Sept. 14 (Bloomberg) — Wall Street readied for a potential Lehman Brothers Holdings Inc. bankruptcy after Bank of America Corp. and Barclays Plc pulled out of talks to buy it and the government indicated it wouldn’t provide funds to prevent a collapse.
Banks and brokers today held a session for netting derivatives transactions with Lehman, or canceling trades that offset each other, in case the New York-based firm files for bankruptcy before midnight.
“The purpose of this session is to reduce risk associated with a potential Lehman” bankruptcy, the International Swaps and Derivatives Association said in a statement today. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the U.S. and abroad.
The step indicates Wall Street lacks confidence that three days of talks to find a buyer for Lehman, held at the Federal Reserve Bank of New York, will be successful. Treasury Secretary Henry Paulson, who has led the talks with New York Fed President Timothy Geithner, was adamant two days ago against using taxpayer funds to help a purchaser take Lehman over.
U.S. regulators are betting that the financial system will be able to withstand the failure of a large institution without severe disruptions to an already weak economy.
A benchmark gauge of credit risk that banks and investors use to speculate on corporate creditworthiness or to hedge against losses was being quoted at the widest levels ever, contingent on a Lehman bankruptcy.
The Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, was trading at about 200 basis points, said Brian Yelvington, a strategist at CreditSights Inc. in New York. It closed at 152 basis points Sept. 12, according to CMA Datavision in London. The index, which rises as investor confidence falls, reached 198 basis points in March, CMA data show.
A gauge of risk in the U.S. leveraged-loan market that falls as credit risk increases was being quoted 1.75 percentage points lower, contingent on a Lehman bankruptcy, according to Goldman Sachs Group Inc. The Markit LCDX index was being quoted at a mid- price of 94.25. The index is tied to the high-yield, high-risk loans of 100 companies.
If Lehman files for bankruptcy, “that obviously puts a lot more risk in the market, so it’s definitely going to be wider,” Yelvington said.
Paulson opposed using government money because Wall Street has had time to prepare for the Lehman situation, a person familiar with his thinking said two days ago. That would make the case different from the Bear Stearns Cos. collapse in March, when the Fed provided $29 billion of financing to help JPMorgan Chase & Co. take over the firm.
“Treasury and the Fed have determined that markets have adjusted to the situation since Bear Stearns,” said Gilbert Schwartz, a partner at Schwartz & Ballen LLP in Washington and a former Fed Board attorney. “If the markets, every time a big institution went bust, expected the government to step in, no one would ever adapt.”
Paulson, Geithner and Securities and Exchange Commission Chairman Christopher Cox held talks with Wall Street chiefs from the evening of Sept. 12.
The market value for all over-the-counter derivatives swelled 50 percent last year to $14.52 trillion, with interest- rate contracts accounting for almost half of the total, according to the Bank for International Settlements.
After the Bear Stearns episode, Paulson pushed for a resolution mechanism to shutter a failing investment bank, similar to how the Federal Deposit Insurance Corp. resolves insolvent commercial banks.
“We must limit the perception that some institutions are either too big or too interconnected to fail,” Paulson said in a June 19 speech. “If we are to do that credibly, we must address the reality that some are.”
Without such a mechanism in place, a failing firm has the option of filing for bankruptcy. Bear Stearns officials told the Fed in March they would have to make such a filing without emergency assistance.
Fed Chairman Ben S. Bernanke said in April that he wanted to avoid another Bear Stearns case.
“The financing we did for Bear Stearns is a one-time event,” Bernanke said in April. “It’s never happened before and I hope it never happens again.”
The fourth-largest securities firm until the past week, Lehman has thousands of such trades in credit, equity, commodity, interest rates and currency derivatives.
The ISDA said the “netting trading session” began at 2 p.m. and will continue until at least 6 p.m. New York time.
“Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time, Sunday, Sept. 14, 2008,” the ISDA said. “If there is no filing, the trades cease to exist.”
Barclays, the U.K.’s third-biggest bank, said earlier today it abandoned talks to buy Lehman, contending it couldn’t obtain guarantees to protect against potential losses at the U.S. securities firm.
Less than three hours after the Barclays news, Bank of America also pulled out, according to a person with knowledge of the matter.