How to Make a Large Merchant Bank Vanish in a Matter of Days

The decision of American authorities during the weekend of September 13th not to rescue the investment bank Lehman Brothers and allow it to declare bankruptcy could prove fatal to Morgan Stanley and even to Goldman Sachs, market experts speculate.

The two sole remaining Wall Street investment banks are gripped in a fight for survival. Their stock dipped Wednesday. The famous “default credit swaps” (dcs) that insures against a default of their debt costs more and more.

Unlike a normal bank, an investment bank does not have the resources to draw upon personal deposits to shore up short-term funds. It’s necessary to put forth some certificates of deposit to bankroll its activity. And that’s even if the majority of investment banks have extended the maturity of their debt in the past few months to safeguard themselves from the effects of the crisis.

The problem is that these financial establishments to whom the investment banks have funded now refuse to loan out that money, because they are either saving it for themselves, or that they no longer trust the banks’ ability to reimburse them. They are now less inclined to lend to those still risky banks because they borrowed a lot to invest and that very financial environment invites caution. In the United States, the banks must register their assets to their cash value, or lower it , thus cheapening their balance sheets, then the invoices from the scoring agencies, etc.

Investment banks like Morgan Stanley and Goldman Sachs could just as well no longer be able to honor their financial commitments. This is what happened to Lehman Brothers last week. This is why central banks again shot liquid assets into the market today.

The fact that the government didn’t save Lehman has a downward effect, certain analysts speculate, even if this factor causes debate. Many Lehman Brothers clients, notably ‘hedge fund,’ are going to take some junk funds in that bank. They don’t want that to happen again and are taking their money out of Morgan Stanley, and into a smaller firm as Goldman Sachs, in order to dump it elsewhere: UBS, JP Morgan Chase, banks that are have little chance of going bankrupt.

All of which explains why investors are selling- defenseless or not- the stocks of Morgan Stanley, and in a lesser degree, Goldman Sachs. “If Morgan Stanley hadn’t successfully leaned back before the weekend, it would suffer like Lehman Brothers,” one financier explains. “The defiance phenomenon heals itself very quickly,” he remarked.

An effective investment technique, notably used by hedge funds, accelerates the drop of investment banks, certainly speculating, even if that causes struggle.

Today, a lot of investors buy debt back from investment banks (or sell the insurance against a default on that debt, which is similar) in the same time that it sells to discover its stock, meaning that it bets on a drop since the corporation is considered close to bankruptcy.

In the instance when a bank pulls through, those investors equally pull up the value of the debt before that stock (regardless whether they lost money).

In the instance when the bank doesn’t pull through, the bet on the stock’s drop wins. And that is partly on the debt since, in bankruptcy, the shareholders of debts are served first when a corporation gets liquidated.

Of course some risks still exists : a harsh bankruptcy that even makes the debt’s shareholders lose everything. An off stability between product’s acquisitions of debts and stocks or a massive recapitalization that makes the bet on the declining stock so wasteful that the debt is no longer a winning deal.