Stock Traders Find Speed Pays, in Milliseconds

By Charles Duhigg (New York Times)

It is the hot new thing on Wall Street, a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices.

It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets.

Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.

These systems are so fast they can outsmart or outrun other investors, humans and computers alike. And after growing in the shadows for years, they are generating lots of talk.

Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer.

And when a former Goldman Sachs programmer was accused this month of stealing secret computer codes — software that a federal prosecutor said could “manipulate markets in unfair ways” — it only added to the mystery. Goldman acknowledges that it profits from high-frequency trading, but disputes that it has an unfair advantage.

Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.

“This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”

For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.

But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.

“It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange. “Markets need liquidity, and high-frequency traders provide opportunities for other investors to buy and sell.”

The rise of high-frequency trading helps explain why activity on the nation’s stock exchanges has exploded. Average daily volume has soared by 164 percent since 2005, according to data from NYSE. Although precise figures are elusive, stock exchanges say that a handful of high-frequency traders now account for a more than half of all trades. To understand this high-speed world, consider what happened when slow-moving traders went up against high-frequency robots earlier this month, and ended up handing spoils to lightning-fast computers.

It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.

Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates.

“You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient,” said Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques. “But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”

Buffett's $5B Goldman Investment Up $2B? Try $6B

By David Clayton

Reports in the media last week indicated that Berkshire Hathaway’s (BRK.A, BRK.B) warrants in Goldman Sachs (GS) now have a paper gain of more than $2 billion.

The difference between the strike price and the share value translates into a $2.19 billion paper profit for Berkshire.

But this approach is wrong. Depending on how it’s calculated, Berkshire’s paper profit at the close July 23 was at least $3.1 billion, and could be more than $6 billion.

The recent article fails in its analysis because the author simply multiplied the number of warrants Berkshire received by the difference between the current stock price and the strike price. This approach provides just part of the story, which is the value of the warrants if they were exercised today.

But it doesn’t reflect the current market value of the warrants, nor does it recognize the value of the warrants when the deal with Goldman Sachs was struck. It also doesn’t include any discussion of the change in value of the preferred shares Berkshire acquired.

On September 23, Berkshire announced the terms of a $5 billion investment in GS preferred equity and warrants. In the eight weeks after the deal was announced, GS common stock was down nearly 60%.

Amid the market chaos, Buffett critics loudly decried the GS and General Electric (GE) investments as mistakes. “So far,” Simon Maierhofer of ETFguide.com wrote on November 18, “Buffett has lost over $2 billion on the Goldman deal.”

This article, like the ones recently, incorrectly valued the investment, and dramatically so. This article failed because it didn’t recognize how good a deal this was for Berkshire from the start.

The Simple Valuation

The easiest way to place a value on the investment is to imagine that it was cashed out today. Here are the terms: for Berkshire’s $5 billion investment:

• Berkshire received perpetual cumulative preferred stock paying a $500 million annual dividend
• Berkshire received warrants to buy 43.48 million GS common shares at $115, exercisable at any time before October 2013
• GS can redeem the preferred stock at any time, and will pay Berkshire $500 million when it does so

If at the close July 23, GS redeemed Berkshire’s preferred shares, and if Berkshire had exercised its warrants, here’s where the accounting would have stood:

This, the most conservative estimate possible, says Berkshire’s return on this investment has been 62% in 10 months.

Of course, Goldman hasn’t redeemed the shares and Berkshire’s not about to cash out the warrants. And it’s necessary to dig deeper to really understand what Berkshire’s return on the preferreds has been.

Analyzing the Investment More Rigorously

The investment has two parts, preferred shares and warrants, and it’s necessary to analyze each part independently to get a full picture of how good or bad the investment is.

Valuing the Warrants

Many authors writing about the Berkshire investment fail to describe the importance of the warrants, all too often indicating that they are somehow less important than the preferred shares.

However, the warrants have the potential to be enormously profitable, and were integral to the deal; they allow Berkshire to benefit from common stock appreciation, while the preferred shares don’t.

"The preferred pays us the dividend, " Warren Buffett said recently on Fox Business. "The warrants are going to make us the money."

The potential to share in gains made this part of the investment very valuable on September 23.

The warrants are basically American-style call options, exercisable at any time before October 2013. While there is no standard method for valuing American-style call options, the Black-Scholes option pricing model is the industry standard for valuing European-style options. European-style options can be exercised only at expiration; since American-style options have greater flexibility in execution, they are more valuable.

The inputs to Black-Scholes and my methods for determining their values:

• The value of the underlying investment – the market price of GS
• Strike price of the option (Strike) – $115/share
• Time to expiration (Time) – at the outset, this was 5 years
• The current risk-free interest rate (IntR) – generally that of Treasury securities maturing at the same time the option expires; the value is based on the Treasury’s daily yield curve tables
• The dividend yield over the life of the option (Yield) – this was estimated using the trailing 12 months of dividends divided by the market price of GS common
• Volatility (Vol) – ideally, this will be the volatility of the underlying option over the option’s life; obviously, this can only be estimated. Since time-to-expiration of the warrants was 5 years, I used a volatility calculation based on the previous 5 years of daily price data. In the 10 months since the deal was struck, GS stock’s volatility has shot up; however, since I believe this to be a short-term disruption in the market, I have elected to use the September 23 volatility figure for all calculations. The result is that Black-Scholes values are lower than they would have been with a higher volatility figure.

Here’s what Black-Scholes says the warrants were worth at the close September 23:

Multiplying this by the 43.478 million warrants Berkshire received, the initial value of the warrants was $1.39 billion.

Valuing the Preferred Shares

We will never know what value the market would place on Berkshire’s preferred GS shares, since they will never be traded. However, we can make reasonable estimates based on the market prices of similar securities.

If there were exchange-traded cumulative preferred shares of GS, this would be a simple matter of assigning the yield of those shares to the Berkshire investment and backing out a market value (divide the $500 million dividend by the yield to return the market value).

However, all of the exchange-traded GS preferred series are non-cumulative. So estimating the value of Berkshire’s investment is a bit more complicated.

Preferred share values are primarily determined by two factors: market interest rates and risk, risk being the probability that the dividend won’t continue to be paid. Because Berkshire’s preferred shares are cumulative, the risk that the dividend won’t be paid is much different than for its non-cumulative preferreds; GS must pay the cumulative preferred’s dividend unless it goes bankrupt.

Therefore, the risk premium demanded by investors in cumulative preferreds is lower than that demanded by non-cumulative preferred investors, and yields are lower.

For example, there are both cumulative and non-cumulative exchange-traded preferred shares of JP Morgan (JPM). The non-cumulative always yields more than the cumulative; between September 5 and September 23, the non-cumulative averaged a 1.0% higher yield than the cumulative.

On March 6, at the market bottom, this spread had increased to 4.4%, reflecting the perception that JPM might at some point not pay the non-cumulative preferred dividend. Since April 1, this spread has ranged between 1.1% and 1.8%.

Another factor affecting the value of the preferred shares is their redemption rules. If the company can redeem the shares and end the investor’s revenue stream, the yield demanded will be slightly higher.

I don’t have a good sense of how large this impact is, and have increased my estimated market yield for the Berkshire shares by 0.2% across the board to account for this effect.

The table below shows September 23 data used to estimate the initial value of Berkshire’s preferred equity investment in Goldman Sachs, where:

• JPM PrI – J-series non-cumulative preferred
• JPM PrE-G – average of three series of cumulative preferred
• GS-PrD – the most liquid of GS non-cumulative preferred series
• GS-PrBRK – estimated yield if GS cumulative preferreds were traded

Dividing the $500 million annual dividend by the estimated yield gives the estimated value: $6.49 billion.

When the Deal Was Made

So, the market value of the $5 billion Berkshire Hathaway investment in Goldman Sachs on September 23 was $7.89 billion, or 58% more than the deal’s price.

This figure is so outsized that it begs for debunking. I invite critiques of method. Perhaps I got something wrong. But even if my calculations end up discredited, there are basic facts indicating that Berkshire significantly underpaid:

• The warrants have some value; the mere fact that they’re not being exercised demonstrates this. "Every instinct in my body," Buffett said, "tells me that we will want to hold those warrants until they're very close to their expiration date." And while Buffett has stated that Black-Scholes increasingly overstates the value of options as the time-to-expiration increases, 5 years isn’t so long that the calculation would be geometrically wrong. I’ve also used a somewhat conservative volatility figure.
• The yield on the preferred shares was far higher than what the market would have demanded. Remove the value of the warrants from the total investment to determine the yield on the preferreds: $5 billion less $1.39 billion is $3.61 billion. The $500 million dividend indicates that the yield on the equity investment was 13.9%. Let’s be very conservative and suppose the warrants were only worth $500 million when the deal was struck (preposterous, since they would have generated a $437 million gain if exercised that day). That would place the cost of the $500 million annual dividend at $4.5 billion, for an 11.1% yield. That’s 2.6% more than what GS non-cumulative preferreds – riskier investments – were yielding on the NYSE.

At the Bottom – November 20

On November 21, shares of GS hit their bottom of 47.14. At this moment, Black-Scholes says that the Berkshire warrants were worth $84 million, for a loss of $1.309 billion since the deal was announced:

The Berkshire preferred yield likely would have peaked at about 10.2%, based on the JPM data and the GS non-cumulative peak yield of 12.3%; this corresponds to a market value of about $5 billion.

So Simon Maierhofer of ETFguide.com was right - Berkshire had lost $2.904 billion. What he didn’t say is that at this point, at the very bottom, when GS common had lost 62% of its value, Berkshire’s investment was worth about $5.035 billion (including accrued dividends), pretty close to what it originally invested.

And had Goldman redeemed the shares then, Berkshire would have collected the $500 redemption premium.

Today

On July 23, GS closed at $165.45, up $40 in the 10 months since the deal was made. GS preferred shares are up close to 40%. And Berkshire’s investment has performed similarly. The warrants:

And the preferred shares:

Add in $404 million of accrued and collected dividends, and Berkshire’s investment is now worth $11.05 billion, not including the $500 million redemption premium GS must pay when it redeems the preferred shares.

The Bottom Line

When the deal was struck, Buffett purchased $7.89 billion of securities at a 37% discount. Ten months later, the investment had grown another 40%; the total return is more than 120% in ten months. Even using the most conservative valuation method, Berkshire’s return is $3.1 billion, or 62%.

During this period, gold has returned 5.7%. The S&P 500 lost 15.9%.

Suppose GS redeems the preferred for $5 billion on October 1. Berkshire will have received $500 million in dividends, or 13.9% of the investment less the initial value of the warrants. Further suppose that GS common stock appreciates by 8.6% per year through October 1, 2013, the warrants’ expiration date, regaining its 2007 high of 233 on that date. Berkshire would buy $10.13 billion worth of stock for $5 billion. That’s an annual return of 36.5%.

Naturally, the return on the warrants is tied to that of GS common. If the stock is stagnant at 165, the options will pay just $2.19 billion, or 11.4% per year. And if Goldman stock declines, the warrants would be worth less.

But if GS grows at 11.3%, as it did for the 7 year period starting 1/1/2000, Berkshire’s gain on the warrants would be $6.19 billion, for a 42.8% annual gain.

When properly valued, this investment certainly looks like it will go down in history as one of Warren Buffett’s greatest.

Sparkling Roger Federer - The Vintage from Paris

So Roger Federer did come good on Sunday's French Open final against Robin Soderling. Who had ever thought of him winning the Roland Garros championship just before the tournament started barely two weeks ago? Yes, he won. No kidding this time -- albeit the absence of his long time nemesis Rafael Nadal in the final did make the process easier for him by beating Robin Soderling in straight sets.

Even though Roger Federer is not at his best form in the French Open, he still managed to produce good service games and some good aces when he needed it. That i think is the most crucial difference why he can still beat Tommy Haas and Juan Martin Del Potro in five sets en route to the final. A lot of his repertoires under his belt are not here to be seen but it is OK if he keeps on producing consistent service game and hold on trying to break his opponent's service game when time comes.

As for the Wimbledon in two weeks time, i don't see anybody will beat Roger Federer on grass this year. He is a different animal on grass. Last year his lost in the epic final to Nadal was one-off story. Also, i don't see Nadal can produce the best form as he did in the Wimbledon last year. Something is missing in Nadal's game lately. Suddenly, Nadal seems vulnerable. Maybe Andy Murray will give some good shows in Wimbledon this year. Who knows?

But now let savour the sparkling Roger Federer - the vintage that finally comes good in Paris. His final jigsaw puzzle in his quest for the Slams has finally put in place and sealed in the history. Salute!

Fed to buy massive amounts of short-term debt

By Jeannine Aversa, AP Economics Writer

WASHINGTON (AP) -- The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debt in a dramatic effort to break through a credit clog that is imperiling the economy.

Invoking Depression-era emergency powers, the Fed will buy commercial paper, a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls.

In more normal times, about $100 billion of these short-term IOUs were outstanding at any given time, sold by companies to buyers that included money market mutual funds, pension funds and other investors. But this market has virtually dried up as investors have become too jittery to buy paper for longer than overnight or a couple days.

That has made it increasingly difficult and expensive for companies to raise money to fund their operations. Commercial paper is a way of borrowing money for short periods, typically ranging from overnight to less than a week.

The unstable situation has left many companies vulnerable. The notion under the plan is for the government to provide a "backstop" that would give companies a new place to get cash, the Fed said. The action makes the Fed a crucial source of credit for nonfinancial businesses in addition to commercial banks and investment firms.

The Fed's action initially helped lift investors' spirits, although concerns about the economy dampened their enthusiasm. The Dow Jones industrials -- which gained about 145 points just after the open -- fell nearly 63 points in midday trading. Monday, a huge selloff put the Dow below 10,000 for the first time in four years.

Concerns about the credit markets pushed investors into longer-term Treasury bonds, considered a secure place to park money in times of turmoil. The rush to safety drove yields lower, though.

Credit markets themselves eased slightly, however, after the Fed's move raised hopes it would quickly relieve the short-term funding problems plaguing some companies.

European stocks posted modest gains on hopes that central banks around the globe would coordinate on rate cuts. Share prices in Britain and in Germany, Europe's largest economy, rose. Iceland, however, is facing the prospect of bankruptcy, according to the Prime Minister Geir H. Haarde, after its banks went on a buying spree across Europe, accumulating massive debts in the process.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

"The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors" have become increasingly reluctant to buy commercial paper, especially longer-dated maturities. As the market for commercial paper shrank, the Fed said rates on the longer-term debt "increased significantly," making it more expensive for companies to borrow.

The Treasury Department, which worked with the Fed on the program, said the action is "necessary to prevent substantial disruptions to the financial markets and the economy."

The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday.

If a company's commercial paper is not backed by assets or other forms of security acceptable to the Fed, the company could pay an upfront fee, the central bank said. The amount of such a fee has not yet been determined.

The Fed said it hoped its effort would jolt the commercial paper market back to life.

"This facility should encourage investors to once again engage in term lending in the commercial paper market," the Fed said. That should eventually spur financial companies to lend to each other and to their customers, including consumers, the Fed said.

The Fed said it planned to stop buying commercial paper on April 30, 2009, unless the Federal Reserve board agrees to extend the program. The Fed created a separate entity to pool and hold the commercial paper it buys. The Fed said this should allow the central bank to more easily manage the program and better control risk.

There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of last Wednesday, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion.

Pressure also is growing on the Fed to reverse course and order a deep reduction in its key interest rate, now at 2 percent. Such a move would be aimed at reviving the moribund economy by encouraging consumers and businesses to boost their spending. Many predict the Fed will act on or before its next meeting on Oct. 28-29. And, some believe it could be part of a broader coordinated move with central banks in other countries.

The White House said President Bush spoke Tuesday with leaders of Britain, France and Italy about measures the United States is taking and the importance of countries working together.

The finance ministers of the G-7 -- the U.S., France, Germany, Italy, Japan, the United Kingdom and Canada -- will meet in Washington at the end of this week and the White House says Bush is open to the idea of a leaders' summit on the economy, as suggested by French President Nicolas Sarkozy.

Fed Chairman Ben Bernanke may offer clues on the Fed's next move when he speaks Tuesday afternoon on the economic outlook and developments in financial markets.

President Bush also was set to talk about the government's bailout effort, which lets the government buy rotten mortgages and other bad debts from banks and other financial institutions. By getting these bad debts off bank's balance sheets, they might be in a better position to raise capital and more willing to lend to each other and to customers.

As the number of failed banks has gone up sharply this year, Sheila Bair, head of the Federal Deposit Insurance Corp., wants to boost fees to financial institutions to replenish the insurance fund that backs the nation's deposits. The increase would double the average paid by U.S. banks and thrifts next year.

The Fed pledged Monday to take "additional measures as necessary" to battle the worst credit crisis in decades.

Treasury Secretary Henry Paulson has tapped a former Goldman Sachs executive to be director of the government's bailout program. Neel Kashkari, who has worked with Paulson at the department since July 2006, was chosen Monday as the interim head of the government's unprecedented effort to unclog the credit markets.

Kashkari, who was a vice president in Goldman's San Francisco office before joining the department, is one of four former executives from the firm now working feverishly to resolve the financial crisis.

The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments. Consumers have retrenched.

Associated Press writers Madlen Read and Tim Paradis in New York and Ben Feller in Washington contributed to this report.

No Deal Reached Yet to Decide Lehman's Fate

By CARRICK MOLLENKAMP, DEBORAH SOLOMON, AARON LUCCHETTI, SERENA NG and SUSANNE CRAIG

The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute.

A sense of optimism that a rescue could be arranged today dimmed as a growing sense of gloom descended on Wall Street. Executives from top banks in the U.S. and Europe huddled with federal regulators in an attempt to come up with plans to either buy pieces of Lehman or prepare for an orderly winding down of the firm in a manner that would minimize the collateral damage for the ailing global financial system.

After 6 p.m., the formal meeting ended for the day with no resolution, though some participants stayed behind to continue talking. "Senior representatives of major financial institutions reconvened on Saturday with U.S. officials at the New York Fed. Discussions are expected to continue tomorrow," said a spokeswoman for the Federal Reserve.

At about 8 p.m., New York Fed President Timothy Geithner was still at the bank's headquarters. Officials from the New York Fed and various banks were expected to continue working through the night.

Under one plan, either Barclays PLC or Bank of America Corp. would buy Lehman's "good assets", such as its equities business, people familiar with the matter say. Lehman's more toxic, real-estate assets would be ring-fenced into a "bad" bank that would contain about $85 billion in souring assets. Other Wall Street firms would try to inject some capital into the bad bank to keep it afloat for a period of time so that a flood of bad assets don't deluge the market, damaging the value of similar assets held by other banks and insurers. The banks are also looking for the government to somehow financially backstop the bad bank.

The problem, though, is getting enough banks to back that plan. While teams of bankers are working through structures, it's clear that only a handful of banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves. Also, banks aren't keen to see a big rival such as Barclays or Bank of America walk away with valuable assets by only paying a pittance.

As of Saturday afternoon, Barclays, the U.K.'s third-largest bank in terms of market value, appeared to have more interest in pulling off a deal for Lehman's good assets. At about 3 p.m. on Saturday, Barclays President Robert E. Diamond Jr. was seen entering the New York Fed's employee entrance on Maiden Lane, carrying a briefcase.

Bank of America, an obvious buyer, appeared to be cooling toward a deal, people familiar with the matter. Of course, some of this could be the posturing that happens in any auction. Neither Barclays nor Bank of America wants to buy all of Lehman without some government assistance, and so far the government has been reluctant to do so.

Both Bank of America and Barclays remain fixated on the disposal of the bad real estate assets, and are less focused on evaluating Lehman's investment bank, said one person involved in the due diligence process. Things were moving so quickly Saturday that there was little time to do extensive employee interviewing that typically happens in company auctions. "It's all triage," said this person.

The real fear in the discussions, this person added, was that the fire-sale prices, or "marks" of Lehman's real estate book could set off a cascade of problems for other Wall Street firms. If those marks were made against other banks' portfolios, it could eventually force those firms to raise more capital, too. For firms' considering funding the bad bank, the calculation has thus become the price of that contribution against the price of a widescale markdown.

There could be further effects to such an event, with the banks calling in loans from hedge funds and other clients, in turn setting off more forced selling that further depresses asset and securities prices.

"Unless something is settled, it's going to be a bloodbath Monday," said this person.

In a meeting at the Federal Reserve Bank of New York in lower Manhattan, some participants also were discussing insurer American International Group Inc. and thrift-holding company Washington Mutual Inc. While those two financial firms aren't the focus of the emergency meeting, participants also are weighing the potential implications of their problems.

One person leaving the building said at least 100 people were gathered inside trying to settle the fate of Lehman, which has been staggered by its exposure to soured real-estate-related assets. By 5:15 pm, some Wall Street executives started to leave the New York Fed one at a time, getting in their cars inside a garage so they can't have their photos snapped.

Outside the Fed's downtown headquarters, a fleet of black towncars waited for bankers who were inside. At one point, the towncars blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards. Meanwhile, bankers and Fed staffers milled around outside, smoking cigarettes and talking on their cell phones about subjects like counterparty risk.

"Everybody is hoping there will be a Wall Street solution to deal with Lehman's toxic assets," said one senior executive at a major bank. "It is a cheaper alternative than having everything unravel."

With it unclear whether the gap between the federal government and potential buyers can be bridged, a second group at the New York Fed is focusing on the possibility that there might be no alternative to liquidating Lehman and winding down its operations in an orderly fashion.

On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.

Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank.

One person familiar with the matter said large dealers contemplated showing each other all of their credit default swap trades with Lehman. Disclosing their positions may enable dealers to find ways to offset their positions with each other wherever possible. Later in the day, some traders were told that Lehman -- with the help of Federal Reserve officials -- will try to figure out which of its counterparties have CDS trades that can be offset. Those counterparties would be informed of the offsetting positions, following which they can unwind their respective swaps with Lehman and concurrently enter into new swap contracts with each other. For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly.

Such moves could help prevent individual firms from scrambling to find new counterparties to rehedge their positions with when the markets reopen on Monday, potentially unleashing turmoil across the credit markets. They could also help facilitate an orderly wind-down of Lehman's derivative positions, if that becomes necessary. Still, sorting out the firm's CDS positions promises to be a difficult and time-consuming task, because many of the contracts have different terms and maturity dates.

It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Wall Street traders poured into their offices Saturday for emergency meetings to consider the actions they would take if Lehman is forced into liquidation. They broke into teams to evaluate their positions and exposure to Lehman in everything from energy trades to equity derivatives to credit,

One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, "if they go into liquidation," it is going to be a bad situation on Monday.

A disorderly unwind of Lehman's derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets -- such as commercial real estate -- could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.

Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.

In a Lehman bankruptcy, the firm's brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm's assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor's property and aren't exposed to the claims of the firm's creditors.

In trying to hold firm to their no-bailout stance even while pressing for a deal, federal officials could try to pit Bank of America and Barclays against each other. But that leverage can work only if both banks stay in the discussions.

Bank of America and Barclays know each other very well, having considered a merger several years ago. More recently, Bank of America agreed to pay $21 billion for ABN Amro Holding NV's LaSalle Bank of Chicago in 2007. That deal came at a time when Barclays was trying to buy ABN and fend off a European consortium bid. Bank of America's purchase was seen at the time as helping that Barclays bid, which ultimately failed.

At Barclays, a big question will be whether CEO John Varley and his No. 2, Mr. Diamond, both agree on buying all or part of Lehman. Mr. Diamond is eager to expand Barclays's U.S. investment bank operations. But the unit, called Barclays Capital, is also responsible for write-downs the bank has recorded.

After 5 p.m., bank executives began leaving the meeting, some getting into cars inside a garage where they couldn't be photographed. Those seen leaving included Merrill Lynch & Co. Chairman and Executive John Thain and Citigroup Inc. CEO Vikram Pandit. Bank of New York Mellon Corp. Chairman and CEO Robert Kelly declined to comment.

While some executives had left the Fed meeting, those of other firms, including three carfuls of Barclays executives, remained at the Fed office past 6 p.m.

At least 20 New York Fed staffers left from another exit. They refused to say if they were done for the night.

How J.P. Morgan steered clear of the credit crunch

By Shawn Tully, Sept 15 issue of Fortune

NEW YORK (Fortune) -- It was the second week of October 2006. William King, then J.P. Morgan's chief of securitized products, was vacationing in Rwanda. One evening CEO Jamie Dimon tracked him down to fire a red alert. "Billy, I really want you to watch out for subprime!" Dimon's voice crackled over King's hotel phone. "We need to sell a lot of our positions. I've seen it before. This stuff could go up in smoke!"

That call marked the beginning of a remarkable strategic shift that helped J.P. Morgan (JPM, Fortune 500) sidestep the worst of a historic credit crisis. J.P. Morgan mostly exited the business of securitizing subprime mortgages when it was booming. With the notable exception of Goldman Sachs (GS, Fortune 500), J.P. Morgan's main competitors - including Citigroup (C, Fortune 500), UBS (UBS), and Merrill Lynch (MER, Fortune 500) - ignored the danger signs and piled into those products in a feeding frenzy. (This is an excerpt from a story that ran in the Sept. 15 issue of Fortune. For more on Dimon and the team of talented lieutenants who helped J.P. Morgan dodge the credit crisis, read the full story)

Make no mistake: J.P. Morgan is also suffering from the credit crunch. While it largely dodged the subprime bullet, J.P. Morgan stumbled in two other areas: funding dubious deals in the LBO frenzy and jumping into the jumbo mortgage market when other banks were getting out. The third quarter is already looking tough. The company has announced that it is taking $1.5 billion in mortgage and leveraged-loan write-downs, and another $600 million to account for the decline in the value of its Fannie Mae and Freddie Mac preferred stock.

Still, J.P. Morgan is weathering the crisis far better than its rivals. From July 2007, when the cyclone began, through the second quarter of this year, J.P. Morgan took just $5 billion in losses on high-risk CDOs and leveraged loans, compared with $33 billion at Citi, $26 billion at Merrill Lynch, and $9 billion at Bank of America (BAC, Fortune 500). And in this market, losing less means winning big. Before the crisis J.P. Morgan was a middle-of-the-pack performer; today it leads in nearly every category, starting with its stock. Since early 2007, its share price has dropped 24%, to $37 (as of Aug. 27), vs. declines of 44% for Bank of America and 68% for Citigroup. Last year its market cap was far below those of Citi and BofA. Today J.P. Morgan stands in a virtual tie with BofA for first place among U.S. banks, and it towers over Citi.

That is largely thanks to J.P. Morgan's decision to shun subprime CDOs - vehicles that sell bonds backed by pools of subprime mortgage-backed securities. J.P. Morgan has long ranked among the biggest buyers of auto and credit card loans, which it turned into asset-backed securities. But even in 2005, J.P. Morgan remained a small player in the hottest business on Wall Street, securitizing mortgages. Dimon wanted to build a far bigger franchise, chiefly by securitizing the loans made by the bank itself through its Chase Home Lending division. By 2006, J.P. Morgan was growing substantially in securitizing mortgages and dabbling in subprime CDOs, a business that was generating billions in fees for other Wall Street firms.

But Dimon soon began to see reasons to pull back. One red flag came from the mortgage servicing business, the branch that sends out statements, handles escrow, and collects payments on $800 billion in home loans, its own and others'. During a regular monthly business review for the retail bank in October 2006, the chief of servicing said that late payments on subprime loans were rising at an alarming rate. The data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan's subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.

Steve Black and Bill Winters, co-heads of the investment bank, were discovering more reasons to be cautious. CDOs issue a range of bonds, from supposedly safe AAA-rated ones with relatively low yields to lower-rated ones with higher yields. Winters and Black saw that hedge funds, insurance companies, and other customers were clamoring for the high-yielding CDO paper and were less interested in the other stuff. That meant banks like Merrill and Citi were forced to hold billions of dollars of the AAA paper on their books. What's wrong with that? Doesn't an AAA rating mean the securities are safe? Not necessarily.

In 2006, AAA-rated CDO bonds yielded only two percentage points more than supersafe Treasury bills. So the market seemed to be saying that the bonds were solid. But Black and Winters concluded otherwise. Their yardstick was credit default swaps - insurance against bond failures. By late 2006 the cost of default swaps on subprime CDOs had jumped sharply. Winters and Black saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters. The combined weight of that data triggered Dimon's call to King in Africa. "It was Jamie who saw all the pieces," says Winters.

In late 2006, J.P. Morgan started slashing its holdings of subprime debt. It sold more than $12 billion in subprime mortgages that it had originated. Its trading desks dumped the loans on their books and mostly stopped making markets in subprime paper for customers. J.P. Morgan's corporate treasury under Ina Drew even starting hedging, betting that credit spreads would widen. Over the next year those hedges reportedly yielded gains of hundreds of millions of dollars.

Dimon's stance was radical: He was skirting the biggest growth business on Wall Street. J.P. Morgan sank from third to sixth in fixed-income underwriting from 2005 to 2007, and the main reason was its refusal to play in subprime CDOs, which its rivals were gorging on. "We'd get the quarterly reports from our competitors and see that they'd added $100 billion to their balance sheets," says Dimon. "And they were hardly adding any capital, so it looked like their investments were almost risk-free." But in the end, of course, the decision to shun subprime made Dimon a hero.

Summer Olympics - Beijing 2008

Hottest news so far...

1. Michael Phelps after all did win 8th gold medal at a single Olympics from the pool with slightest of a margin -- his 100m butterfly event was only 1/100 of a second ahead of Milorad Cavic of Serbia.

2. Usain Bolt of Jamaica is indeed running like a lightning bolt in the 100m men sprint event with a world record time of 9.69 second. The final showdown between Bolt, Asafa Powell and Tyson Gay did not materialize after Gay failed to qualify for the final. Powell finished the event in the 5th place.

3. Roger Federer of Switzerland did win the gold medal from Beijing -- not from the men single but from the double event in which he teamed up with Stanislas Wawrinka to beat Sweden pair of Simon Aspelin and Thomas Johansson in the men tennis double final.

4. Rafael Nadal of Spain celebrates his world no.1 status with an emphatic win over Chilean Fernando Gonzalez in the final of men tennis to win the gold medal.

5. Can China win the overall title from United States of America? China is still leading in the gold medal haul but USA is closing the gap fast with Olympics is only less than a week to go.