What the Lehman Crisis Really Means for the Stock Market

Yesterday, for the first time since the 2001 terrorist attacks on America, the Dow Jones Industrial Average fell over 500 points to end at 10,917.51 — just 185 points above its July 2008 low of 10,731.96.

There has been enough written about Lehman Brothers Holdings, Inc. in the financial news in the last two days. All I can add is my opinion: Lehman fell prey to the subprime mess that it helped create. Lehman was the biggest underwriter of mortgage-backed securities right when the U.S. real estate market was at its peak. U.S. property prices faltered, so did mortgage-backed securities, and so did Lehman.

The cleanup on Wall Street continues, now without the help of Treasury Secretary Henry Paulson. After putting government money behind the Bear Sterns deal and the Fannie Mae/Freddie Mac bailout, the Fed looks like it is taking a break from bailing out damaged Wall Street firms. I’m happy Paulson is sending the message: fix the mess you created or perish. Finally, the excesses that were created in the 2002-2005 property boom, and those that got rich from it, are correcting on their own.

Merrill Lynch was lucky to find Bank of America as its savior; otherwise, I believe it would have been a casualty, too. In the end, I believe the investment banks of Wall Street will eventually all be owned by the big banks, because the cost of capital of the big banks is simply cheaper than the cost of capital of the investment banks. In Canada, all the major stock brokerage houses are now owned by large banks. I see the same thing eventually happening in the U.S.

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So what’s next for the U.S. economy?

It looks like American International Group (AIC) and Washington Mutual will be the next to go. My suspicion is that the stock market has already discounted in the demise of these two financial companies.

What is critical for the stock market, and what is critical for investors, is that the July 2008 lows of the Dow Jones Industrial Average are not broken. If they are, the stock market could be in real trouble. Therefore, the trading direction today and in the next couple of days is very important.

To date, I have been very impressed with the market’s ability to trade above its July 2008 lows in the face of the increasing problems for Wall Street firms. With debt of over $600 billion, Lehman’s bankruptcy may just be the biggest in American history. If the stock market is able to stay above its July 2008 low in spite of the Lehman bankruptcy and the possible demise of AIG and Washington Mutual, this will be a major plus for the stock market. On the other hand, a decisive break below the July 2008 Dow Jones Industrial Average low of 10,731.96 would be a strong signal that the worst is far from over.