Indeed, the other shoe has dropped

The current environment demands and explanation. So let me first reiterate the impact of uncertainty and then share one perspective on the recent news of Merrill, Lehman, and AIG.

"Uncertainty" is different than "Risk." In risk, the underlying probabilities of a certain event are known, as well as the effects (i.e. you are able to quantify the payoff) those events will have. Thus, roulette is a game of risk (all probabilities and payoffs are known). War is an uncertainty, in that the effects of the same can't be accurately quantified. As I stated in a previous post, when you are unable to quantify the problem, the more likely you are to follow the herd. And the herd will demonstrate a tremendous amount of overshoot (up, if the news is good, down, if the news is bad). And the less one is able to identify the "high" and the "low," the less likely the trend will end anytime soon. The presence of magnificent leverage, or debt, exposes both institutions AND individuals to extraordinary financial risk amidst uncertainty. So I think we're in for a long ride. Unfortunately, the overshoot and uncertainty is so great, and the leverage all too common, that it has produced multiple victims (seen in high profile bankruptcies on the corporate side, and massive foreclosures on the consumer side).

Now, on to the hemorrhaging on Wall St. Merrill was sold to Bank of America (not a big deal, although alarming), Lehman declared bankruptcy and will sell off various divisions, and AIG was bailed out by the government. I don't think I will address the actual remedies of Merrill Lynch, Lehman Brothers, and AIG. Those have been treated in great detail by others more qualified than me. Perhaps the question you may be asking is, "Why was one sold, one bailed out, and one not? And what does that say about our financial system?"

Merrill Lynch was wise and found a potential buyer before things got really ugly. They realized they were going to run out of money. But unlike many of their competitors that kept the news quiet until the last moments, Merrill's CEO was forthright and honest about the current state (probably because he was only hired in November and is still in the honeymoon stage with the Board). In the words of beloved JPMorgan CEO Jamie Dimon, "It's one thing to buy a house (referring to BoA's acquisition of Merrill), it's an entirely different matter to buy a house on fire." Merrill bailed while the flames were beginning to torch the grass but have not yet reached the home.

Before discussing AIG and Lehman, let me interject here that I've been pleased with the coordination between Bernake's Fed and Paulson's Treasury (the Fed is responsible for monetary policy while the Treasury is responsible for fiscal policy, or, how the government spends money). They've both approached this disaster with very innovative ideas, which I think are in the best long term interest of the U.S. economy. The biggest problem most people have, rather, what I hear people complain about most frequently is the doctrine that government should not undertake bailouts because it creates a type of "moral hazard." Although the government is stepping in to help AIG, average taxpayers face a higher standard of living over the long run from utilizing a taxpayer-funded "bailout" to re-establish growth than they do by permitting a collapse of the global financial system. Furthermore, management and shareholders often pay a heavy price under such circumstances (which is not the case in other countries where governments have stepped in and protected shareholders).

So why save AIG and not Lehman (who filed for chapter 11)? Although Lehman is huge, AIG is the hub of a spoke and wheel network whose wheel is the global economy. Their integrity must be protected. One economist we work with said, "what we are seeing is a certain level of experimentation and sampling. The financial system has never really been stress-tested and is evolving." No one really knows how it will end up. That makes it difficult to say "bailouts" are either good or bad. Apparently, the risks of testing the system by letting a huge global giant like AIG go bankrupt are too high to assume until we have experimented with smaller companies, like Lehman. I believe we are seeing a testing-while-protecting strategy from the Treasury and the Fed, and, I think on the balance, they are doing a good job.

Again I'll end with an ominous prediction. Whose next? Wall Street seems to think Morgan Stanley and Goldman Sachs are next (based on credit default spreads, which gauge risk). I would not be surprised to see a partnership between the two. I would be surprised, if twelve months from now, those two organizations still stand independant.