Lehman Shock Waves Hit European Bourses

Buying Lehman Brothers was a risk Barclays ultimately refused to take, adding to investor fears about the state of Europe's finance industry

When U.S. Treasury Secretary Henry Paulson called Barclays President Bob Diamond on Sept. 12 and asked him to consider buying Lehman Brothers, both the U.S. government and Barclays (BARC.L) knew that the London-based bank could not consummate the deal over the weekend without U.S. government help.

Nevertheless, with much of the detail worked out, the deal fell apart on Sept. 14 because the American government refused to backstop Lehman's hundreds of billions in outstanding trades, according to a source close to Barclays. The London bank could not take on that risk without obtaining shareholder approval, Barclays says. As a result, Lehman (LEH) is going into bankruptcy.

That new tough-guy approach is not going down well in European markets. By midday on Sept. 15, the FTSE 100 index of the London market was down 5.08%. Paris' CAC 40 plummeted 5.57%, while Germany's DAX index took a 4.31% hit. Europe bore the brunt of the shock wave because most major Asian bourses were closed for a holiday.

In an indication of the fears sweeping the financial industry, $43 billion in liquidity auctioned off on Sept. 15 by the European Central Bank was three times oversubscribed. The Bank of England pumped in another $9 billion, and Switzerland's central bank added still more. The industry's powerful thirst for liquidity could lead to still more infusions from central banks, analysts say. "It doesn't look good. We are quite worried," says Jacques Cailloux, an economist at Royal Bank of Scotland (RBS.L).

Bank Stocks Battered

Bank and other financial stocks weigh heavily in the European indexes, and these shares are taking a severe pounding as credit jitters rule the day. Barclays didn't get much of a reward for its caution. Its stock was down 14.91%. Royal Bank of Scotland, which outbid Barclays for ABN Amro last year, also took a beating and was down 15.54%.

Even worse was HBOS (HBOS.L), the largest British mortgage lender, which fell nearly 30%. European banks also encountered extreme investor disfavor. Deutsche Bank (DBKGN.F), Germany's largest, was down 8.9%, while France's Société Générale (SOGN.PA) fell 13.35%. Insurers also took a pounding, with German giant Allianz (ALVG.F) down 7.72%.

The broad punishment meted out to bank stocks is not surprising, given the shock of one of the four largest U.S. investment banks folding and another venerable American institution, Merrill Lynch (MER), seeking refuge in the acquisitive arms of Bank of America (BAC) in a $50 billion deal. Over time, though, the market is likely to distinguish between different types of risk. Already HSBC (HSBA.L), which is managed more conservatively than most other banks and was early in recognizing and dealing with its U.S. real estate loan problems, appeared relatively unscathed with just a 3.85% decline on Sept. 15.

Lehman's Asset Sales Will Have Impact

Analysts at Keefe, Bruyette, & Woods, an investment bank that specializes in financial companies, say there are two main types of risk for European banks in the fallout from Lehman. First: counterparty risks on trades involving Lehman. It will take some time to see if problems emerge, but market participants had some time to see this one coming and may have taken precautions. Besides the actions by European central banks, the U.S. Federal Reserve has loosened lending restrictions in what appears to be a coordinated effort to calm the markets.

At a press conference in the auditorium of Lehman's gleaming tower at London's Canary Wharf, Steven Pearson, part of a team from PricewaterhouseCoopers that has taken control of Lehman's British operations, said the company "was exceptionally complex, with hundreds of billions of dollars" in outstanding assets and liabilities, mostly to trading counterparties. The PWC administrators said they had dozens of people in the Lehman building, and when they started looking at Lehman's British books they found no cash because all of the money was swept up by New York each night. While they indicated they would want some senior managers to remain in place for several months, they said there was no certainty yet that there would be funds to meet Lehman's next payday on Friday. The administrators did say the Bank of England was providing special facilities to help unwind trades.

The second worry is that fire sales of Lehman assets such as residential mortgage-backed securities and commercial real estate loans—Lehman has $17 billion and $33 billion of these, respectively—will force European banks to further mark down their portfolios of these types of securities, further unnerving investors and adding to pressure on their capital ratios. Keefe Bruyette says European banks with large investment banking arms such as Barclays, RBS, UBS (UBS), and Credit Suisse (CS) are at most risk of such markdowns. However, analysts say that regulators might give the banks breathing room on mark-to-market requirements to avoid further downward spirals.

Even on a bleak day there are some silver linings. For instance, Bank of America is paying a healthy premium for Merrill Lynch—about 70% over Sept. 12's closing share price. As likely consolidation continues, that could be good news for banks such as Credit Suisse and UBS that have solid franchises in private banking that continue to churn out healthy profits despite the investment banking turmoil.

Other Buying Opportunities?

The group of European banks that could be directly affected by the Lehman fallout is likely to be limited. Most Spanish, German, and Scandinavian institutions are "more removed" from the investment banking turmoil, Keefe Bruyette says. Adds Giorgio Questa, a veteran European banker who now teaches at London's Cass Business School: "European banks are a lot more solid" than the markets' immediate reaction would indicate. "The markets are hyperreacting," says Questa.

In addition, European banks may be in the best position to benefit from the American turmoil. Despite its share price taking a battering this year, Barclays was able to consider buying Lehman and is now ready to sign up teams of first-rate bankers from Lehman, Merrill, or other institutions who may now be looking for a home.

Old World banks, with their relatively strong balance sheets, may find themselves well-positioned to buy other distressed American assets. Now that Merrill appears to have been taken out, bankers are casting an eye at Morgan Stanley (MS), which along with Goldman Sachs (GS) is one of the last two major U.S. investment banks not attached to a behemoth such as JPMorgan Chase (JPM) or Bank of America. In today's risky world, bankers in Europe say, it is doubtful that an investment bank can stay on the playing field without the backing of a big commercial sister.

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