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Lehman Failure, Merrill Sale Stun Muni Market

CHICAGO - The news of Lehman Brothers's bankruptcy and Merrill Lynch & Co.'s sale to Bank of America Corp. stunned the municipal market and its participants yesterday, sparking immediate worries over the status of pending deals and unease over how the absence of two venerable Wall Street brokerages stands to reshape the muni landscape.

The 158-year-old Lehman Brothers announced it would file for bankruptcy protection after failing to find a buyer amid the federal government's refusal to provide assistance, and 94-year-old Merrill Lynch agreed to be acquired by Bank of America - a recent suitor of Lehman - in a $50 Billion stock deal.

The dual news - unprecedented in recent decades -marked the most dramatic event in the financial markets' crisis to date and follows UBS Securities LLC's exit from the municipal market in June and Bear, Stearns & Co.'s collapse and absorption by JPMorgan in May.

The latest shift leaves only JPMorgan, Citi, Goldman, Sachs & Co., and Morgan Stanley standing among the top eight Wall Street-based senior managers of last year, according to Thomson Reuters. Two regional firms, Bank of America Securities LLC and RBC Capital Markets, placed ninth and 10th.

For issuers polled yesterday, the news posed near-term headaches for some with concerns over the future competition for bond transactions, while others said they anticipated regional firms would continue to step up to fill the growing void. Issuers were most concerned over the status of Lehman, which they were told would remain up and running in the near term as the broker-dealer was not directly included in the list of firm holdings filing for bankruptcy.

Ben Watkins, the director of Florida's division of bond finance, said neither announcement bodes well for the market even though Merrill Lynch escaped a more devastating fate.

"The bankruptcy of Lehman Brothers and the sale of Merrill to Bank of America signal a contraction of capital available in our market, and that's never a good thing," he said. "They've both got very talented people working in the municipal area and not having them engaged in the business would not be good."

Both Lehman and Merrill are among the pool of underwriters used by Miami-Dade County, according to Rachel Baum, finance director of the county. "It does sadden us as many of the investment bankers that we have been doing business with over the years may loose their employment and may not be able to be placed with other banks in as much as the number of investment banks is shrinking. Of course as the number of firms shrinks, the competitive nature will also diminish and the support that we count on during bond pricings will be that much more important from the remaining participants."

Miami-Dade County established a pool of 14 large underwriters in 2006 for a five-year term. They included Lehman, Merrill, UBS, Bear Stearns, and Wachovia Corp.

Wisconsin capital finance director Frank Hoadley said Lehman's bankruptcy would pose some minor inconvenience as the state would need to replace it as agent on one of its commercial paper programs ahead of a remarketing set for Oct. 1. The firm did not contact the state yesterday, but Hoadley called Lehman.

Lehman has played a significant role as an underwriter on both negotiated and competitive transactions, according to Hoadley. "We like to see healthy competition and fortunately we don't have any transactions coming to market. I'm concerned about issuers who have transactions they have to put in the market right now," he said.

Hoadley said of late seven or eight firms have submitted competitive bids on the state's deals sold that way, up from a traditional number of three to five. "We are seeing players, regional firms stepping in with hundreds of millions of dollars of capital, that we haven't seen before," he said. "Firms are changing. This isn't moving the deck chairs around, this is replacing them."

At least one regional banker believes the crisis bodes well for his firm and other regional broker-dealers.

"It's been a busy time and our retail business continues to be strong," over the last few days, said James Merten at City Securities Corp., an Indianapolis-based broker-dealer. "There are less bidders on blocks of bonds, and we think we're buying good quality bonds at attractive yields."

The firm also expects to step into the liquidity void created by the departure of Lehman a few months after Bear's exit. "I think liquidity is almost nonexistent right now," said Merten. "We'll provide more liquidity in the market than normal, and that will provide some good opportunities for us."

Financial advisers were also busy yesterday fielding calls from worried clients and checking with bankruptcy attorneys to assess the full impact on swaps, investment agreements, and pending deals.

All agreed that Lehman's bankruptcy demanded more immediate attention than Merrill's acquisition. "These are very different situations," said Kenneth Kaufman of Kaufman, Hall & Associates Inc., an Illinois-based advisory firm that specializes in health care. "The Lehman situation is much more immediate. Bankruptcy is an event for termination, so a lot of people are scrambling on that right now. This is really complicated stuff. Everybody is involving bankruptcy counsel and seeing where to go forward from here."

A QUESTION OF SWAPS

Chief questions from issuers include the impacts on their outstanding swaps and the work needed to hire new bankers on pending deals.

"Another banker has to be found and in some cases there are other complications, so it's going to be a lot of work to get that fixed up, especially as we're not exactly working in the most stable of markets right now," Kaufman said. "This is a pretty big day." He said his firm was already working with bankruptcy attorneys to assess the full impact of Lehman's move, as was another Midwestern financial advisor.

Advisors at Public Financial Management will hold internal meetings today regarding the impact on outstanding swaps, said Peter Kessenich, a managing director at PFM's Atlanta office.

"With Merrill, we've been assuming it will be like JPMorgan and Bear Stearns, where Bank of America will assume all of the responsibility and no one should get too excited at the present time," he said. "It's another matter with Lehman. Some of our clients with Lehman as a dealer and remarketing agent are trying to work through what to do with that." He added that as of yesterday it was still too early for the firm to be making any formal recommendations to clients.

The impact on the municipal groups of Lehman and Merrill also remained unclear yesterday. Merrill most recently listed 229 professionals in its listing with the Municipal Marketplace while Lehman listed 121 professionals.

Lehman operates offices in Los Angeles, San Francisco, Washington, D.C., Chicago, Boston, New York City, Philadelphia, San Juan, Houston, and Seattle. Sources said some employees walked out while others remained on the job trying to conduct business. Some traders were selling off the firm's municipal inventories, sources said.

Employees have not received any word from the firm's leadership. Even Lehman public finance head Ron Stack had no additional details to provide employees Monday morning. Sources said the broker-dealer and the asset management business - two more typically profitable businesses - are among the business units withheld from the bankruptcy filing and they are looking for a buyer.

Lehman chief executive officer Richard Fuld had said earlier this year that he believed the firm had weathered the credit crunch. While Lehman's struggles escalated over the last quarter, many employees believed the firm would secure a buyer with help from the federal government, sources said. The firm's collapse followed Moody's Investors Service move last week to place the firm's credit rating on review for a downgrade.

Merrill recently scooped up nearly 30 bankers from UBS Securities, taking advantage of what John Lawlor - chairman of Merrill's municipal markets business - called a "once-in-a-decade opportunity." Merrill operates public finance offices in Atlanta, Boston, Chicago, Dallas, Florida, Houston, Los Angeles, New York City, Philadelphia, Pittsburgh, San Francisco, and Seattle. Nationally, Merrill has held the top spot on competitive transactions for the last 12 years.

MERRILL'S 'CROWN JEWEL'

Merrill held a company-wide conference call yesterday morning for its 60,000 employees during which officials talked up the positives of the deal, echoing statements by chief executive John Thain at a news conference.

"We were told it is a good strategic fit because of our global debt and equity and mergers business and that this will only enhance our business, give us more capital and liquidity and put us in markets with access to a client base we had not had before," said a Merrill source. The "integration" would take a few months, the source said, and the deal is expected to close in the first quarter of 2009. A key draw for Bank of America was Merrill's lucrative private wealth management business.

Bank of America chief executive officer Ken Lewis called Merrill's wealth management business the "crown jewel" Merrill brings to the table and that he intends to keep the name and organization intact with both firms' wealth management groups being combined and operating under Merrill's name. Members of the public finance team said they were not told whether layoffs loomed or what name the underwriting business would continue under. The transaction has been approved by directors of both companies and is subject to shareholder votes and regulatory approvals.

Several Merrill sources said the hope is that the firm can avoid deep cuts as a massive retail brokerage will remain to support and is expected to grow with a boost in business from Bank of America's retail shops. Bank of America also has a leaner public finance staff. It listed 187 professionals in its marketplace listings with offices in California, Colorado, Connecticut, Washington, D.C., Florida, Georgia, Illinois, Massachusetts, New York City, , North Carolina, Rhode Island, Texas, and Virginia.

The acquisition will clearly boost North Carolina-based Bank of America' underwriting rankings, which are already among the top 10. Last June, the bank announced the hiring of Peter Hill as its head of public finance investment banking to replace Phil Smith who had resigned to move over to Wachovia Securities. Hill had most recently served as head of public finance at ACA Financial Guaranty Corp. Hill previously was head of public finance at JPMorgan, where he spent 14 years.

Regulators sought to calm fears that the financial crisis would expand. To the surprised reaction of many market participants, regulators attempted to dampen anxiety by minimizing its impact on the municipal market.

Lynnette Hotchkiss, the executive director of the Municipal Securities Rulemaking Board, said there are several large and regional firms ready to meet the financing needs of issuers. "There is certainly no expectation or concern that other firms in the industry would not be able to absorb new issue volume," she said.

Because Lehman's brokerage unit is still technically open for business, Ronald Stack, head of public finance, remains scheduled to become chairman of the MSRB next month, Hotchkiss said. He will replace Frank Chin, managing director and manager of public finance at Citi.

"Ron is our chair as of Oct. 1," she said. "If something happens between now and then, we have internal policies that handle any sort of special election that has to take place."

Though Stack could not be reached for comment yesterday, sources said that Lehman began selling off some of its inventory of municipal securities yesterday. Sell-side bankers did not expect to bring any new issuances to market and traders spent the day preparing their resumes. Some have already quit.

Lehman spokesman Mark Lane declined to comment on specifics of the public finance department.

POLITICIANS WEIGH IN

The crisis could impact the presidential race, heightening voter attention on economic issues. The nominees both weighed in on the news yesterday. Republican nominee U.S. Sen. John McCain of Arizona said in a statement: "The crisis in our financial markets has taken an enormous toll on our economy and the American people ... I am glad to see that the Federal Reserve and the Treasury Department have said no to using taxpayer money to bail out Lehman Brothers, a position I have spoken about throughout this campaign. We are carefully monitoring the financial markets, including the duress at Lehman Brothers that is the latest reminder of ineffective regulation and management."

"It is essential for us to make sure that the U.S. remains the pre-eminent financial market of the world. This will be a highest priority of my administration. In order to do this, major reform must be made in Washington and on Wall Street. The McCain-Palin administration will replace the outdated and ineffective patchwork quilt of regulatory oversight in Washington and bring transparency and accountability to Wall Street."

The Democratic nominee, U.S. Sen. Barack Obama of Illinois, issued a statement saying: "The situation with Lehman Brothers and other financial institutions is the latest in a wave of crises that are generating enormous uncertainty about the future of our financial markets. This turmoil is a major threat to our economy and its ability to create good-paying jobs and help working Americans pay their bills, save for their future, and make their mortgage payments.

"The challenges facing our financial system today are more evidence that too many folks in Washington and on Wall Street weren't minding the store. Eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans have brought us to the most serious financial crisis since the Great Depression. For years, I have consistently called for modernizing the rules of the road to suit a 21st century market - rules that would protect American investors and consumers," Obama said.

Other congressional members also weighed in while others withheld comment. Alabama Rep. Spencer Bachus, the ranking Republican on the Financial Services Committee, urging against "fault-finding or recrimination."

"At this time, we all need to work together to restore stability to the markets and to support our economy," Bachus said. "Once that is accomplished, we can examine how we got here and what to do to prevent this kind of hazard to our economic well-being in the future."

Once the dust settles, he urged the examination of "excessive leveraging, the over-extension of credit, the failure of regulators to limit these risky practices, and the complete failure of rating agencies to accurately assess risk."

Alabama Sen. Richard Shelby, the ranking Republican on the Senate Banking Committee, said that the announcements mark "another major shift in the landscape of financial markets" and said it is the responsibility of the committee to conduct a "thorough review" of how the events transpired and what the implications are "for global finance, the banking system, the U.S. economy and the American taxpayer."

Christopher Dodd, the Democratic chairman of the Senate Banking committee, declined to comment as of press time.

Though a congressional source said that House Financial Services Committee chairman Barney Frank, D-Mass., spoke with Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke, Frank chose not to make any public statements to "save himself from saying something not well informed," the source said.

"Any misstatements by a leader in this area could be disruptive," the source added.

Democratic Senate Majority Leader Harry Reid's office sent reporters a statement blaming the financial crisis on the "Bush-McCain economic policies."

"Failing to police lenders and neglecting to protect consumers ushered in the subprime crisis that has brought the American economy and Wall Street to their knees," Reid said in a statement. "This 'anything goes' approach to governing has resulted in lost jobs and carries an enormous price tag for the American taxpayer."

Democratic House Speaker Nancy Pelosi of California blamed the Lehman bankruptcy and sell-off of Merrill on "eight years of weakened regulation of our nation's financial system - including a failure to regulate risky, and often predatory, lending practices - by the Bush administration and Republicans in Congress."

House Republicans sent out of press release of their own from Minority Leader John Boehner of Ohio that said "the destructive tax-and-spend economic policies promoted by this Democratic Congress are failing to meet the needs of workers, seniors, and small business."

LEHMAN, MERRILL RANKINGS

Meanwhile, the Securities and Exchange Commission and the Financial Industry Regulatory Authority said in statements that their staff are working on-site at Lehman and will oversee the orderly transfer of customer assets. In the interim, Lehman and Neuberger Berman LLC, Lehman's asset-management division, will remain a member in good standing of FINRA.

Since 2004, Merrill ranks fourth, Lehman sixth, and Bank of America eighth among senior managers on all issuance. On competitive deals, Merrill was first, Lehman third, and Banc of America eighth. On negotiated deals, Merrill ranked fifth, Lehman sixth, and Banc of America ninth. In education, Lehman ranked fourth, Merrill was fifth, and Banc of America eighth. Lehman ranked eighth in electric power, with Merrill fourth and Banc of America fifth. On environmental deals, Lehman ranked seventh, Merrill ranked eighth, and Banc of America ranked fifth. On general purpose bond transactions, Merrill ranked second, Lehman was fifth, and Banc of America eighth.

In health care, Merrill ranked third, Banc of America eight and Lehman 10th.. In the housing sector, Merrill ranked second, Lehman ranked fourth, and Banc of America ranked 10th. Bank of America ranked third, Lehman ranked fourth and Merrill 10th in public facilities. In the transportation sector, Merrill ranked fourth, Lehman sixth, and Banc of America seventh. In utilities, Merrill ranked fourth, Bank of America ranked seventh, and Lehman ninth. In the development sector, Bank of America ranked first, Lehman ranked second, and Merrill eighth.

In other commentary from issuers regarding the Lehman and Merrill announcements, the District of Columbia said Lehman is remarketing agent for $125 million of its variable-rate demand obligations that the district brought to market on Sept. 3.

David Umansky, spokesman for the district chief financial officer's office, issued a statement about Lehman's role with the bonds going forward: "The Lehman Brothers holding company has filed for bankruptcy, but not the broker-dealer. Therefore, our bonds continue to be remarketed by Lehman. We are carefully watching developments, however, and are prepared to substitute another remarketing agent should it be necessary to do so."

Florida chief financial officer Alex Sink said: "While our nation is experiencing significant financial disorder, investment firms can and do fail from time to time, and investors must position portfolios to weather financial storms. We have positioned Florida's Treasury to meet the cash needs of investors and balance the obligations of the state.

The Florida Treasury held $139.5 million par value in Lehman Brothers Holding Inc. bonds as of Friday. Of this amount, $104.1 million was senior debt and $35.4 million was subordinated debt. The total exposure represents less than 0.6 % of Treasury investments, which total $24 billion. The Treasury is proceeding with an orderly liquidation of the subordinated debt this month.

The East Bay Municipal Untility District in Oakland has two outstanding swap agreements with Lehman and both are under water, said finance director Gary Breaux. Lehman is also the remarketing agent on $160 million, or about half, of the district's commercial paper.

Breaux and other issuers at The Bond Buyer's California public finance conference spent much of the day Monday huddling with financial advisos, lawyers, and bankers at the conference - or sneaking out of sessions for hastily arranged conference calls - to try to figure out what the news means for them. Breaux said it's still unclear what Lehman's bankruptcy will mean for the utility district, other than cold calls from bankers who want to snatch up Lehman's business.

"I turned on my Blackberry at 8 a.m. this morning, and I had two offers from firms to help me in any way they can, one of which was JPMorgan, which I thought was getting out of the swap business," Breaux said during one panel. "That's great customer service," drawing laughs from the audience of municipal professionals.

"No. Thank God!" said San Francisco debt manager Nadia Sesay, when asked if she had any exposure to Lehman.

NEW JERSEY, PUERTO RICO OFFICIALS COMMENT

New Jersey is currently reviewing its entire pool of underwriters, according to state Treasury spokesman Tom Vincz. The state's current senior management team includes Goldman, Merrill, and Morgan Stanley. Bear, Stearns & Co. and UBS Securities LLC are also on the list.

While New Jersey's senior underwriting team decreases, the state does have a large pool of 30 firms to tap into for co-managing services. Lehman Brothers is included in that list.

Like New York, New Jersey will feel the effects of fewer jobs on Wall Street. Gov. Jon Corzine yesterday on CNBC's Squawk Box said he anticipates the state's income tax revenues to decrease and officials may have to cut the current budget even more.

"I'll tell you we have benefited enormously by the growth in the earnings power by the people on Wall Street, aside just from the number of jobs, and that I think speaks for itself in the current climate," Corzine said.

To help the economy, the first-term governor said the federal government must draft a second stimulus package and said infrastructure investments are "absolutely essential" in boosting the economy and creating more jobs.

"First of all, I think we need something that works on the real economy," he said. "We need to get people back to work ... absolutely I think there needs to be a second stimulus."

Others too were concerned over effect the reduction in firms vying for deals would have on borrowing costs.

"That might be one effect," said Jorge Irizarry, president of the Government Development Bank for Puerto Rico, the commonwealth's financial adviser. "There's some consolidation, so there will be fewer players and then could end up being more expensive because they'll be less competition. And everybody's gone through a rough time and so when you start doing transaction with the bankers again, it may be more costly."

Irizarry said plans for a $400 million Puerto Rico Municipal Finance Agency deal with Merrill Lynch as lead manager are still in place. That deal is set to price next month with Ramirez & Co. and RBC Capital Markets as co-senior managers.

Merrill has also been working with Puerto Rico on a $3 billion taxable pension deal that would price on the mainland. Yet officials have postponed that transaction due to market conditions and less liquidity in the global market. Once market conditions improve, Puerto Rico could benefit from Bank of America's buyout of Merrill Lynch, Irizarry said. While Merrill has a global presence, Bank of America could infuse much-needed cash into Merrill's investment banking business.

"I think, if anything, this merger strengthens Merrill. If Merrill was in a weakening position, in having a balance sheet like Bank of America standing there, which has plenty of liquidity, then I think Merrill is much more viable in conjunction to B of A, it seems to me," Irizarry said. "So, going forward now there's an investment banking firm that has a bank balance sheet to it, which is a big plus nowadays."

While Irizarry said it is "unfortunate" to see bankers leave who have been working with the GDB over the years, he agreed with some of his counterparts that the fall of Wall Street banks could give rise to smaller, boutique firms and minority-owned or female-owned companies.

"The smaller firms had no exposure to all this subprime, all this mortgage paper all these [collateralized debt obligations] and in that sense they're not taking as much risk so it may be they're more attractive," Irizarry said. "And they're more concentrated on a particular business segment. The big firms want to be all things to all people, so smaller firms may have an opportunity here to make inroads and get more business."

'A HISTORICAL MOMENT'

On Monday, many issuers had a certain number of their bonds put back because Lehman could not remarket them, leading at least one financial adviser to spend part of the day trying to find new remarketing agents to take over Lehman's services. Lehman itself was working to find new remarketing agents for its outstanding debt.

"It's a historical moment," said one veteran financial adviser based on the East Coast. "It's shocking that you've got an institution started in 1850 in Alabama as a cotton broker, and moved to New York during the Civil War and has gone through all these various depressions, and it no longer exists."

The near-term impact on the market is likely to be higher fees and higher spreads amid a smaller municipal market, the adviser said. "We're talking about a shrinking universe of participants in the municipal market, so we'll probably start seeing spreads and compensation going higher as a result."

"I think regional banks will increase in value in terms of their role in distributing bonds and participating in the market," he said. "I would imagine that on competitive issues, you'll see more firms bidding alone as opposed to as members of a syndicate."

"There's a lot of talent that has now gone away from this market," said the adviser. "When that brain power has been siphoned off, it's harmful to our business."

 

 

 

 

 

 

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