Lehman Endgame Looks Ugly

It’s looking like Lehman Brothers may not be able to count on the federal government for any help in its hour of need and that has all of Wall Street shaking. Shares of Lehman sunk deeper into penny stock territory on Friday, as the beleaguered firm races to find another bank to buy it in a bid to stave-off an imminent collapse of the historic 158-year-old firm.

In early Friday trading, Lehman’s stock fell 10% to $3.80, continuing a downward death spiral that began Sept. 8. Now that Wall Street has concluded Lehman CEO Dick Fuld won’t be able to pull-off his previously announced plan for shoring-up the investment firm’s balance sheet, it’s pretty much become a race against time for Fuld to find a buyer—at any price—for the firm. The speculation on Wall Street is that Bank of America, Barclays and consortium of private equity firms are the most interested suitors.

But it’s not clear if any of those potential buyers will want to do a deal with Fuld, as long as the acquirer must also take on some $30 billion in rotting commercial real estate assets that Fuld was planning to unload. Treasury Secretary Hank Paulson, according to wire service reports, say the federal government is unwilling provide any additional help to Lehman beyond allowing it continue borrowing short-term money from the Federal Reserve—-something the firm has been able to do since the spring.

When JPMorganChase agreed in March to a shot-gun marriage with Bear Stearns, to similarly save that investment firm from collapse, the Fed guaranteed up to $29 billion of Bear’s bad mortgage-related assets. The Fed backstop gave JPMorgan CEO Jamie Dimon enough security to take on the risk of rescuing Bear from a certain bankruptcy filing. This time, however, it doesn’t appear that either the Fed or Treasury is willing to provide a similar guarantee to Lehman’s would be savior.

And without that kind of government-backed guarantee it’s by no means certain any bank will be willing to take on the risk of adding Lehman’s questionable commercial real estate assets to its balance sheet. “There’s very little chance anyone will do a deal for Lehman without the government stepping in,’’ says Janet Tavakoli, a derivatives and structured finance consultant in Chicago.

That’s why some of Lehman’s trading partners are beginning to demand cash settlement for trades, meaning trades must be completed within a day instead of the typical three-day period, sources say. Hedge funds and other banks are still trading with Lehman. They are worried if Lehman will be around to make good on those transactions.

The apparent reluctance of either Treasury or the Fed to go the distance and insure that a deal gets done is why some on Wall Street are beginning to whisper the unthinkable: a Lehman bankruptcy filing at some point in time. A bankruptcy filing, of course, could be a real mess for Wall Street given all the tens of billions in short-term loans other banks have extended to Lehman, which are backed by collateral. And of course there are numerous other trades and transactions Lehman has done with hedge funds and other trading partners that also are backed by collateral—-in some cases potentially backed by pieces of the same assets.

Andrew Rahl, a bankruptcy lawyer with Reed Smith, says a Lehman bankruptcy filing would be an unprecedented event, given that some of Lehman’s division, such as it brokerage arm, are regulated entities. “Clearly this would be a filing without any real precedent. There could be unintended consequences; there could even be some favorable consequences.’’ One favorable outcome might be the freezing of some of Lehman’s ailing commercial real estate assets by the bankruptcy court—meaning those assets wouldn’t find their way into the market anytime soon.

One way Lehman could avoid such a calamity would be to simply break itself up into many pieces and let would be acquirers buy what they like best. A bank could take on Lehman’s investment banking arm, another buyer could get its Neuberger Berman operation and vulture investor might take a flyer on Lehman’s distressed commercial real estate property.

The fear of Lehman failing is one reason shares of other financial firms with mountains of troubled-assets on their balance sheet are plunging too—most notably Merrill Lynch and American International Group. Wall Street is coming to grips with the reality that if the federal government can’t bailout all these institutions, there may be no buyers out there to save them. In the government’s bailout of Fannie Mae and Freddie Mac, it wasn’t just shareholders who got creamed—-holders of Fannie and Freddie’s higher-yielding preferred shares also took a beating. To date, most Wall Street banks have been able to raise capital by selling preferred stock to deep-pocketed sovereign wealth funds and private equity firms. But Wall Street won’t be able to do those deals if there’s uncertainty about whether those preferred shares will have any value down the road.

It’s not a pretty picture. But it’s another reason why this yearlong mortgage-inspired credit crunch is shaping up as one of the worst financial disasters in decades.