Lehman Brothers demise triggers huge default

Lehman Brothers, the bust investment bank, triggered one of the biggest corporate debt defaults in history yesterday as it emerged that the US Federal Reserve is harbouring grave concerns about whether Washington’s $700 billion (£413 billion) bailout fund will avert a financial meltdown.

An auction of Lehman’s bonds yesterday determined that the bank’s borrowings were worth only 8.625 cents on the dollar. The valuation leaves the insurers of the debt a bill of about $365 billion. It is not clear whether the insurers, which are required to settle the bill in the next two weeks, will be able to pay – a development that could further undermine increasingly stressed capital markets.

The $365 billion default came as stock markets around the world suffered one of their worst days since the crash of 11 years ago. Panicking about the prospect of global recession, the FTSE 100 index of leading shares in London crashed within seconds of opening, losing 8.9 per cent of its value, its worse fall since October 1987.

The index recovered to close down 225 points, marking a 5 per cent decline, but more than a fifth was wiped off London shares this week alone. Issues in New York fluctuated wildly as the Dow Jones industrial average slumped by 312.14 points at lunchtime before closing at 8,451.19, down 128.00. Both markets had been scared by losses in Tokyo, where the Nikkei lost 10 per cent of its value.

Amid the mayhem across the world’s stock markets, senior Fed officials now doubt whether Washington’s bailout fund will work unless it is launched in some form in the next two weeks.

The Times has learnt that central bankers in America are anxious that if the Treasury is not able to accelerate the speed at which it launches its rescue scheme, it will have no effect. At the moment, the Treasury, which controls the fund, is working to a five-week schedule to get the rescue package up and running. Under present plans, the bailout fund is not expected to buy its first distressed mortgage-backed bonds until after the US elections on November 4.

It is understood that the Fed believes that this will be too late to help the banks that are suffocating under market conditions. Credit markets have frozen up and many banks have been cut off from being able to borrow from one another.

Mr Paulson’s bailout fund is designed to buy up distressed bonds held by troubled banks. This week the former chairman of Goldman Sachs appointed Neel Kashkari, one of his protégés at the Wall Street bank, to run the fund. Mr Kashkari had already been working closely with Mr Paulson during the negotiations over the passage of the “troubled asset relief programme” on Capitol Hill.

Mr Paulson is also considering a range of other forms of financial assistance, which include the Treasury using taxpayer funds to buy stakes in Wall Street banks. Under such a plan, the cash received in return for the shareholding would provide much-needed capital for the banks.

Lehman’s corporate debt default promises to increase the stress across global credit markets. Sean Egan, of the Egan-Jones ratings agency, said: “This is a killer. Lehman said a month ago that it was in terrific shape and now you can’t even get ten cents on the dollar for its debt.

“It underscores the deep structural flaws in our financial system, knocks confidence in the financial markets and raises the cost of capital. It also demonstrates that we are experiencing not only a crisis of confidence, but a crisis.”

About 350 banks and investors are thought to have insured an estimated $400 billion of Lehman’s debt through complex derivatives, known as credit default swaps. These include Pacific Investment Management, the manager of the world’s largest bond fund, Citadel, the US hedge fund, and American International Group, the insurer that the US Government recently bailed out with two loans totalling about $123 billion.

The Times has learnt that the US Treasury has been overwhelmed with requests from executives of other beleaguered sectors who are seeking a similar bailout scheme for themselves. It is thought that representatives from the US car and airline industries have approached the Government for assistance. It is understood that Mr Paulson does not believe that it is his job to help them. Rather, he is intent on addressing the root problems of the financial crisis.

Tom Bawden in New York and Suzy Jagger in Washington
October 11, 2008

Source: The Times

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