Last Updated: March 18, 2008: 4:36 AM EDT
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Lehman rout tests Fed's resolve

Investors still don't know what lurks on Wall Street balance sheets - and the ranks of possible bailout partners are getting thin.

By Colin Barr, senior writer

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Lehman Brothers is trying to stave off a run on the bank similar to the one that brought down Bear Stearns.

NEW YORK (Fortune) -- The Fed's resolve to defend the stressed-out U.S. financial system was put to an early test Monday when investors bet that Lehman Brothers could be the next Wall Street giant to fall.

The brokerage firm saw its shares drop as much as 39% in early trading in wake of JPMorgan Chase's $2-a-share purchase of Bear Stearns (BSC, Fortune 500). Monday's selloff took Lehman (LEH, Fortune 500) shares to $24.50, down from $39 Friday, before they staged a mild recovery.

The collapse of Bear Stearns has fueled fears of a widespread breakdown in the U.S. financial system. Lehman, like Bear Stearns, has been a big player in the mortgage market in recent years and investors worry that its exposure to now-toxic mortgage-based securities, combined with its relatively small size, might be fatal. Lehman is the fourth-largest U.S. player on Wall Street, behind Goldman Sachs, Merrill Lynch and Morgan Stanley.

On Monday, Lehman executives sought to calm investors. In a statement, they said the firm's solid cash position will be bolstered by the Federal Reserve's decision Sunday to let securities firms use the Fed's discount window for emergency borrowing. Until now, direct Fed lending was restricted to banks, which the Fed regulates. The Fed does not oversee securities firms like Lehman.

The Fed said the decision would "improve the ability of primary dealers to provide financing to participants in securitization markets." Lehman chief Richard S. Fuld Jr. agreed, saying that the Fed move "improves the liquidity picture and, from my perspective, takes the liquidity issue for the entire industry off the table."

The Fed's expansion of access to the discount window aims to prevent a repeat of last week's run on Bear Stearns. Bear was forced to sell itself at a 93% discount to Friday's market closing price after its core customers - the hedge funds that used Bear Stearns to borrow money and make trades - fled en masse, betting they wouldn't be able to get their money out in the event of a bankruptcy filing.

The Fed's decision to expand access to the discount window is crucial because big banks and brokerages are trying to conserve cash to deal with their own problems, rather than stepping up to buy distressed properties. Investors remain fearful in part because the prices of all sorts of assets, ranging from houses to bonds, are in free-fall - so it's not easy to determine the true value of bank and brokerage firm balance sheets.

JPMorgan execs admitted as much on a conference call Sunday evening, when they characterized the $2-a-share price they're paying to take over Bear Stearns' assets and liabilities as a "cushion" for JPMorgan (JPM, Fortune 500) shareholders against future problems at the brokerage firm. An additional cushion comes from the Fed, which has agreed to provide a $30 billion loan to JPMorgan.

According to JPMorgan, Bear Stearns has $33 billion in so-called risk positions: $16 billion worth of commercial mortgage-backed securities, $15 billion in nonsubprime residential mortgages, and $2 billion in subprime assets. JPMorgan said it plans to use two-thirds of the Fed's loan to defray JPMorgan's exposure to those positions. Presumably it is holding the other $10 billion in reserve for problems that aren't yet on the horizon.

The uncertainty about financial firms' exposure to bad loans means that the next bank or brokerage to run into trouble will likely face a near wipe-out of its equity investors, just as Bear Stearns did. Roger Ehrenberg, a former Wall Street executive who writes the Information Arbitrage blog, says he is in general "not a big fan of the bailout game." But with Bear shareholders getting $2 a share on a stock that traded at $170 a year ago, no one can claim equity investors are being made whole by U.S. taxpayers.

The issue of so-called moral hazard aside, it's clear the market tumult is adding new wrinkles to the government's bailout game plan. With JPMorgan having taken on Bear Stearns' bloated balance sheet and Bank of America (BAC, Fortune 500) under contract to do the same with struggling Countrywide (CFC, Fortune 500), there aren't many domestic financial firms left to step up for the next bailout. Ehrenberg said Friday that he believes the only U.S. firms with big enough balance sheets to help out a top tier player are JPMorgan, Bank of America and perhaps AIG (AIG, Fortune 500), the big insurer that has had its own troubles in recent weeks with mounting derivatives writedowns.

The inability of big domestic players to come to the rescue of their struggling peers could presage a second wave of sovereign wealth fund investments. Big U.S. trade partners such as Dubai, China and Abu Dhabi have funneled billions of dollars into money-losing bets on U.S. companies such as Citi (C, Fortune 500), Morgan Stanley (MS, Fortune 500) and Blackstone (BX). But Ehrenberg believes they will be back for more, though - only at much better terms.

In the meantime, Ehrenberg says, executives, legislators and regulators will have to work to restructure the U.S. financial system to remove the incentives for players to take irresponsible actions. The Bear Stearns meltdown, he says, offered "a window into the inherent conflicts and weaknesses" in current arrangements which, for instance, allowed mortgage brokers and banks to originate loans without taking any realistic view of whether the loans could be repaid. They did this in part because they stood to make big fat fees for doing deals, while other investors bore the risk that the loans would go bad - which they did in huge numbers once housing prices stopped rising.

"The cycle will come back," Ehrenberg says. But when the economy starts growing again, he adds, financial firms must have incentives "to originate good loans, not just to originate loans."  To top of page