Lehman: The End Game

As markets start to open in Asia, there's still no real clarity on what on earth is going on with Lehman Brothers. But the base-case scenario at this point is bankruptcy: ISDA's been netting derivatives transactions for four hours of Sunday afternoon, trying to minimize Lehman's counterparty risk in the event it goes bust, and the BBC is reporting that PWC has been lined up to run Lehman's UK operations under the same scenario.

Mohamed El-Erian isn't sugar-coating anything:

"This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today's highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, the chief executive of Pimco, the world's biggest bond fund, based in Newport Beach, California.

Wall Street is already one step ahead: Lehman's bankruptcy would make Merrill Lynch's position extremely precarious, so Merrill seems to be stepping gratefully into the welcoming arms of Bank of America. Meanwhile, AIG is lining up an emergency capital-raising, in the hope that an extra $10 billion or so will give the market some confidence in its solvency.

Would a bankruptcy be Chapter 11 or Chapter 7? There's even less clarity on that, but my feeling is that it would be both: the brokerage units would file Chapter 7 and liquidate, while the holding company would file Chapter 11. In any event, things would surely get pretty messy for a while, and given the ability of financial markets over the past year to go from bad to worse, Paulson and Geithner are definitely risking a serious meltdown here.

That said, a meltdown would benefit no one, and Wall Street has every incentive to avoid it -- as we're seeing in the shotgun marriage of Merill and BofA. If people can keep their heads through the end of the week, this could turn out to be Wall Street's finest hour since John Pierpont Morgan used his own money to save the day during the panic of 1907.

It's a fluid situation, of course, as all the news stories are at pains to point out. But right now it looks like the best-case scenario is that Lehman goes bankrupt, with the rest of Wall Street playing a generally supportive role. And the worst-case scenario? You don't want to go there.

Update: Yes, it's bankruptcy, and liquidation, for Lehman.