Convertibles sag on Lehman Brothers bankruptcy, Merrill Lynch takeover; AIG remains an overhang

By Rebecca Melvin

New York, Sept. 15 - The market for convertible preferred shares fell about 4 or 5 points on Monday, and convertibles in general lost about 1 to 1.5 points, following the dual bombshells of Lehman Brothers Holdings Inc. being unable to secure a sale of the company and filing for bankruptcy and Merrill Lynch & Co. Inc. being taken over by Bank of America Corp.

The market was "in a word, terrible," said an East Coast-based trader focused on financial issues.

While there wasn't selling en masse at the open, and there were even some early buyers, the session was generally quiet and weakened further toward the end of the day as equities slid to the close, leaving the Dow Jones Industrial Average down more than 500 points, its worst single-day drop since the terrorist attacks of Sept. 11, 2001.

"There wasn't a rush for the doors. I think people are assessing the situation, figuring out exposures, and coming up with a game plan," a New York-based sellside trader said.

As players evaluated what was being called "the new financial landscape," American International Group Inc. remained a continuing overhang to the market, the sellsider said.

Trading was light, with players unwilling to focus very much on individual names, and attention was more on what that new landscape will look like going forward, traders said.

"There are three less market participants now than there were six months ago .... Bear, Lehman and the Merrill/BAC combination eliminates one more. It could mean fewer markets, less liquidity overall. As far as issuance, I'm sure some of the other banks will pick up the slack," a New York-based sellside desk analyst said.

But players weren't completely sure about new issuance either in the immediate term. "All bets are off now. We had three deals last week. But I'm not seeing anything right now," a West Coast-based sellside trader said.

Lehman paper goes away

Perhaps it was the speed at which the Lehman Brothers demise occurred that took the market most off guard, the West Coast trader said. "It was an important desk. I know competitors will talk about taking market share, but they may just shop themselves into another firm," he said.

The Lehman preferred paper, which was trading in the 500 to 600 range even in mid-July, when the market hit its most recent low point, traded on Monday at 1 or less.

The paper "goes away" since the company filed Chapter 11 bankruptcy protection to allow it to restructure while creditor claims are held at bay. The filing was made Monday in the U.S. Bankruptcy Court for the Southern District of New York.

The 158-year-old investment bank had said earlier that none of its broker-dealer subsidiaries or other units would be included in the Chapter 11 filing. It says it is exploring the sale of its broker-dealer operations and is in "advanced discussions" to sell its investment management unit.

Players had left their offices Friday half expecting a deal for Lehman with Bank of America or some other big balance sheet bank. But Bank of America said Monday that it thought all along that government assistance would be required for such a deal, and when that wasn't available, they had to walk away. Meanwhile the bank moved toward Merrill Lynch, the acquisition of which was called "the opportunity of a lifetime" by Bank of America chairman and chief executive Ken Lewis.

B of A weakens with downgrade

Fear that Bank of America's all-stock purchase of Merrill Lynch for $50 billion could curb its strength put pressure on its stocks and bonds Monday.

Bank of America's 7.25% perpetual convertible preferreds traded at 828 early Monday and were seen closing at 820 versus a share price of $26.55, compared with 902 versus a share price of $33.74 on Friday.

Standard & Poor's lowered its long-term counterparty credit rating on B of A to AA- from AA, and Moody's Investors Service placed on review for possible downgrade its long-term debt ratings.

Charlotte, N.C.-based Bank of America has also acquired US Trust, LaSalle and Countrywide Financial, growing to a financial behemoth. The US Trust conversion has been concluded, LaSalle's is expected to conclude in October, and Countrywide's is ongoing.

The Merrill transaction is expected to close late in the fourth quarter or early in the first quarter, Lewis said in a news conference.

He also said that he expects Bank of America will have the largest market share, in the best regions, with the international capabilities of Merrill Lynch. If you want to create that kind of a machine, and that formidable a company, then you have to act "opportunistically," he said.

Lewis also said that he didn't expect the problems besetting the financial services industry will be resolved any time soon. He said write-offs will continue at significant levels for the near term, with 2009 remaining a difficult year.

AIG overhang remains

Whether the government could legitimately step in to help AIG after the government had refused to assist Lehman Brothers was a question market players considered Monday.

The size and scope of the giant insurance company put potential failure of the company beyond comprehension. And it appeared certain allowances were being made for it to get its capital needs in place, including additional time from the ratings agencies.

State regulators said that AIG would be able to use funds from its subsidiaries to shore up the holding company. And the Federal Reserve has asked Goldman Sachs and JPMorgan Chase to help make $70 billion to $75 billion in loans available to the company, according to reports.

Treasury secretary Henry Paulson said in a news conference Monday that important steps were taken in the Fannie Mae and Freddie Mac takeovers, and that the administration is committed to working with regulators and lawmakers to ensure orderliness of financial markets. Nevertheless, he said he doesn't take likely putting taxpayers on the line to support an institution.

AIG's 8.5% mandatory convertibles due 2011 were seen at 14 versus a share price of $4.76 at the close Monday, compared to 29 versus a share price of $12.14 on Friday.

Shares of the New York-based firm closed down 61%.

Merrill jumps on takeover news

Merrill Lynch's 0% accreting convertible bonds due 2032 popped with the takeover news. They were quoted at 97 bid, 99 offered early in the session, but closed lower at about 96 versus a share price of $17.06. That level was still higher than where they had previously traded, sources said.

The all-stock deal for the New York-based Merrill, the world's largest and most widely recognized brokerage, came together in less than 48 hours, executives for the two companies said.

Bank of America will exchange 0.8595 of a share of B of A for each Merrill share.

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