Lehman's Got a Reluctant Safety Net in Uncle Sam

The federal government has stepped up to aid Bear Stearns, Fannie Mae and Freddie Mac in their hours of need. And while its largess has limits, some firms may be too big to fail. Simon Constable weighs in with The Real Story (above).
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It has been another tumultuous day in trading for

Lehman Brothers

(LEH)

, as the firm continued to weave in and out of the rumor-mill blades.

Though several factors will play a part in whether Lehman can keep its head above water, a key question is whether federal regulators will be willing to extend the same assistance they provided for

Bear Stearns

,

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

since the start of the year.

Treasury Secretary Henry Paulson and

Federal Reserve

Chairman Ben Bernanke have made tough statements in recent weeks indicating that the government will not bail out any and every financial institution in need of help. And while regulators are trying to avoid the "moral hazard" of removing risk from the market, they're likely to do everything in their power to avoid a major bank failure that would force the financial markets into chaos.

"They're not supporting the brokerage firms because of some vast outpouring of altruism on their part," said Brad Hintz, a Sanford C. Bernstein analyst and former Lehman CFO. "It's not because they want to save the brokerage firms, it's to save the fixed-income parties that continue to deal with them -- in a perfect world they'd be perfectly pleased to see mistakes cause economic losses."

Lehman shares closed down more than 12% to a 52-week low of $12.65 Monday, in a volatile day of trading in which it soared as high as $16.30, a gain of nearly 13%.

The firm was first buoyed by news that regulators would

step in

to prevent Fannie and Freddie from collapsing. Lehman is a major player in the mortgage-bond underwriting market, meaning that the ultimate fate of those government-backed mortgage lenders will have an impact on its finances as well. Reports on Friday that those companies may become insolvent sent Lehman shares down to the lowest level in nearly a decade.

A report from Hintz also supported shares early in the day, as the analyst predicted the company not be "forced into a 'shotgun marriage' like Bear Stearns."

However, the trading tides turned once the

Wall Street Journal

reported that Lehman had met with officials from the

Fed

and

Securities and Exchange Commission

to discuss options to build up its share price. Lehman is now considering a strategic partnership, buyback plan or asset sale to boost its shares, the

Journal

said, citing sources familiar with the situation.

Regardless of what steps Lehman ultimately takes to right itself, Hintz says the government will not allow Lehman or its peers to go under, because of the sheer complexity of assets and the effect it would have in the greater capital markets. As with Bear Stearns, Lehman's trades are intertwined with a number of other banks, and federal regulators stepped in not just for Bear but to support the broader financial system

Joseph Lynyak, a partner in the bank regulatory practice at law firm Venable LLP, says Bernanke and Paulson are talking tough to avoid giving the impression that the feds will step in to heal the wounds of every community bank that lent millions to subprime homebuyers.

Instead, they are trying "to strike the right balance in their remarks to the public," says Lynyak, a onetime honors fellow at the FDIC. "They're concerned about conveying a false impression to the marketplace that they would bail out every institution in every situation."

Bob Medlin, senior managing director at FTI Consulting, says regulators will likely decide whether -- and how -- to assist banks on a case-by-case basis, depending on the bank's situation and market conditions. That makes it tough to determine whether the feds will step in to heal the wounds of a

Washington Mutual

(WM) - Get Report

or

National City

(NCC)

the same way they would Bear or Lehman.

Indeed, the Office for Thrift Supervision allowed

IndyMac Bancorp

(IMB)

to fail. The regulator on Friday stepped in to

seize IndyMac's assets

in the second-biggest failure in the agency's history.

"They appear to be examining each situation each situation one at a time," says Medlin. "I don't think they're necessarily looking to bail out each situation that comes along."

Or, as Hintz puts it, "Small banks out in Kentucky and Tennessee don't have much of an impact on the debt capital markets."

In cases of major commercial banks, deposits are insured by the Federal Deposit Insurance Corp., but shareholders are not yet any more protected than those of Bear Stearns -- whose stock ended up at just a fraction of its value a few months before its sale to

JPMorgan Chase

(JPM) - Get Report

for $10 a share -- or IndyMac. It remains unclear what shareholders will get out of that deal.

Richard Bove, an analyst with Ladenburg Thalmann, places a heap of blame on the regulators themselves, who he says created the "recent era of regulation-lite" and are now making up for lost time as the markets entered the current turmoil. He says the government will "create as much money as is necessary to stop the runs on the system," although some bank failures will be inevitable.

Bove examined ratios of non-performing assets to total loans outstanding, as well as non-performing assets to total reserves and common equity. Besides IndyMac, the only other major bank near the "danger zone" was Washington Mutual, he said.

While there are surely more bleak days ahead for every company in the banking space, Bove is doubtful that this rumor-fueled crisis of volatile trading, insufficient liquidity and housing trauma will take out major commercial banks whose deposits are growing at a healthy rate.

"Does anyone really believe that

Bank of America

(BAC) - Get Report

is not going to be around one hundred years from now?" he asked in a note late last week. "If so I cannot find that person. May be the hysteria is being overdone."

Paulson and Bernanke are now pushing Congress to enact laws that give regulators the power to limit the impact of individual bank failures.

Hintz says these last-ditch efforts to bail out financial institutions would not be necessary if regulators were able to disentangle the exposure that is shared among many institutions. Cubillas Ding, a senior analyst at Celent, says that going forward, regulators will also have to do a better job of understanding and monitoring the exotic practices and products that Wall Street manufactures.

"This will be new territory for both banks and regulators alike," he adds.