In one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America for roughly $50 billion to avert a deepening financial crisis, while another prominent securities firm, Lehman Brothers, hurtled toward liquidation after it failed to find a buyer, people briefed on the deals said.
The humbling moves, which reshape the landscape of American finance, mark the latest chapter in a tumultuous year in which once-proud financial institutions have been brought to their knees as a result of tens of billions of dollars in losses because of bad mortgage finance and real estate investments.
They culminated a weekend of frantic around-the-clock negotiations, as Wall Street bankers huddled in meetings at the behest of Bush administration officials to try to avoid a downward spiral in the markets stemming from a crisis of confidence.
“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I‘ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm the Blackstone Group, who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration.
It remains to be seen whether the sale of Merrill, which was worth more than $100 billion during the last year, and the controlled demise of Lehman will be enough to finally turn the tide in the yearlong financial crisis that has crippled Wall Street. Questions remain about how the market will react Monday, particularly to Lehman’s plan to wind down its trading operations, and whether other companies may still falter, like the American International Group, the large insurer, and Washington Mutual, the nation’s largest savings and loan. Both companies’ stocks fell precipitously last week.
Though the government took control of the troubled mortgage finance companies Fannie Mae and Freddie Mac only a week ago, investors have become increasingly nervous about the difficulties of major financial institutions to recover from their losses.
How things play out could affect the broader economy, which has been weakening steadily as the financial crisis has deepened over the last year, with unemployment increasing as the nation’s growth rate has slowed.
What will happen to Merrill’s 60,000 employees or Lehman’s 25,000 employees remains unclear. Worried about the unfolding crisis and its potential impact on New York City’s economy, Mayor Michael R. Bloomberg canceled a trip to California to meet with Gov. Arnold Schwarzenegger. Instead, aides said, Mr. Bloomberg spent much of the weekend working the phones, talking to federal officials and bank executives in an effort to gauge the severity of the crisis.
The weekend that humbled Lehman and Merrill Lynch and rewarded Bank of America, based in Charlotte, N.C., began at 6 p.m. Friday in the first of a series of emergency meetings at the Federal Reserve building in Downtown Manhattan.
The meeting was called by Fed officials, with Treasury Secretary Henry M. Paulson Jr. in attendance, and it included top bankers. The Treasury and Federal Reserve had already stepped in on several occasions to rescue the financial system, forcing a shotgun marriage between Bear Stearns and JPMorgan Chase this year and backstopping $29 billion worth of troubled assets — and then agreeing to bail out Fannie Mae and Freddie Mac.
The bankers were told that the government would not bail out Lehman and that it was up to Wall Street to solve its problems. Lehman’s stock tumbled sharply last week as concerns about its financial condition grew and other firms started to pull back from doing business with it, threatening its viability.
Without government backing, Lehman began trying to find a buyer, focusing on Barclays, the big British bank, and Bank of America. At the same time, other Wall Street executives grew more concerned about their own precarious situation.
The fates of Merrill Lynch and Lehman Brothers would not seem to be linked; Merrill has the nation’s largest brokerage force and its name is known in towns across America, while Lehman’s main customers are big institutions. But during the credit boom both firms piled into risky real estate and ended up severely weakened, with inadequate capital and toxic assets.
Knowing that investors were worried about Merrill, John A. Thain, its chief executive and an alumnus of Goldman Sachs and the New York Stock Exchange, and Kenneth D. Lewis, Bank of America’s chief executive, began negotiations. One person briefed on the negotiations said Bank of America had approached Merrill earlier in the summer but Mr. Thain had rebuffed the offer. Now, prompted by the reality that a Lehman bankruptcy would ripple through Wall Street and further cripple Merrill Lynch, the two parties proceeded with discussions.
On Sunday morning, Mr. Thain and Mr. Lewis cemented the deal. It could not be determined if Mr. Thain would play a role in the new company, but two people briefed on the negotiations said they did not expect him to stay. Merrill’s “thundering herd” of 17,000 brokers will be combined with Bank of America’s smaller group of wealth advisers and called Merrill Lynch Wealth Management.
For Bank of America, which this year bought Countrywide Financial, the troubled mortgage lender, the purchase of Merrill puts it at the pinnacle of American finance, making it the biggest brokerage house and consumer banking franchise.
Bank of America eventually walked away from its talks with Lehman after the government refused to take responsibility for losses on some of Lehman’s most troubled real-estate assets, something it agreed to do when JP Morgan Chase bought Bear Stearns to save it from a bankruptcy filing in March.
A leading proposal to rescue Lehman would have divided the bank into two entities, a “good bank” and a “bad bank.” Under that scenario, Barclays would have bought the parts of Lehman that have been performing well, while a group of 10 to 15 Wall Street companies would have agreed to absorb losses from the bank’s troubled assets, to two people briefed on the proposal said. Taxpayer money would not have been included in such a deal, they said.
Other Wall Street banks also balked at the deal, unhappy at facing potential losses while Bank of America or Barclays walked away with the potentially profitable part of Lehman at a cheap price.
For Lehman, the end essentially came Sunday morning when its last potential suitor, Barclays, walked away from a deal, saying it could not obtain a shareholder vote to approve a transaction before Monday morning, something required under London Stock Exchange listing rules, one person close to the matter said. Other people involved in the talks said the Financial Services Authority, the British securities regulator, had discouraged Barclays from pursuing a deal. Peter Truell, a spokesman for Barclays, declined to comment.
Lehman was expected to seek bankruptcy protection for its holding company by late Sunday in what would be the largest failure of an investment bank since the collapse of Drexel Burnham Lambert 18 years ago, people close to the matter said. Lehman’s subsidiaries were expected to remain solvent while the firm liquidates its holdings, these people said. Under this scenario, a group of banks have tentatively agreed to provide a financial backstop to assist in an orderly winding down of the 158-year-old investment bank. Such an agreement could expose those banks to losses on Lehman’s assets.
Herbert H. McDade III, Lehman’s president, was at the Federal Reserve Bank in New York late Sunday, discussing terms of Lehman’s dissolution with government officials. The Fed was expect to play a supporting role in the process by temporarily accepting lower-quality assets from banks in return for loans from the government.
Lehman’s filing is unlikely to resemble those of other companies that seek bankruptcy protection. Because of the harsher treatment that federal bankruptcy law applies to financial-services firms, Lehman cannot hope to reorganize and survive. It was not clear whether the government would appoint a trustee to supervise Lehman’s liquidation or how big the financial backstop would be.
Lehman has retained the law firm Weil, Gotshal & Manges as its bankruptcy counsel.
The collapse of Lehman is a devastating end for Richard S. Fuld Jr., the chief executive, who has led the bank since it emerged from American Express as a public company in 1994. Mr. Fuld, who steered Lehman through near-death experiences in the past, spent the last several days in his 31st floor office in Lehman’s midtown headquarters on the phone from 6 a.m. until well past midnight trying to find save the firm, a person close to the matter said.
The weekend’s events indicate that top officials at the Federal Reserve and the Treasury will take a harder line on providing government support of troubled financial institutions.
While offering to help Wall Street organize a shotgun marriage for Lehman, both the Fed chairman, Ben S. Bernanke, and Mr. Paulson had warned that they would not put taxpayer money at risk simply to prevent a Lehman collapse.
The tough-love message was a major change in strategy, but it remained unclear until at least Friday whether the approach was real or just posturing. If the Fed was faced with the genuine risk of another market meltdown, analysts said, it would be almost duty-bound to ride to a rescue of one kind or another.
What few people anticipated was that the Treasury and Fed officials might reach for an even broader strategy.
“They were faced after Bear Stearns with the problem of where to draw the line,” said Laurence H. Meyer, a former Fed governor who is now vice chairman of Macroeconomic Advisors, a forecasting firm. “It became clear that this piecemeal, patchwork, case-by-case approach might not get the job done.”
At first glance, the new strategy by Mr. Paulson and Mr. Bernanke represents a much purer and tougher insistence that Wall Street work out its own problems without government help.
But that is only the first glance. If Bank of America acquired Merrill Lynch, its capital reserves would immediately fall below the minimum requirements for bank holding companies. Federal regulators, including the Federal Reserve, would have to show lenience for as long as it took the capital markets to regain their confidence — which could be quite a while.
And Merrill Lynch is hardly the only troubled financial institution on the horizon. Administration officials acknowledged this week that more bank failures were inevitable, and the main protection for depositors — the Federal Deposit Insurance Corporation — is likely to exhaust the reserves it has built over the years from bank insurance premiums.
“What we need now is a systemic solution and to admit that this is an extraordinary situation,” Mr. Meyer said. He said the government should go to the heart of the crisis — the mortgage market — and start buying mortgage-backed securities in a broad rescue.
That is similar to an approach urged by Alan Greenspan, Mr. Bernanke’s predecessor as chairman of the Federal Reserve. Mr. Greenspan, who has long been a staunch opponent of government intervention in the economy, said Sunday that the federal government might have to shore up some financial institutions.
“This is a once-in-a-half-century, probably once-in-a-century type of event,” Mr. Greenspan said in an interview on ABC. “I think the argument has got to be that there are certain types of institutions which are so fundamental to the functioning of the movement of savings into real investment in an economy that on very rare occasions — and this is one of them — it’s desirable to prevent them from liquidating in a sharply disruptive manner.”
Most economists say that bailouts are often bad economic policy because each rescue tends to encourage “moral hazard” — the tendency of institutions and investors to take even bigger risks because they assume the government will rescue them, too.
Both Mr. Paulson and Mr. Bernanke worried that they had already gone much further than they had ever wanted, first by underwriting the takeover of Bear Stearns in March and by the far bigger bailout of Fannie Mae and Freddie Mac.
Officials noted that Lehman’s downfall posed a lower systemic threat because it had been a very visible and growing risk for months, which meant that its customers and trading partners had had months to prepare themselves.
Outside the public eye, Fed officials had acquired much more information since March about the interconnections and cross-exposure to risk among Wall Street investment banks, hedge funds and traders in the vast market for credit-default swaps and other derivatives.
But James Leach, a former Republican congressman from Iowa and chairman of the House Banking committee, said the Fed and Treasury might not be able to avoid a broader rescue.
“The Fed’s historic position is to object philosophically to a rescue role but in the end to do everything in its power to avoid anything that poses systemic risk,” said Mr. Leach, now a lecturer at Harvard.
“My sense is that the systemic question will be the only question on the table if Lehman falters,” he continued. “If systemic risk is considered grave, the Fed, perhaps with Treasury playing at least an advisory role, will intervene.”