Lack of bailout for Lehman sends message to Wall Street

ANALYSIS: A meltdown of the US financial system seems unlikely but increased regulation looks certain

AND THEN there were two. With Lehman Brothers' collapsing, Merrill Lynch being swallowed up by Bank of America and Bear Stearns a distant memory, only Goldman Sachs and Morgan Stanley remain of the five big investment banks that dominated the financial landscape less than a year ago.

"We will see other major firms fail," former federal reserve chairman Alan Greenspan said yesterday. That such a sentiment has become increasingly commonplace is evidenced by predictions-market firm Intrade, which is allowing punters to bet on which US bank will come next.

Washington Mutual, the sixth-largest bank in the US, is an obvious suspect. Shares have plunged by more than 90 per cent during over the last 18 months and by more than 20 per cent yesterday, valuing the firm at less than $4 billion. At the end of June, the bank had $143 billion in insured deposits.

Furthermore, approximately $2,500 billion of US deposits is uninsured at the moment. Some commentators have expressed concern that a high-profile failure could cause uninsured depositors to exit en masse from weaker banks, destabilising the banking system as a whole.

At the moment, however, the firm giving real cause for concern is AIG, the largest American insurer by assets. AIG sold credit default swaps that protect against default to mortgage providers and investors during the subprime boom. With the mortgage market meltdown, it's been left with massive writedowns that threaten to cripple the company.

An AIG failure could have systemic consequences - it has written more credit default swaps than Bear Stearns. Bank of America chief executive Ken Lewis said that while it had "nominal" exposure to Lehman Brothers, he didn't "know of any major bank that doesn't have exposure to AIG". An AIG failure would present a "much bigger problem" than Lehman's collapse.

This weekend's refusal to bail out Lehman is being taken as a signal moment in the credit crisis, a message that Wall Street will have to clean up its own mess rather than assuming that government money is always at hand. US authorities have made it known that they are sensitive to the "moral hazard" argument, the theory that parties are less likely to behave in a responsible manner if irresponsible risk-taking is continually rewarded via bailouts.

While authorities were intent on sending a message to Wall Street, it seems that government was also less concerned about a Lehman bankruptcy. Lehman is regarded as a less inter-connected bank than Bear. Furthermore, Wall Street has had six months to prepare for such an eventuality whereas the Bear Stearns collapse shocked market participants.

What's next? More writedowns are universally expected. A Wall Street Journalreport suggested that AIG and Citigroup could see further writedowns of $15 billion and $7 billion respectively, based on the maths Lehman Brothers last week applied to its mortgage-backed securities.

In the longer term, increased regulation looks inevitable. In 2002, Warren Buffett warned that derivatives were "weapons of mass destruction" and that "these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear". With concerns that the $62 trillion credit derivatives market might unravel in the wake of the continued stresses on the US financial system, that time appears to have arrived.

Will the US financial system collapse in the coming days? Paul Krugam, Princeton economics professor and New York Timescolumnist, says he "doesn't think so" but is "nowhere near certain". Mohamed El-Erian, chief executive of Pimco, the world's biggest bond fund, is similarly cautious. "In today's highly disrupted financial markets, the unthinkable is thinkable."