Market Tumbles on Pervasive Fears of Financial Failures

Lehman is trading at $4 in the pre-market.  To answer myself from Tuesday's "Will Lehman Go To Zero? Today?" post: Yes, but apparently not until tomorrow.  Equity investors have given the firm up for dead as it has finally dawned on them that the investment bank cannot recover from this crisis of confidence.  Frankly, this is terrible news for the other investment banks as the business model is seriously being questioned.  One investment bank's failure can be viewed as a "one-off" capitulation event.  Another bank clinging to survival a mere six months later begs the question of whether investors want to bet on a model that relies on borrowing huge sums of money on a short term basis.

The market is also betting that Washington Mutual is toast, as the stock has fallen below $2.  Although this is not a surprise to anyone who knew of WaMu's option ARM portfolio (i.e. anyone reading Mock The Market for the past six months) and default rates hitting option ARMs, realization has finally dawned on the market like a ton of bricks in the past week.  What is a surprise to me, is that Wachovia is yet to hit the single digits, as its option ARM portfolio is over $120 billion.

Finally, AIG has been pummeled for the past few days on widening spreads in the CDS market.  As I mentioned in my last post about AIG's toxicity after its earnings announcement, "I don't care how good the insurance business is, until AIG figures out a way to mitigate the risk in its derivatives portfolio, the company will continue to post losses until the credit markets return to normal."  $441 billion in notional CDS?  $57.8 billion tied to subprime?  AIG is short volatility in the volatility perfect storm.  Furthermore, there is a story in the Financial Times addressing the losses that insurers are likely to suffer from the default on Fannie and Freddie CDS.  Apparently the recovery value is currently expected to be around 95 cents on the dollar on an estimated $200-$500 billion of outstanding contracts.  This translates into potential losses of $10-$25 billion for the insurance industry that offered credit insurance.  The International Swaps and Derivatives Association is expected to announce today which of the bond issues from Fannie and Freddie will be eligible to be used to settle the CDS.

Where do we go from here?  Who's next to fail?  How many more bailouts can the US grant? These are all the questions floating around in the market, which makes me think that we can only go lower from here.