Wall Street Was Too Busy To Watch Football on Sunday

"Omigod!" Brett Arends of the Wall Street Journal spells this exclamation differently, but he suggests we thrust open the windows and shout it out three times, "Omigod! Omigod! Omigod!" Then he advises in his column this morning, since we have gotten the screaming out of our systems, we can try to calm down and take in the weekend's astonishing financial market events more thoughtfully.

We thought we had gotten over a hump last week at this time with the Federal Government rescue of Fannie Mae and Freddie Mac. Markets bounced in relief for exactly one day. Then Tuesday, they began to reassess their view of Lehman Brothers, a major player on Wall Street since 1850 which helped finance the Civil War. More recently Lehman had been a major player in the mortgage markets and the reversals in that sector have turned out to be their undoing.

The weekend was extraordinarily dramatic for them, for Merrill Lynch and for other big Wall Street firms and banks. The Federal Reserve Bank of New York hosted numerous executives from Friday evening until late Sunday night, pushing those people to conceive a plan to keep Lehman in business or to make its closing an orderly process. Significantly, Treasury Secretary Paulson, who is a former head of Goldman Sachs, and the NY Fed President Tim Geithner, a lawyer by profession, facilitated the meetings, but insisted that no government funding or guarantees would be available.

Secretary Paulson drew a line. Moral hazard was not to be part of this. Security dealers who were in over their heads would have to solve their own problems this time. The Bear Stearns event in March came suddenly and caught everyone by surprise; we learned then that lack of liquidity – that is, short-term funding, as much as capital – permanent long-term financing – could cripple a company. The government and the Fed stepped in to prevent a world-market-shattering breakdown of trading. Last week's actions with Fan and Fred addressed issues with institutions founded by the Government itself. But Lehman doesn't match either one of those conditions. Yes, short-term funding likely was being strained, but there was no surprise in that circumstance this time. And there is, of course, no government franchise here either.

So Lehman was allowed to fail.

As that outcome was emerging yesterday afternoon, an industry trade association, the International Swaps and Derivatives Association, conducted an extraordinary Sunday trading session involving the outstanding transactions Lehman is party to. Personnel from other firms met to exchange information with each other on the multitude of Lehman's contracts and begin to create a chain for concluding them that doesn't involve Lehman. Thus, the most immediate disruption in debt market trading could be averted. Again, there's no abrupt surprise in these developments, so they can be tackled in a somewhat orderly way.

Lehman is not the only firm in trouble. Merrill Lynch was perceived as possibly being the next in line for real trouble. Its stock price dropped 38% last week alone in recognition of its stretched condition and its recent heavy losses. Its leaders, seeing a most murky road ahead, began negotiations on Saturday and arranged the sale of this venerable American institution to Bank of America by Sunday evening. American International Group, an insurance company known mainly for its unique international dealings in political risk and business insurance, has seen this core undermined by an over-aggressive move in domestic mortgage lending. It continues this morning to negotiate asset sales and other actions to stem its losses. Finally, the big thrift Washington Mutual, also faces big losses and will likely require some major structural shift to right itself.

The boom in mortgage lending and the subsequent reversal have thus generated enormous fallout on Wall Street. Probably the recent wide swings in commodity prices haven't helped, but the massive write-downs at these firms are occurring overwhelmingly in mortgages gone bad.

What happens now? I wish I knew! I own some stock in one of these companies!

What we can say is that the bad news is out. The negative factors are all out in front of us, so as began to happen yesterday with the Swaps and Derivatives, market participants can set about reordering their own positions in light of the changed circumstances. This is good. And possibly few would concede it today, but it is also good that a failing firm is allowed to fail, rather than being kept on life-support, prolonging the day of reckoning and dragging out the uncertainty.

While we bemoan the over-sized and excessive use of the mortgage market by imprudent traders and money managers, we do want to repeat a favorable argument we've made before. We think subprime mortgages are a great innovation. No, of course, not the predatory kind that suck in uninformed borrowers and play with them like pawns. But the good kind that extend credit in an "emerging" neighborhood and promote economic development and personal growth. As of June 30, some 30% of subprime mortgages were in foreclosure or delinquent in their payments, but the other 70% were not. 70% of these loans were current and in good standing. Good for those people! May they enjoy their homes for many years!

And as for us investors, Mr. Arends of the Wall Street Journal cautions us not to panic, not to rush out or in. "Invest little, often and broadly," he urges. Stocks have already fallen. ". . . there are a lot of good stocks out there that are pretty reasonably valued. Even long-standing bears, skeptics and curmudgeons are starting to say this. These stocks may not be dirt cheap. Times may get much worse before they get better. But if history is any guide, buying good stocks when they are reasonably priced and hanging on for five years or more has tended to be the best thing you can do with money."

Good luck. And while you're at it, pray for the folks who will be laid off from Lehman and the other firms and for those mortgage traders and borrowers who got themselves – and us – into this mess in the first place.