01 Oct 2008, Peter Madigan, Risk magazine
Bank of America's (BoA) decision to acquire Merrill Lynch last month turned out to be the final nail in the coffin of Lehman Brothers. Ironically, the plan took seed while the two banks were locked in closed-door meetings to try to save the 158-year-old broker-dealer from collapsing.
At 5pm on Friday September 12, Federal Reserve Bank of New York president Timothy Geithner convened a meeting of representatives from all the major Wall Street investment banks, broker-dealers and securities firms to discuss possible measures to save Lehman Brothers. In the previous two trading days, Lehman's equity price had halved, while credit default swap spreads had almost doubled, following the firm's admission of a $3.9 billion loss for the third quarter. Reports the firm was frantically searching for a buyer intensified as the weekend approached.
The Friday evening session adjourned around 8pm without agreement, although BoA and Barclays Bank were already being touted as the two most likely candidates to swoop in and save Lehman.
The following morning, the summit reconvened with chief executive John Thain heading the Merrill Lynch delegation. Thain was no doubt mindful of the fact the equity price of his own firm had slid 38% during the previous week's trading, to reach $17.05. Already, some market participants were beginning to speculate Merrill Lynch could be the next to collapse, joining Bear Stearns and Lehman Brothers.
Unbeknown to the rest of the delegates as talks resumed, Thain had earlier been advised by Merrill president Gregory Fleming to approach BoA chief executive Ken Lewis to gauge his receptiveness to acquiring the firm. With Lewis absent from the Fed meeting and Thain acutely aware that BoA remained in the frame as a potential Lehman rescuer, he decided to make his play before it was too late.
"Over the course of those discussions at the Fed about the implications of a Lehman bankruptcy, it became clear to me it would make sense for us to explore some options and that the funding of independent investment banks would come under pressure. The first conversations began Saturday morning," Thain revealed at a press conference the morning after the deal was struck.
Thain made his first approach via telephone, before meeting Lewis in person a few hours later and coming to provisional terms pending an examination of Merrill Lynch's books. By Saturday afternoon, a 45-strong team from BoA and private equity firm JC Flowers - which had recently conducted extensive analysis of Merrill's finances for another unsuccessful transaction - were scrutinising the dealer's balance sheet.
Back at the New York Fed, US Treasury and Federal Reserve officials declared no government safety net would be forthcoming to insulate any Lehman purchaser from losses on its $53 billion commercial real estate and residential mortgage securities portfolio, souring what interest, if any, BoA might have had in saving the broker-dealer.
After a full day spent analysing Merrill's books, the first rumours began swirling that a deal had been reached on Sunday evening. At the same moment, Lehman Brothers was instructing its lawyers to prepare for a midnight trip to the New York bankruptcy court.
When formal confirmation of the acquisition arrived, the most surprising aspect was the relative generosity of the offer. BoA paid $50 billion in stock for Merrill, implying an equity price of $29-a-share - a 70% premium on the previous trading day's close of $17.05. However, that price represents a bargain when compared with the record high of $97.53 set on January 24, 2007.
Whether BoA would have made a bid to buy Lehman Brothers without the backing of the Federal Reserve is doubtful. Although reported to have been in preliminary talks as early as September 10, the fact scant progress was made on the deal before talks with Merrill Lynch began on Saturday September 13 suggests Lewis was waiting for a pledge of support from the US Treasury before he would commit shareholders' money.
The withdrawal of BoA's interest effectively put the failure of Lehman Brothers beyond doubt. Despite Barclays' interest - and its subsequent capture of Lehman's North American investment banking business for a mere $250 million - the heated political climate and nationwide anger over the government bailouts of Fannie Mae, Freddie Mac and American International Group would have made the notion of the US Treasury putting taxpayers' money on the line to protect a UK bank against losses on Lehman's book all but unthinkable.
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