Weekend turmoil in financial markets

John Greenwood, Invesco Chief Economist, gave the following comment in response to the news: "At its core the Lehman-Merrill Lynch-AIG financial crisis is about balance sheets. On the way up the credit bubble helped to inflate the values of houses and commercial real estate and mortgage-backed securities based on them, as well as the values of risky equities, high-yielding currencies and finally commodities. As long as asset prices were rising, investment banks, mortgage finance companies and hedge funds were only too happy to borrow more and more to fund such acquisitions. Rising asset prices fostered illusions of balance sheet strength.

"Now as the credit bubble bursts the positive feedback loop that strengthened asset values and investors' equity in the boom years has gone into reverse. Two types of investors have been, and will be hit hardest: (1) those holding substantial amounts of assets in the previously targeted risky, high return areas such as real estate, high-yield currencies and commodities, and (2) those firms, funds, or individuals that are most heavily leveraged. Investment banks like Lehman Brothers and Merrill Lynch were at the forefront of the balance sheet boom, but now their assets have gone bad, and lenders have been unwilling to roll over their loans. Lehman's large holdings of real estate and mortgage backed securities, combined with their massive leverage has destroyed its business".

Lehman Brothers files for bankruptcy

The fourth-largest investment bank in the US, Lehman Brothers, succumbed to the subprime mortgage crisis and filed for bankruptcy, as potential buyers Barclays plc and Bank of America abandoned takeover talks at the weekend. Lehman Brothers, the 158-year old firm, said it intended to file for Chapter 11 bankruptcy protection, which allows a company time to reorganise and devise a plan to pay creditors. The bank, which employs 25,000 staff worldwide, including 5,000 in the UK, has seen its share price tumble 94% in the year to date.

Barclays, which had emerged as a leading candidate to acquire Lehman Brothers, was first to pull out yesterday, saying it could not obtain guarantees from the US government or other Wall Street firms to protect against potential losses on Lehman Brothers' assets. Bank of America then withdrew around three hours later, before declaring it would be buying Merrill Lynch.

Merrill Lynch agrees to be bought

In what was a dramatic weekend, investment bank Merrill Lynch, which has suffered over US$52bn in losses and writedowns from subprime-mortgage related securities, agreed to be taken over by Bank of America. Merrill Lynch has seen its share price fall by 80% since peaking at US$97.53 early last year. Bank of America said it had agreed to buy the bank for US$50bn in a deal that will create the world's largest financial services company and end 94 years of independence for Merrill.

Emergency funds

In a related but separate development, 10 of the largest banks in the world agreed to establish a US$70bn emergency fund. It is intended that any of these banks can utilise up to one third of the fund should they face any liquidity problems. Elsewhere, AIG also made the headlines. The world's largest insurer, which has been reeling from real-estate losses, approached the Federal Reserve for US$40bn to shore up its finances.

Market reaction

Stockmarkets in Europe and Asia dropped sharply and the US dollar tumbled against both the euro and yen as Lehman's failure raised fears about the strength of the global financial system.

In bond markets, a flight-to-quality has seen government bond prices surge. By 11am, US two-year Treasury yields have fallen 35bps, to 1.86%, the sharpest drop since 17 March 2008, the day Bear Stearns was bailed out. In credit markets, spreads have widened and the cost of insuring against default has soared. The iTraxx Crossover index, an index of 50 mostly high-yield corporate bonds, which is seen as a barometer of investor appetite for riskier credit, has soared. The cost to insure €10m of debt rose from about €545,000 last Friday to €608,000 by 11am today. European central banks have pledged support. The Bank of England stated that it will take "appropriate actions if necessary'' to ease money market tension, while the European Central Bank has said it will offer financial institutions as much capital as is required via today's auction, at a minimum rate of 4.25%.

The chances of a US interest rate cut at tomorrow's meeting of the US Federal Reserve increased sharply according to futures markets. Last Friday futures markets implied a 12% chance of a 0.25% cut, however the implied probability has now increased to an 82% probability.