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September 9, 2008 / 3:34 PM / 9 years ago

Lehman stock tumble raises government rescue specter

By Karey Wutkowski - Analysis

WASHINGTON (Reuters) - A 45 percent slide in the shares of Lehman Brothers Holdings Inc LEH.N, on concern it was struggling to raise desperately needed capital, stirred speculation that a U.S. government-sponsored rescue was increasingly likely.

The forced-sale of the Bear Stearns brokerage in March and the pre-emptive seizure Sunday of mortgage finance giants Fannie Mae FNM.N and Freddie Mac FRE.N has set a template that U.S. financial authorities might find hard to avoid.

Lehman, left as the smallest major U.S. independent investment bank after Bear Stearns’ takeover by JPMorgan Chase & Co (JPM.N), has a prominent role in many of the same markets that Bear Stearns had: interest rate swaps, credit default swaps and equity derivatives.

While the government would be very reluctant to intervene yet again, especially if it required taxpayers’ money, several experts say there may be no alternative to avoid a systemic financial crisis.

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke may be forced to act to preserve stability in the rest of the financial system.

“There is a risk that you could get the equivalent of a financial black hole and more people getting sucked in,” said Robert Litan, a senior fellow in the economic studies program at the Brookings Institution in Washington.

Litan doubted Paulson or Bernanke wanted to go down in history books as an example of what not to do.

The tipping point of government intervention comes down to exactly how much counterparty risk exists with Lehman.

Several financial experts said Paulson, a former Goldman Sachs chairman, was likely calling friends on Wall Street asking what people know, who is exposed and how much loss they are willing to take.

“Clearly, as was the case with Bear Stearns, there’s concern that there would be outstanding trades that would be problematic to unwind should a worse case scenario develop,” said John Canavan, analyst at Stone & McCarthy Research Associates.

COUNTERPARTY RISK

The Fed already has a borrowing facility open to Lehman, a measure offered to investment banks after the Bear Stearns failure. But it is meant to ensure short-term liquidity and not prop up an insolvent firm.

Some experts said if the counterparty risk is deemed to be small enough, regulators could move away from the precedent they set with Bear Stearns and send a message that the investments are not too big to fail.

“It’s a closer call,” said New York University economics professor Lawrence White, who formerly served on the Federal Home Loan Bank Board. “I don’t think there would be a big effect in the stock market... If (the counterparty risk is) relatively small, the Fed turns its back and says tough luck.”

Concerns about the survival of Lehman have been circulating for months, causing its stock price to drop almost 90 percent this year. Lehman has complained that unfounded rumormongering by traders who profit from share price declines are behind the dramatic decline.

    Lehman shares closed Tuesday down 45 percent at $7.79 on the New York Stock Exchange, and touched their lowest level since October 1998.

    The stock tumbled after a report by Dow Jones Newswires that talks on a possible investment from Korea Development Bank broke down, citing the chairman of South Korea’s top securities regulator, Jun Kwang-woo. A spokesman for the regulator denied the report, telling Reuters that Jun never made the statement.

    The Dow article also quoted an unnamed government official as saying KDB had decided not to invest in Lehman.

    A Lehman spokeswoman and representatives for the Federal Reserve and Securities and Exchange Commission declined to comment.

    A U.S. Treasury Department spokeswoman said the department stays in touch with Wall Street on a regular basis. NYSE Regulation spokesman Scott Peterson said the exchange is monitoring trading in Lehman shares closely.

    Lehman shares rose 8 cents to $7.87 in after-hours trading after Citigroup Inc (C.N), Credit Suisse Group AG CSGN.VX, Goldman Sachs Group Inc (GS.N) and Morgan Stanley (MS.N) all said they were still trading with Lehman.

    And some experts are more bullish on Lehman’s prospects as a stand-alone institution, saying it has a long tradition of success that won’t quickly evaporate.

    “My guess is that Lehman will end up finding a way to survive without government help,” said economist Allen Sinai, head of Decision Economics Inc, a global economics and financial markets advisory firm.

    But if other firms start pulling their money out of Lehman and it looks like a spreading credit seizure is underway, regulators will be forced to pull the trigger on another shotgun marriage like the one it arranged with Bear Stearns, Litan said.

    “That’s the nightmare you worry about, Even if it’s only a 5 percent or 10 percent risk of that happening, do you really want to take that risk?” Litan said.

    Additional reporting by Mark Felsenthal, Kevin Drawbaugh, Rachelle Younglai; and Ellen Freilich, Christian Plumb in New York

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