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Lehman collapse portends fallout of inaction

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Members of Congress had balked at the $700 billion bailout of Wall Street, but the spectacular failure of Lehman Brothers two weeks ago showed the catastrophic consequences of not taking action and led to the current crisis, analysts say.

The severe credit crisis gripping Wall Street today was in large part triggered by the sudden bankruptcy of Lehman Brothers on Sept. 15 and its default on a stunning $165 billion of unsecured debts, stinging investors around the world with $120 billion in instant losses that are making them reluctant to lend again, financial analysts say.

At the time, the Treasury and Federal Reserve - like the public - viewed Lehman as a "sacrificial lamb" whose failure would be an object lesson for Wall Street firms that took flagrant risks, while they thought the financial system could absorb its defaults on a total of $613 billion in secured and unsecured debts without disastrous consequences.

But within days, the cascading fallout from the Lehman failure, including first-ever losses and closures at money market funds, forced regulators to reverse course and engineer a massive $85 billion bailout of American International Group to avoid further roiling financial markets.

Edward Hadas, an analyst at Breakingviews.com, said the Lehman bankruptcy was a seminal event in the world's credit markets.

"Confidence in the markets has evaporated," he said. "The markets have been seizing up off and on for the last year. But after the failure of Lehman Brothers, those who have funds are keeping them, and those who need them are desperate."

Investors' massive flight from world loan markets is so severe that it's now straining the resources of the Fed and other central banks as they pump cash into the money markets to try to revive them, he said.

Richard Berner, chief economist at Morgan Stanley, which assisted the Treasury in its bailout of Fannie Mae and Freddie Mac earlier this month, said the Fed did not realize how pervasive the impact of Lehman's failure would be, given its enormous debts and extensive and intricate ties with major investors and institutions around the world.

Lehman's default on unsecured, short-term debt it issued in the commercial paper market caused a money-market fund, Reserve Primary Fund, to "break the buck" for the first time. But beyond that, it unleashed a perverse chain reaction around the world as the "first failure of a major counterparty in the modern derivative world," Mr. Berner said.

The credit default swap market, a $55 billion global network of insurance on credit deals in which Lehman and AIG both were major players, fell into disarray and was one of the biggest casualties.

"What was underappreciated at the time of the Lehman bankruptcy was the impact on the counterparty system, the unsecured bondholder and money- market investors," Mr. Berner said. "Bondholders were decimated, creating a shock wave across money-market funds, pension funds and the entire 'buy-side' community."

It was "just too much for the system to handle," he said. Undoubtedly, the "unprecedented volatility and destruction in the credit markets [that ensued] served as a catalyst" for the Fed's about-face only days later when it rescued AIG and proposed along with Treasury the massive bailout bill for banks.

AIG had even more extensive ties than Lehman with financial institutions and investors around the world, as did Merrill Lynch and several other banks that were teetering on the edge.

Since Lehman's failure, all of the remaining top investment banks on Wall Street have either merged with other banks, like Merrill, or converted into bank holding companies, like Morgan Stanley, to escape the continuing fallout from stung and angry investors.

Fed Chairman Ben S. Bernanke conceded in testimony last week that the central bank was forced to reverse course after the unexpectedly harsh reaction to Lehman's bankruptcy, combined with the sudden emergence of AIG as the next possible failure.

"While perhaps manageable in itself, Lehman's default was combined with the unexpectedly rapid collapse of AIG, which together contributed to the development last week of extraordinarily turbulent conditions in global financial markets," he told the Joint Economic Committee.

"These conditions caused equity prices to fall sharply, the cost of short-term credit - where available - to spike upward, and liquidity to dry up in many markets. Losses at a large money-market mutual fund sparked extensive withdrawals from a number of such funds. A marked increase in the demand for safe assets - a flight to quality - sent the yield on Treasury bills down to a few hundredths of a percent," Mr. Bernanke testified.

Despite the case Mr. Bernanke and Treasury Secretary Henry M. Paulson Jr. have made for a congressional rescue of the bank and credit markets, most Americans don't seem to be buying it and don't understand how the disarray eventually could affect the man on the street.

A poll released Friday by the Associated Press found that only 30 percent of Americans support the bailout, and 45 percent are opposed.

Calls to congressional offices are "running 50 percent 'no' and 50 percent 'hell, no,'" Rep. Paul Kanjorski, Pennsylvania Democrat, told CNBC Friday. "Out of 100 calls, you are lucky if one of them is positive."

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