Post Lehman - Financial market recap

We already knew today was going to be an interesting one, after seeing two of the five largest investment banks (Lehman Brothers and Merrill Lynch) in the US essentially self destruct over the weekend.  Lehman Brothers filed for Chapter 11 bankruptcy at 1:45 AM this morning and a shotgun merger was reported between Merrill Lynch and Bank of America.  We also have a potential nuclear crisis at the massive insurance companies AIG as well as several large regional banks like Washington Mutual in dire straights.

The big headline number right now is the Dow Jones Industrials dropping 500 points or just under 5% on the day.  This is pretty much the median of what I had thought the bloodbath might look like after last nights news.  Had the Merrill Lynch merger not been announced I suspect we would have seen a circuit breaker tripping 10% drop in the stock markets today.  But there is a lot of interesting news items within that big story.

AIG's stock price plummeted 60%

The FED balked at providing emergency capital to AIG after private equity firms stepped away from them over the weekend.  To help buy time NY regulators set aside some safety valve regulation allowing AIG to borrow $20 Billion from their subsidiary companies.  This type of regulation is there for a reason to contain problems, while it buys time it increases the chance of a much larger systematic blowup with AIG.  Due to AIG's involvement is writing hundreds of billions in credit default swaps, which are basically insurances against debt defaulting, a collapse of the company could potentially cause a chain reaction throughout the whole financial system, as companies are forced to realize losses they've insured against.

Yields on Treasuries across the curve plummet

The yield on 10 year treasury bonds fell a whopping 24 basis points or 6.6% while the yield on the 13 week treasury collapsed 65 basis points or more than 44%  This represents a massive flight to safety as investors moved money out of pretty much every other asset class, stocks, commodities, corporate debt, etc and put it in the safest parking garage.  The fact the government did not step in to bailout Lehman probably also contributed to the huge movement in the 10 year as it reassured the bond market somewhat.

Technically this should drive mortgage rates down but if we start seeing regional bank failures, credit availability is going to dry up pretty fast regardless of what the interest rate is.

Intrabank lending rates skyrocket

LIBOR skyrocketed today and the effective fed funds rate was over 6%.  While the target fed funds rate set by the federal reserve currently 2% banks were not following it, the 2% vs 6% is a pretty massive difference.  To compensate the FED injected about $65 Billion in additional short term lending the the system in an attempt to drive the effective funds rate down to target.  We'll know in the morning if this was successful or not, if it wasn't look out.  Scary coincidence the last time there was this large of a differential between the effective funds rate and the target was just prior to the 1987 stock market crash.

There's a good gage of stress in the credit markets called the TED spread which is the difference in rates between 13 week treasury rates and LIBOR rates, and it basically rocketed straight up today.

Washington Mutual gets downgraded

S&P cut Washington Mutuals counter-party credit rating to junk.  If Moody's follows this downgrade which they probably will, it will totally lock out WaMu from the capital markets leaving the FHLB (Federal Home Loan Banks) as the only lender to fund them.  Basically at that point they are dead, no if ands or buts.  Highly unlikely, WaMu survives more than another couple weeks as an independent firm.

So what now?

The most critical things over the next 24-48 hours is getting some type of resolution to the crisis with AIG, this is without a doubt a much bigger issue the Lehman.  We've also got a FED meeting tomorrow and expectations (or rather hope) is that they will cut the target rate.  I have no idea what they'll try to do, but if they can't drive that overnight fed funds rate down with their $65B injection today there is zero chance it will happen.  I think their is also a realization the cut would do absolutely nothing long term other than juice the stock markets for what, maybe a couple days?

We've also got the fact many Asian markets were closed last night and will open for the first time with the double wammy of the investment bank implosions and a massive dump in the US stock markets.  You'd expect them to follow, but if they actually crash that may lead to another bad day for us tomorrow.

Anyways it's scary and interesting times, we are definetly sitting on a precipace right now, the various blowups are starting to come faster and faster and we may start to find how deep the rabbit hole really goes.

Update #1:

AIG has been downgraded by A from AA- by Fitch, if S&P or Moody's follow suit this could result in significant collateral calls on the companies credit default swaps.  Meaning the company will have 48-72 hours to raise billions or follow Lehman to bankruptcy