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Lehman Doesn't Pose Systemic Risk

A Lehman liquidation won't have that bad of a ripple effect on other financial firms. Otherwise, the Fed would have stepped in to save it.

The Sunday night headlines are that

Bank of America

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has agreed to buy

Merrill Lynch


, while

Lehman Brothers


is preparing to file for bankruptcy after its leading potential buyer, Barclays, walked away. Meanwhile,


(AIG) - Get American International Group, Inc. Report

reportedly is scheduled to announce a restructuring and possible recapitalization plan Monday. There's still no word on the fate of

Washington Mutual

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U.S. equity futures are currently down sharply in overseas trading, indicating a very bad opening come Monday morning. But I believe that because the Treasury and the

Federal Reserve

are letting Lehman fail, its interconnectedness with other firms in terms of counterparty risk must have diminished after the collapse of

Bear Stearns

. Thus, the headline risk of Lehman's bankruptcy could be far greater than the systemic risk to the financial system.

The Fed's dealer liquidity window, which was Ben Bernanke's creation after Bear Stearns collapsed, has likely kept Lehman on life support for some time, but again, the Fed's decision to let Lehman go belly up indicates that the central bank didn't perceive that there would be too bad of a ripple effect from a Lehman collapse. Otherwise, the Fed would have felt forced to backstop a buyer for Lehman. (While critics decry the use of public funds for any bailout, the Fed


to act if there is "systemic" financial system risk.)

The July 15 (and 2008) low for the

S&P 500

is 1200. On Friday, the S&P 500 closed at a gain for the week, at 1251, thus the S&P 500 is still between the March 17 and July 15 lows. We added a short position when the S&P 500 fell below 1256.98, and there is a good chance we will retest the lows of July 15, but the market continues to hang in despite the headline risk.

Monday morning will be interesting.

Following is an article Jim Cramer posted on

Sunday afternoon. As successful as Jim is, he still works pretty hard keeping readers informed on actionable events. I disagree with his statement that Lehman was the worst of the mortgage buyers: Bear Stearns gets that nod, although the speed of Bear's collapse had a lot to do with how it was financed (i.e., funded).

No Barclays Bid?

By Jim Cramer

Now that we know

there is no Barclays bid

, should we just presume no bid? Sure seems that way. Without a buyer of

Lehman Brothers


we will have chaos and dislocation, and whatever firms have provided financing to Lehman will have to take hits larger than they possibly can, and we will see what happens when a major


of mortgages goes under.

Lehman owns hard-to-value assets and it borrows a lot of money to finance that inventory. We don't know who is lending to it, but theoretically, the

Federal Reserve

could lend the new entity the money it needs for a disorderly -- not


-- liquidation. (You would only get an orderly one with a real buyer.)

Obviously anyone owning mortgages takes a hit tomorrow with no buyer for Lehman. But how big a hit?

I think the missing element here is that Lehman was the worst mortgage lender among the majors. (Of course no one was worse than the Novastar/Fremont stooges, but they were not majors.)

Because as public sightseers we have


idea what Lehman really owns, we know right now that it must be pretty toxic. The perception is that we have a huge game of chicken going on here where the government is holding out the disruption of the banking system and the terrible hits the remaining banks will take vs. a smooth and orderly hit if the banks buy the whole shebang.

I think the banks are willing to take their chances because the real problems with Lehman are in Europe, not here, and they would rather pick up the Lehman assets without having to pay anything for them.

It's really hard to figure out how bad this will be, and I know there are tons of so-called counterparty risks, but I think, in the end, with no deal the market gets hit hard for a couple of days, the bears try to break





(AIG) - Get American International Group, Inc. Report

(I hope there's some plan there, but I don't know.) and


(C) - Get Citigroup Inc. Report

, and then there's really no one else left that's in big trouble right now.

Washington Mutual

(WM) - Get Waste Management, Inc. Report

? Hard to break it from this level.

It's a fluid situation. I will try to update with scenarios when we know more.

One thing's for certain though. If Barclays had bid, we would have been up gigantically, especially because it's looking like crude oil prices are down a bunch.

Not going to happen.

At the time of publication, Cramer had no positions in stocks mentioned.

At the time of publication, Gilmartin was had no positions in stocks mentioned, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback;

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