The Blackest Monday since 1929

The biggest reshaping of the US financial sector since the Great Depression occured as Merrill Lynch sold itself to Bank of America, and Lehman Brothers filed for bankruptcy after failing to find a buyer.

"I've never seen a weekend like this one," says Wall Street veteran Michael Holland of Holland & Co. No wonder. It saw the biggest reshaping of the US financial sector since the Great Depression as 84-year-old Merrill Lynch sold itself to Bank of America in an emergency deal, and Lehman Brothers, the fourth-biggest investment bank, filed for bankruptcy after failing to find a buyer. The highly geared bank it was leveraged around 30 times suffered a crisis of confidence after losses on dodgy mortgage-related securities eroded its capital base and it had trouble raising money (see: What went wrong at Lehman Brothers).

Jitters over the ramifications for the financial system were compounded by the news that giant insurer AIG, widely deemed an even more significant element of the financial system than Lehman, was on the critical list and scrambling to raise capital. "Black Monday? Try Blacker Than a Dark Cellar at Midnight Monday," says Mark Priest at ETX Capital. Stocks tanked, with the S&P recording its biggest one-day fall since September 11th 4.7% while the FTSE dropped by 4%, hitting a three-year low. Asian equities slumped by 5%-7%

The money markets had a "heart attack", as Philip Aldrick puts it in The Daily Telegraph, with interbank lending rates surging. The overnight dollar rate doubled and the sterling rate shot up to a seven-year high of 6.8% on Tuesday, even as central banks pumped $200bn of short-term funding into the money markets early this week. On Wednesday stocks continued to weaken despite the Fed's $85bn bail-out of AIG (see: Fed steps in again to head off meltdown).

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A major worry now is the potential collateral damage as the "body of Lehman" is extracted from the global "financial web", says Nils Pratley in The Guardian. As Lehman's assets are sold off, prices will fall. With the positions of other players in the financial system thus sliding in value they may also be hit by losses on Lehman debt they will have to sell assets of various kinds to make up the losses as their capital positions erode; this applies especially to leveraged players such as hedge funds. The potential for contagion as deleveraging progresses is clear from the fact that several major Norwegian stocks lost as much as 7% early last week, due to rumours that a big hedge fund was unwinding positions.

A timebomb in derivatives?

A particular headache for the financial system is the market for credit default swaps (CDS) insurance contracts against debt default or downgrades. This part of the derivatives market encompasses contracts with a face value of $62trn and Lehman was among the top ten counterparties in the market. What's more, according to Sandy Chen of Panmure Gordon, there are around $350bn of CDS written against Lehman's debt. Even applying an optimistic valuation to the debt, banks providing the insurance could lose $140bn.

The wider point, however, is that the huge market has no standard settlement procedures and no regulated exchange; it is based on bilateral, private deals, and many banks don't have the logistical resources to handle unwinding a huge number of contracts. Unwinding Lehman is an unprecedented stress test for the opaque market, "a bit like preparing to decommission a nuclear power plant", says's Edward Hadas. "A lot can go wrong." At best, says Gillian Tett in the FT, the credit world faces weeks of uncertainty, and at worst some markets could seize up, creating new chain reactions. Small wonder Warren Buffett described derivatives as "financial weapons of mass destruction" a few years ago.

This is "without doubt the most serious financial shock" since 1929, says Larry Elliot in The Guardian. The question now is whether there is a "complete meltdown in the financial system with institutions crashing like ninepins", or whether "a severe rationing of credit" by cash-strapped banks will lead to a nasty recession. Even if a meltdown doesn't materialise, we are in for "a prolonged credit crunch against a backdrop of deteriorating economic fundamentals", agrees Capital Economics.

The next shoe to drop

In this context, the next problem will be Alt-A mortgages "the new subprime", as John Mauldin puts it on Alt-A mortgages, a market worth $1trn, compared to subprime's $855bn, were taken out by borrowers who had better credit scores than their subprime counterparts, but couldn't, or wouldn't, document their income. According to one estimate, 70% of Alt-A borrowers may have exaggerated their incomes. Already payments on 16% of Alt-A loans issued in 2006 are at least 60 days in arrears and to make matters worse, many Alt-As were taken out on low initial interest rates and rates can jump 4% to 8% when the loans reset over the next three years. Expect "a steady wave of foreclosures" across the country.

Given the ongoing housing slump and darkening economic outlook, future bank losses are set to spread beyond Alt-A. There is still 11 months worth of supply of unsold homes; overall foreclosures jumped at the fastest rate in 30 years in the second quarter; and consumers are cutting back amid rising unemployment (witness the second successive slide in retail sales in August). Commercial real estate and credit-card loans will induce further writedowns. Then there's corporate loans. Companies are coming under increasing pressure: Moody's estimates that the global default rate for junk bonds will surge to 7.4% in a year, from 2.7% now. With growth likely to shrink in America as well as in Britain and Europe, it's no wonder Professor Nouriel Roubini of New York University reckons global losses from the crisis could reach $2trn.

With cash-strapped banks set to curtail lending, growth will suffer. According to Goldman Sachs's Jan Hatzius, another 10% slide in US house prices would take mortgage-related losses to $636bn, implying a $2trn reduction in lending, and knocking 1.8% off GDP growth. Worldwide, that much liquidity has already disappeared, reckons Worldwide credit-related losses exceed $500bn and just $350bn of equity has been replenished. Applying the average rate of leverage to the $150bn gap implies a $2trn fall in liquidity: "hence the severe shortage of credit and predictions of worse to come". Talking of worse to come, a key danger at this point is that "as recession bites", banks become even more cautious and thus "magnify the economic downswing", blunting the impact of interest-rate cuts, as Stephen King points out in The Independent.

Earnings estimates are still too high

All this is depressing enough, but to make matters worse, earnings estimates look far too rosy. Take America, where, according to Bloomberg figures, analysts' earnings estimates proved accurate for just 6.7% of S&P 500 firms in the second quarter. That seems of a piece with Wall Street's forecast of an increase of over 20% on S&P profits next year. Yet that's never happened with GDP growth of less than 3.2%, still twice the consensus forecast for next year, notes David Rosenberg of Merrill Lynch. In Canada, earnings growth is expected to hit 24% next year, which "beggars belief", says Merrill's David Wolf. Pan-European and UK estimates also look optimistic at around 12% and 8% respectively.

All this makes stocks look vulnerable to repeated earnings downgrades and disappointments a hallmark of bear markets, as Mauldin has pointed out. But with emerging stocks and commodities also suffering as global growth slows rapidly, is anywhere safe? We look at some possibilities below.

Where to shelter from the storm

The fundamental backdrop "will continue to favour bonds over equities", says Capital Economics. With the credit squeeze undermining growth and earnings, deflation playing on investors' minds and interest rates set to fall in Britain as inflation fades, short-dated gilts are worth a look. Cash is always a good idea in rocky times, while another classic safe haven is gold, the ultimate form of insurance against financial upheaval and disaster. At these levels, gold offers "superb potential for significant capital gains during an environment of acute financial restructuring", says Tim Price, while longer term, central banks may well end up bailing out financial systems with huge cash injections, fuelling inflation.

Another place to hide is the Japanese yen. One of the hallmarks of rising risk aversion is the unwinding of the carry trade, whereby investors borrowed and sold yen, which offered a tiny yield, in order to buy riskier, higher-yielding assets elsewhere ranging from emerging market currencies to commodities and cashed in on the difference. Japanese retail investors alone hold $300bn in commodity and emerging-market currencies, according to Lehman Brothers, and overseas banks' borrowings in yen remain high, says Steve Barrow of Standard Bank. So there is plenty of scope for the yen to rise further as risky assets come under pressure and carry trades are unwound. The yen is historically cheap in real trade-weighted terms, it hasn't been this low since the mid-1980s, says Lex in the FT. Barrow sees the yen rising to 95 against the dollar and 125 to the euro over the next year. Moreover, Japanese stocks look a far better bet than any of their developed market counterparts (see: Find a safe haven in Japanese small caps).