He's Not Heavy. He's my (Lehman) Brother

Here we go again folks. Another Wall Street icon is on the brink of collapse. It is the same old story, bets on an inflated real estate market fueled by easy money (accommodative Fed) and alchemists (Ivy League quants) who believed they could turn lead-like structures, consisting of subprime mortgages, risky commercial real estate loans, LBO loans, credit card receivables, auto loans and whatever they could cram into a structure, into gold. Common sense says that a chain is only as strong as its weakest link. These rockets scientists (some quants are actually rocket scientists) thought different. Thus, they created the CDO (collateralized debt obligation). Wall Street firms and banks believed that they could lay off the risk of such structures by using off-balance sheet vehicles such SIVs. Events of default triggers brought these structures careening back onto financial institutions balance sheets. The result has been billions of dollars in writedowns and losses and the near failures if two Wall Street firms (Bear and Lehman) and the conservatorship of GSEs FNMA and FHLMC.

The question now is: Will Lehman survive? My guess is that it will survive as pieces carved up by banks and private equity firms. The next target on the radar screen appears to by Merrill, which kept writing subprime loans right up until the bitter end (buying subprime lenders to generate new loans fro its structures). While a Merrill (or Lehman) bankruptcy is not likely, the horizon is not sunny for neither Wall Street investment bank.

The strategy here is to hold onto Lehman, Morgan Stanley, Merrill and even Goldman bonds, but preferred holders had better beware of how potential "rescue plans" affect this asset class. Mr. Paulson has set a few dangerous precedents with the GSEs.

In my internal use only publication I created at my employer (taken out of publication for being frighteningly accurate) I warned last month that credit spreads would widen in the corporate bond and preferred markets. Thus far this has been the case. Mr. Paulson believed that his takeover of the GSEs would stabilize the financial sector. Instead, he frightened investors away and has made it nearly impossible for financial institutions to raise Tier-One capital in the equity and preferred securities markets.