The Shakeout After Lehman, Merrill, AIG…

As credit stays tight, power shifts to Bank of America, Barclays, hedge funds, and private equity—and regulators will keep a more watchful eye

by David Henry and Matthew Goldstein

Once-mighty Wall Street has turned into the Boulevard of Broken Dreams. From Bear Stearns (BSC) and Lehman Brothers (LEH) to Merrill Lynch (MER) and AIG (AIG), the punishment for years of bad decisions has been shockingly swift and brutal. As firms wobble, markets gyrate, and investors quiver, the question is: When will the pain end?

The signs aren’t encouraging. Sure, the Federal Reserve’s dramatic bailout of American International Group prevented the full-out global panic that might have unfolded with the collapse of the largest U.S. insurer. But AIG’s sudden lurch toward bankruptcy also showed how dangerously intertwined the financial system has become.

For years that interconnectedness masked enormous underlying risks, but now it’s amplifying them. As each new thread from the crazy web has unwound during the 13-month credit crisis, a fresh problem has emerged. How bad things will get from here depends on how cleanly the losing firms and toxic investments can be extricated from the rest. With each passing day the task seems to grow more difficult. By the end of the credit bust, the total losses, now $500 billion, could reach $2 trillion, according to hedge fund Bridgewater Associates. What’s likely to be left when the Great Unwind is finally complete? A smaller, humbler, highly regulated Wall Street barely recognizable from its heady past, where caution reigns and wild risk-taking is taboo.

Plenty of Skeletons

Merrill’s ties to AIG show just how difficult it might be to untangle the financial system. During the mortgage boom, Merrill churned out billions of dollars worth of dubious collateralized debt obligations, those troublesome bonds backed by pools of risky subprime mortgages. To cut down its own risk, Merrill bought insurance contracts from AIG called credit default swaps, which pay off if the mortgages blow up. Merrill holds $5 billion worth of guarantees from AIG alone. In all, AIG insures $441 billion of CDOs, including $58 billion with the subprime taint. It’s unclear which firms bought those guarantees, but AIG sold many to big European banks.

When AIG hit the skids, it couldn’t be trusted to make good on those contracts. If the insurer had remained in jeopardy, Merrill and others would have faced another round of losses. Given that possibility, it’s no wonder the Fed stepped in.

The massive credit-default-swap market became so complex that in some cases firms lost track of their stakes. AIG, for example, pleaded for capital from several private equity firms over the Sept. 13-14 weekend. After scouring the insurer’s financials, the firms balked at a deal, concluding that even AIG management didn’t know where all the skeletons were buried, according to a person familiar with the situation. AIG disclosed in February that auditors had found “material weakness” in its systems for valuing its credit default swaps. In its quarterly report on Aug. 7, the company said it was still trying to implement a reliable valuation system.

The unwinding of Lehman, one of the world’s biggest bond players, won’t be easy. When the firm filed for bankruptcy on Sept. 15, pain quickly rippled across the financial system. A day later, the $62 billion Reserve Primary Fund, the world’s first money-market fund, reported it had lost money on debt instruments issued by Lehman. Such losses are virtually unprecedented in money-market funds, which are supposed to be as safe as cash stuffed under a mattress. Wachovia (WB), already reeling from mortgage losses, pumped extra dollars into three of its money-market funds after Lehman fell.

Lehman’s tremors are being felt in other markets, too. One of the next danger zones could be the $20 billion market for so-called catastrophe bonds, arcane securities sold by insurers to guard against big payouts on major natural disasters like hurricanes. Bond rating agency A.M. Best tells BusinessWeek it might trim the ratings on several catastrophe bonds backed by a Lehman subsidiary. Lehman also sold guarantees on commercial mortgage-backed securities, including some issued by the Italian government. In the wake of the firm’s bankruptcy, those bonds might lose value.

As Lehman and Merrill faltered, investors began betting heavily against two other big independent investment houses, Goldman Sachs (GS) and Morgan Stanley (MS). The fear: The banks’ main funding sources would dry up. Goldman and Morgan Stanley are still alive, but their shares have been battered, falling by 14% and 24%, respectively, on Sept. 17 alone. In a recent conference call, Goldman said its goal was to remain a stand-alone firm. As of press time, Morgan Stanley was exploring a merger with Wachovia.

The Housing Sinkhole

A future without Goldman or Morgan Stanley is no longer inconceivable. Whereas big commercial banks like Citigroup (C) and JPMorgan Chase (JPM) rely on a steady base of deposits to finance their operations, large investment banks have come to resemble high-flying hedge funds, borrowing short-term cash from other firms to invest in riskier securities. Goldman’s gross leverage ratio—one measure of borrowed money—jumped from 18.7 times assets in 2003 to 26.2 by 2007. Morgan Stanley’s topped 32 last year. But the lenders in these esoteric markets hold all the power now. They can demand at any time that borrowers put up more collateral or cut the financing altogether. That’s what happened to Bear and Lehman—and investors worry a similar fate could befall Goldman and Morgan Stanley. “I don’t think they could survive too many rounds of this,” says Manhattan College finance professor and Wall Street historian Charles Geisst.

At the center of the global financial web, of course, sits the U.S. housing market—and here, too, the outlook seems bleak. Home prices continue to fall, reducing the values of mortgage-backed securities. More worrisome, the subprime contagion is spreading to categories of home loans once considered less risky. So-called Alt-A loans, made to people with better-than-subprime credit, are deteriorating rapidly. In normal times, 2% to 3% of such loans are troubled; now the figure stands at 15%. Delinquent subprime loans make up 30% of the subprime total, up from 10% historically. “Subprime in overall magnitude is bad,” says Mark Fleming, chief economist for research firm First American CoreLogic. “But in terms of the magnitude of change, the Alt-A market is bigger.”

Even homeowners with the highest credit ratings, known as prime borrowers, increasingly are falling behind on their payments. Prime mortgages make up 40% of all foreclosures. Those sorts of problems will continue to rise through the mortgage food chain to lenders and investment banks.

Already there are new signs of distress. At the height of the mortgage boom, scores of small to midsize banks binged on risky debt investments called trust preferreds that allowed them to collect cash from investors and gave banks the right to defer their interest payments. With mortgage loans and related investments going bad, at least 38 banks in the past 12 months have stopped making their payments. Several have been seized by regulators, including IndyMac and Silver State Bancorp. For others, like FirstBank Financial Services (FBFS), CapitalSouth Bancorp (CAPB), and Omni Financial Services (OFSI), the decision not to pay raises a red flag. First Bank, CapitalSouth, and Omni could not be reached for comment.

As the housing crisis continues to spread throughout the U.S. economy, new problems for financial firms make the Great Unwind all the more challenging. Defaults on corporate loans, for example, are likely to rise. According to Standard & Poor’s Leveraged Commentary & Data, prices of corporate junk loans on Sept. 16 fell to a record low of 85¢ on the dollar as investors demanded higher yields for assuming the risk.

However the credit crunch plays out, one thing is certain: Wall Street, newly chastened, will never be the same. Its new catchphrase is “de-risking,” or cutting back on lending, hoarding cash, and eschewing leverage. Marriages of commercial banks and investment banks could occur as former high-fliers come to crave the simplicity and stability of ordinary bank deposits. “The investment banks’ model is a problem,” says Nouriel Roubini, a New York University professor. “They will have to be regulated like commercial banks.”

The geography will be different, too, as the balance of power shifts away from Wall Street’s fabled corridors to other parts of the country and the world. Bank of America (BAC), now the largest bank by assets, calls Charlotte, N.C., home. Britain’s Barclays (BCS), which agreed on Sept. 16 to buy parts of Lehman, could emerge among the elite as well.

And nontraditional firms will horn in on businesses once dominated by the Lehmans of the world. Private equity firms, hedge funds, and even sovereign wealth funds from the Mideast could expand further into traditional investment banking functions such as lending to early-stage businesses.

For years Wall Street has eaten everyone’s lunch. The lesson of the Great Unwind is that the tables can be turned.

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