If you're an investor who woke up on the morning of Sept. 15 to a new level of alarm in the more than year-old financial crisis and wondered what the drastically changed landscape on Wall Street means for your portfolio, you're not alone.
Lehman Brothers Holdings' (LEH) massive bankruptcy filing, the possibility that insurance giant American International Group (AIG) could succumb by the end of this week, and the prospective disappearance of Merrill Lynch (MER) via a merger with Bank of America (BAC) sent the market reeling with fear at the potential for huge losses to investment portfolios.
While the damage that Lehman Brothers' filing for Chapter 11 protection could inflict on investors is anyone's guess for the moment, it's sure to extend beyond the shares of the investment bank owned by mutual funds to contracts that banking counterparties had with Lehman. An AIG failure. if it materializes, would be much more devastating, in view of "the huge spectrum of investors" who own the stock or the still highly rated corporate debt or have other kinds of exposure to the company, such as insurance policies, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass.
New York Steps In
"If you have a guaranteed annuity by AIG, what does that mean today? Those are people that the government doesn't want to get hurt," he says. His worry was that if the shares closed below $5 on Sept. 15, it would accelerate ratings downgrades and invite predatory buyout offers from entities that would force the company to dispose of assets that generate the most revenue.
AIG's stock finished nearly 61% lower, at $4.76, on Sept. 15 despite news that New York state will allow AIG to borrow up to $20 billion from its subsidiaries and a Wall Street Journal report that the U.S. government has asked Goldman Sachs (GS) and JPMorgan Chase (JPM) to head up a lending facility for AIG worth $70 billion to $75 billion.
Nearly as big a fear is that even if the company survives, its cost of borrowing could rise to such an extent that it would no longer be able to turn a profit from some of its businesses. "People have been trying to get out of their corporate bonds in AIG for the last month," which has caused yield spreads vs. risk-free Treasuries to widen to extremes, says Larkin. AIG's double-A rated 5.85% coupon notes due Jan. 16, 2018 had a yield of just over 14% on Sept. 15, vs. the 9.1% yield on the double-B rated Merrill Lynch high-yield index, he says.
Debt Pulled from Networks
Larkin thinks prices for AIG's senior debt probably haven't been hammered that much because the company has so many valuable assets that could be sold to pay off debt holders. Still, on Sept. 15, the widening yield spreads prompted certain broker networks to pull all the AIG debt from electronic trading platforms because they didn't want anyone to get stuck with orders they couldn't fill.
Anyone tempted to do some bottom-picking in the financial sector would do better to buy a retail bank index rather than any one individual stock, says Larkin. Given the interconnecting Web of obligations in the banking industry, it's hard to know which banks have counterparty risk exposure to Lehman and whether their debt will be made whole at the end of the Lehman's bankruptcy process, he says.