Why Lehman's Bankruptcy Matters

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What an extraordinary day!

As I write this, the market is down 2.5% on the tumultuous events of the past weekend -- the most prominent of which is the looming bankruptcy of Lehman Brothers (NYSE: LEH  ) . Overseas, the UK FTSE 100 index lost 4.3% on the day and the German DAX lost 3%. (Most of Asia’s major stock markets were closed on Monday for holidays.)

What’s the big deal? How does Lehman’s bankruptcy affect more than just a handful of bankers and traders who work in the world’s financial capitals? More importantly, how does it affect you?

Handicapping the bottom of the crisis
The crisis of confidence that overwhelmed Lehman had its roots in the firm’s balance sheet, which is bloated with underperforming assets (Lehman has more than $21 in assets for every $1 in shareholder’s equity). However, between Lehman’s bankruptcy and Merrill’s takeover, we may be witnessing the fever breaking for the bedridden financial markets.

At the very least, the sale of Lehman’s $600 billion in assets will be a milestone in the cleanup of the rot that has been paralyzing Wall Street. Even if it is conducted in an orderly manner, the sale will put pressure on the prices of LBO loans, commercial real estate, and real estate securities. This may force other banks to take further writedowns on their assets and/or sell some of their own underperforming assets.

In the short term, this means more pain for the financial services industry, including broker-dealers, commercial banks, and insurance companies. But it’s the kind of pain that comes from cleaning a wound, and it will ultimately move the industry toward the end of the current crisis.

That’s good for everyone -- workers, business owners, and investors -- because when credit (read: the ability/willingness to make loans) is constrained, it’s a brake on business. The sooner banks can begin lending normally again, the better it is for the economy.

Goldman, Morgan, and the future of the industry
Who needs parasitic investment banks -- they don’t actually produce anything, right? Well, sort of. It’s true they produce nothing tangible, but in many instances, they’ve provided U.S. business with a very real competitive advantage.

Broker-dealers help grease the wheels of the economy by pairing those who have capital (investors) with those who seek it (companies, as well as governments). In the 1860s, for example, Lehman’s future partner Kuhn, Loeb underwrote much of the construction of the railroads.

At the turn of the century, Lehman contributed to the expansion of retailing as one of the first financiers of (among others) Woolworth and Sears, Roebuck.

Lehman’s disappearance will leave only two major independent investment banks, Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) . (I’m assuming Bank of America’s (NYSE: BAC  ) acquisition of Merrill Lynch (NYSE: MER  ) will go through.) They will compete with several universal banks: Bank of America, Citigroup (NYSE: C  ) , and JPMorgan Chase (NYSE: JPM  ) .

With the number of participants shrinking by the day, how will this affect competition in the industry? After all, investment banks already had oligopolistic tendencies to begin with.

The credit-default swap snowball
Barely a week after Fannie Mae (NYSE: FNM  ) and Freddie Mac were nationalized, Lehman’s bankruptcy is another test for the $43 trillion (notional amount) credit-default swap (CDS) market, in which participants buy and sell insurance against bond defaults. Lehman was a dealer of these swaps, as well as the reference entity for some of them (i.e., people were buying insurance against a default on Lehman’s own obligations).

Yesterday, CDS traders were furiously trying to match offsetting trades in which Lehman was one of the counterparties. Sorting out who has exposure to Lehman and winding those exposures down will be a key task over the coming weeks.

Is the CDS market the next shoe to drop? I don’t know, but we should find out how resilient that market is.

Lehman customers
As of the end of August, Lehman Brothers’ investment management division -- which includes Neuberger Berman -- managed $273 billion on behalf of individuals, pension funds, foundations, etc. It’s important to note, however, that only the Lehman Brothers holding company will file for bankruptcy; the broker-dealer and investment management subsidiaries aren’t included in the filing.

The bankruptcy will likely lead to a winding down of the broker-dealer over time, but for customers, it’s business as usual with respect to their accounts right now; their assets are shielded from the bankruptcy proceedings, in compliance with SEC regulations.

In the event of bankruptcy, please remain calm
Lehman’s bankruptcy is undoubtedly a historic event with many ramifications. However, for individual investors, there is no call for panic. It’s a headache for the industry, but few firms not involved in financial services have any direct exposure to Lehman. Make sure you understand the dynamics of the companies you own in your portfolio, keep your wits about you, and remain focused on the long term. We’ll do our level best to help you along the way by keeping you informed.

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Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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