. But now he's taking more of a tough-love approach. He's there to listen and encourage financial firms to work together, but so far he's refused to keep putting taxpayer dollars at risk.

Secretary PAULSON: The situation and the facts around Bear Stearns were very, very different to the situation we are looking at here in September. And I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.

ARNOLD: Some analysts say it's good that the government let Lehman fail. They think that might get Wall Street to fix its own mess instead of waiting for bailouts. Andy Kessler is a former hedge fund manager and analyst who now writes about Wall Street.

Mr. ANDY KESSLER (Former Hedge Fund Manager; Writer): This happens every cycle. And, you know, I used to work on Wall Street, and I competed against Drexel Burnham and Shearson and Dean Witter and E.F. Hutton, and they're gone. And, you know, each of them made some mistake or another along the way. And this is nothing new. I mean, I don't think we've entered a new era of the 1930s and the Depression.

ARNOLD: Kessler says the investment banking industry basically had too many players. Some competition and technology had squeezed a lot of the profit out of it. They couldn't make money executing stock trades for customers like they used to. That led some to get overleveraged and to gamble on risky investments, like all those loans to people who it turns out couldn't pay them back. So, he says, the more badly managed firms are now going under.

Mr. KESSLER: At the end of the day, no one really measures them because someone else steps up and takes over their business. And quite frankly, a lot of the people that work at those firms, the better of them, you know, get jobs across the street.

ARNOLD: But other people aren't so optimistic. Nariman Behravesh is chief economist at the forecasting firm Global Insight. We've talked to him a lot over the past year as the credit crisis has dragged on.

Dr. NARIMAN BEHRAVESH (Chief Economist, Global Insight): I have to be honest with you, I am worried. This is big, it's scary, and the biggest concern is it might get out of control, because all of a sudden we're looking at not one but a series of investment banks and now a major insurance company in deep trouble. And I think this is quite a bit bigger than anybody thought it was.

ARNOLD: Behravesh is referring to the giant insurance company AIG which saw its stock fall 60 percent yesterday alone. And after that, the company's credit rating was downgraded. There are now worries about whether AIG will be the next firm to fail. That would send another big shock through the financial system. So Behravesh is growing skeptical that the government can avoid a huge bailout here.

Dr. BEHRAVESH: I'm a big believer in free markets, and I can understand why the Treasury and the Fed don't want to keep bailing out. Investment banks that have gotten themselves into trouble, however, resolving this crisis this way, I think is very messy.

ARNOLD: Behravesh thinks the federal government is going to have to take the bad loans off of all these companies' books, like it did back in the 1980s in the savings and loan debacle. Otherwise, he worries the current crisis could cause a lot more damage to the nation's banking system and lead to a severe recession. Chris Arnold, NPR News.

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Q&A: The Rise And Demise of Wall Street Firms

Lehman Brothers' decision to file for bankruptcy and Merrill Lynch's decision to sell itself to Bank of America mark a historic restructuring of Wall Street.

Now — following the sale of Bear Stearns in March — only two of the five largest independent broker-dealer firms are still standing. Here, a look at some of the implications this sea change will have on the financial landscape for consumers.

What happened to Lehman Brothers and Merrill Lynch?

Lehman Brothers, the 158-year-old Wall Street firm, filed for bankruptcy as a result of an unsuccessful quest to find a buyer.

Meanwhile, Bank of America is taking over Merrill Lynch, one of the largest Wall Street brokerages. Bank of America agreed to purchase the firm for $50 billion in an all-stock transaction.

Both Lehman and Merrill suffered large losses in the past year from mortgage-related investments that lost value as home values declined.

What happened to Lehman's search for a buyer?

Reports indicate that companies that were weighing whether to purchase Lehman Brothers got cold feet when they learned that the government would only facilitate discussions and wouldn't commit any cash to help save Wall Street firms.

The Treasury Department and the Federal Reserve engineered the sale of Bear Stearns to JPMorgan Chase in March by guaranteeing some of Bear Stearns' debt as an incentive for the purchase to go through quickly. In the case of Bear Stearns, the government put nearly $30 billion of taxpayer money at risk.

How do I know Bank of America won't fail?

With the purchase of Merrill Lynch, Bank of America — which also recently purchased Countrywide Financial, one of the nation's largest mortgage lenders — is poised to become one of the world's largest financial institutions. Bank of America has sustained losses from mortgage-related investments, but it has deep pockets from different business lines, including its retail banking and credit card businesses, that put it in better financial health than many of the troubled Wall Street investment banks.

A spokesman said Bank of America was "one of the strongest banks in the United States," with second-quarter earnings of $3.4 billion and nearly $163 billion in shareholders' equity.

He said Merrill Lynch's underlying business remains very strong and that the firm has done a lot to directly address its "problem assets" from housing-related investments they made.

What does this mean for me if I have accounts with Merrill Lynch or Bank of America?

The deal won't close until the first quarter of 2009, so there won't be any immediate changes for clients of either company.

Ken Lewis, the chairman and CEO of Bank of America, said the Merrill Lynch acquisition was a "strategic opportunity of a lifetime" for its retail and corporate banking businesses. Bank of America said that the purchase of Merrill will create the largest brokerage in the world, with $2.5 trillion in assets.

A spokesman for Bank of America said that it plans to use Merrill Lynch's name for wealth management activities and that further decisions about the use of the Merrill brand won't occur until the transaction closes.

Currently, about half of Bank of America's business is in consumer and small-business banking, including deposits, credit cards and home loans. About 30 percent is devoted to corporate and investment banking, 15 percent focused on wealth management and the remaining 5 percent in miscellaneous business lines. A spokesman said the Merrill acquisition will enable Bank of America to increase its corporate and investment banking and wealth management businesses.

Will a bigger Bank of America translate into savings for consumers?

It's too early to tell. But it will depend on whether efficiencies from the combination trickle down to consumers.

John Thain, CEO of Merrill Lynch, said the sale of the storied firm with a bull as its logo wasn't "the outcome I would have expected when I took this job," but he said that the purchase presented a good opportunity for Merrill's shareholders and employees — including its flock of 16,000 brokers.

Lewis said Bank of America plans to keep the Merrill organization intact, but he didn't rule out layoffs once the two companies merge. The joint company, he said, would be "a much stronger entity and will survive most anything as a result of the combination."

What's happening with AIG, and are other companies in trouble?

Insurance giant American International Group Inc., one of 30 stocks listed on the Dow Jones industrial average, insures bonds tied to the mortgage market. When mortgage defaults go up it has to cover these bonds. It's facing a large ratings downgrade that would be devastating to its bottom line, and its stock price has fallen dramatically in recent days.

AIG gained permission from New York state to use $20 billion in assets held by its subsidiaries as collateral to borrow cash to help it stay afloat. New York Gov. David Paterson asked the state's insurance regulators to permit AIG to make this loan to itself while also calling on state regulators to push for a separate federal loan to the embattled company. AIG has asked the Federal Reserve for emergency funding.

All of the firms on Wall Street have ties to one another. That creates ripple effects throughout the markets. One firm's demise can drag down others. Other financial services companies are likely to face problems in the coming months as a result of investments they made in housing-related bonds.

Is the housing downturn the primary cause of the financial turmoil?

Secretary of Treasury Henry Paulson said on Monday that he remains confident in the "soundness and resilience" of our financial system, but he reiterated his assertion that the housing correction is "at the root of the problem." Turmoil in the financial markets will continue, he said, until there is "more stability in housing prices."

In terms of timing, he said it's likely that the worst part of the housing correction may be behind us within a "number of months as opposed to years."

Economist Dean Baker, co-director of the Center for Economic and Policy Research, agrees that the housing crisis has kept the financial markets in disarray. Housing prices, he says, continue to fall at a quick pace: "When you get rapid decline in house prices you are going to see very high rates of defaults and foreclosures."

Neither Bear Stearns, Lehman Brothers, Merrill Lynch nor any of the other Wall Street firms were "banking on this sort of downturn," he explains.

What's more, consumers are having trouble making payments on everything from consumer loans and car loans to credit cards.

"There's a lot of evidence that with virtually every type of loan the default rate is rising," says Baker.

From NPR reports and The Associated Press

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