Credit crisis enters perilous new phase

The global credit crisis enters a perilous new phase as the failure of Wall Street's fourth-largest investment bank ushers in the most dramatic transformation of the global financial industry in at least a generation.

The headquarters of Lehman Brothers, Wall Street's fourth-largest investment bank, in New York.

The global credit crisis has entered a perilous new phase as the failure of Wall Street's fourth-largest investment bank ushers in the most dramatic transformation of the global financial industry in at least a generation. After two days of a intense bargaining and negotiations over the weekend on Wall Street, the last hopes that a saviour could be found to rescue the 158-year-old Lehman Brothers faded and the bank moved to file for bankruptcy. Meanwhile, in a surprise move aimed at keeping another global financial powerhouse from the brink, Wall Street's third-largest broker, Merrill Lynch, agreed to be purchased by Bank of America for $50 billion in stock. And AIG, one of the world's largest insurers and biggest insitutional investors, scrambled to raise as much as $40 billion in new capital and while turning to the Federal Reserve for loans in an attempt to stave off a bankruptcy of its own. The insurer's shares plunged 31 per cent on Friday as Lehman lurched toward failure.

Jittery financial markets around the world plunged in response today, with the Dubai Financial Market index falling as much as 10 per cent and the Abu Dhabi Securities Exchange fell as much as 5 per cent in early trading. Lehman's failure marked a new approach by US regulators, who refused to provide the sort of tax-payer backed rescue financing that smoothed the demise of Bear Stearns as it was purchased by JP Morgan Chase Bank and the twin ailing mortgage powerhouses Fannie and Freddie earlier this year. Those bailouts, which Federal Reserve and Treasury officials said were necessary to head off a global financial firestorm, subjected the government to scathing criticism from some quarters complaining about once-highflying investment bankers being spared financial ruin and encouraging still more future risk-taking by diminishing the pain for those who overextended themselves.

The questions now are how effectively the global financial system is able to absorb the blow of the Lehman failure and shifting ownership of at least one other brokerage powerhouse, and how heavily the fallout hits an already fragile global economy. The world's largest economy, the US, is already in a funk. Unemployment hit a new high recently and consumer spending has shown signs of fading as consumers find themselves in a vice, with higher gasoline prices driving up their expenses and falling home prices pulling down their net worth. Any significant pull-back by US consumers, whose spending makes up three-quarters of US economic activity, would reverberate around the globe, dampening US demand for the Gulf's oil, Chinese manufacturing exports and European luxury goods.

How the the convulsions in the financial industry will affect the US housing market is key to whether the turmoil roiling financial markets spills over into the real economy. The books of Lehman Brothers, Merrill and AIG are laden with securities linked to the housing market. If selling them forces prices of those securities into further falls, it will hit other financial institutions who have to write them down to reflect the lower value. That, in turn, could exacerbate the credit crunch as lenders reduce their lending, including to potential home buyers, sending housing prices still lower and starting the viscious cycle on another similar turn.

Among the highest priority of the cabal of investment banking chieftain who met over the weekend is to set up a system to prevent those securities, and the complex contractual agreements based upon them, from flooding on to the market at once. They agreed to set up a joint fund to that would take on Lehman's troubled portfolio and unwind its positions slowly and spent much of the weekend in unprecedented sessions revealing trading positions with each other and attempting to puzzle out ways to pair and counteract them to lessen the confusion Lehman's failure may cause. [e-mail]