Two More Wall Street Dominoes Fall

A year ago, it was almost unthinkable that Bear Stearns, Merrill Lynch and Lehman Brothers would vanish from the landscape.
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If someone had predicted one year ago that

Bear Stearns

,

Merrill Lynch

(MER)

and

Lehman Brothers

(LEH)

would no longer exist today, such a statement would have been laughable.

Each of the three securities giants had their liquidity issues last year, but it was virtually unthinkable that

Goldman Sachs

(GS) - Get Report

,

Morgan Stanley

(MS) - Get Report

and

JPMorgan Chase

(JPM) - Get Report

would be essentially the only ones left standing among Wall Street's giants.

But now we have

Lehman Brothers

filing for Chapter 11 bankruptcy protection after a series of weekend meetings involving Treasury Secretary Henry Paulson, New York

Federal Reserve

President Timothy Geithner and several Wall Street chiefs failed to find it a dancing partner. The investment bank will now be forced to liquidate assets and its shareholders are left with a 20-cent stock.

We also have

Merrill Lynch

being taken out in a $50 billion all-stock transaction by

Bank of America

(BAC) - Get Report

, which reportedly had been mulling a bid for Lehman before talks broke down.

It's the end of the world as we know it, but no one really feels all that fine.

"Clearly, this has been a category 5 hurricane we've been hit with this weekend," says Paul Mendelsohn, chief investment strategist with Windham Financial. "As the sun came up this morning, we could see how much damage has been done. The problem is that it's not what we see that is going to hurt us, it's what we don't see yet that is really going to hurt us."

To many observers, the failure of Lehman Brothers is a systemic problem that will shake the stock market greater than any event since the stock market crash in 1929. That includes the failure of Long-Term Capital Management exactly 10 years ago, when the hedge fund required a bailout by Wall Street's investment banks after its highly leveraged positions were exposed by the Russian financial crisis.

"This blows anything we've ever seen since 1929 right out the window," says Mendelsohn. "This isn't an LTCM. Bringing together a group of firms to bail out LTCM was a cakewalk. That was nothing compared to what we're seeing here. This is systemic. This is complicated. This is a big problem."

Robert Pavlik, chief investment officer with Oaktree Asset Management, agrees that this weekend's events were a watershed for the financial market. But while the failure of Lehman and the buyout of Merrill will certainly affect a lot more people, including many displaced employees, Pavlik says that the market will eventually navigate the mess and this event will become just another memory in a timeline of market-shaking events.

"Eventually we'll get through this and the financial markets will be in a better position going forward. There will be less excess," says Pavlik. "However, there is more additional downside going forward. There is still a broader problem in the overall market where we have a slowing global economy."

While the end of Lehman and Merrill as standalone companies is certainly a big news item, both became the latest dominos to fall in a serial collapse that has already claimed Bear Stearns, which was sold to JPMorgan at a gigantic discount, as well as

Freddie Mac

(FRE)

and

Fannie Mae

(FNM)

, which the U.S. government bailed out, and Countrywide Financial, which was acquired by BofA.

The unfortunate part is that even with the removal of Bear Stearns, Fannie, Freddie, Lehman and Merrill from the chain, there still isn't enough breathing room to keep the next meltdown. "My concern is that we don't have enough space between the Lehman Brothers domino and everyone else," Mendelsohn says. "We're not going to stop the chain reaction. I'm not sure anyone is safe here."

Both Mendelsohn and Pavlik agree that the repercussions for the collateralized mortgage obligation and credit default swap market are enormous and could take even longer to work out, given the size and complexity of each. "We still have many these toxic debt instruments out there in companies that have written credit default swaps against other firms that might not even be able to back those swaps," Pavlik says.

Now attention has turned to the health of insurance colossus

AIG

(AIG) - Get Report

. Already, the company has reached out for a $40 billion bridge loan from the central bank in order to recapitalize, but a 45% decline in the stock price Monday says all that needs to be said about the market's expectations the loan will secure its future.

AIG

now faces a major restructuring that will require the sale of assets in order to fend off a ratings downgrade from Standard & Poor's.

"Right now the biggest problem is AIG," Mendelsohn says. "Lehman and Merrill are done. Now the focus moves to AIG and their problems recapitalizing. Their doors are shut to potKnowing their derivatives operations and their security business, they have a tremendous cross-party risk."

In addition to AIG,

Wachovia

(WB) - Get Report

and

Washington Mutual

(WM) - Get Report

are also being viewed with caution.

"We're running out of banks that are strong enough to take over the weak," says Mendelsohn. "With the credit market contracting the way it has, businesses are going to have trouble getting loans. Anyone that needs to borrow money due to cash flow issues is not going to be able to get it. This economy is going to come to a standstill."

But market analysts are not on the same page when it comes to the market's prospects for the next six to 12 months should the dominos keep tumbling. Pavlik says that if a washout were to come on a short-term basis, the market could see a bounce from its July 15 lows because a lot of money is on the sidelines and many people are hoping to time the bottom.

On the other hand, Mendelsohn says that the rapid removal of any more firms could cause the floor to crumble beneath the market. "The longer the process takes, the more probability you have that you can shore up the CMO market. I would rather walk down a flight of steps under control than fall off the landing. Lehman failing here doesn't accomplish that."