Rumors of a capital crisis due to overexposure to distressed U.S. securities drove shares of a Hong Kong bank sharply lower today (Wednesday), as concerned customers lined up outside retail branches to withdraw deposits.

The Bank of East Asia Ltd. (OTC ADR: BKEAY), commonly referred to as BEA, asked Hong Kong authorities to investigate “malicious rumors” spread mainly via cell phone text messages that called the third-largest Hong Kong lender’s liquidity into question.

“The management of BEA hereby states in the strongest possible terms that such rumors have no basis in fact,” BEA said in an e-mailed statement today. “The bank’s financial position is sound and stable.”

Hong Kong-traded shares of BEA dropped 11% to a new 52-week low as investors and retail customers alike lost confidence in the bank. The stock recovered slightly in late afternoon trading to end the day down almost 7% at the Hong Kong close.

“We’re a little bit concerned,” Sonny Hsu, a Hong Kong-based analyst at Fitch Ratings Inc. told Bloomberg News. “We’ll keep an eye on what’s going on. If you just look at the numbers, I think the bank is financially still sound.”

BEA had $51 billion (HK$396.6 billion) in assets as of June 30 and a capital adequacy ratio of 14.6%, according to Bloomberg data.

The rumors stemmed from concern about BEA’s exposure to securities of the now bankrupt U.S. investment bank, Lehman Bros. Holdings Inc. (OTC: LEHMQ), but the Hong Kong bank’s exposure is only $61 million, or less than 0.2% of its total assets.

“The rumors took various forms,” said Bank of East Asia’s deputy chief executive, Joseph Pang, at a news conference, The Wall Street Journal reported. “Some said the company’s financials were problematic, and others said the government is about to take over our bank. Some others said there is a 10,000 Hong Kong dollars [U.S. $1,282] limit to each withdrawal. All of these are baseless.”

BEA extended retail branch hours to accommodate the influx of worried customers and honored all withdrawals.

Hong Kong’s central back pledged its full support to BEA today, saying it would bolster the bank’s liquidity if needed.

“I can confirm categorically that these rumors are unfounded,” Joseph Yam, chief executive of the Hong Kong Monetary Authority, told the press, Reuters reported.

“The banking system of Hong Kong is very robust,” Yam added.

Hong Kong officials are anxious to dispel these rumors and cut off a potential crisis of confidence similar to the one in the United States that caused the collapse of Wall Street giants as The Bear Stearns Cos. Inc. and Lehman Bros.

“Hong Kong’s regulation over banks is really tight, so the chances of having a bank go bust is very slim,” Francis Lun, a general manager with Fulbright Securities, told The WSJ. “The problem is that there were recent instances where big, global banks vanished overnight, so every one just got panicky.”

Hong Kong authorities are investigating the source of the rumors, but have few leads.

“The case is still under investigation and no arrest has been made so far,” the Hong Kong police department said in an e- mailed statement, Bloomberg reported.

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It was a rough weekend for the U.S. financial system. Investment banker Lehman Brothers Holdings Inc. (LEH) collapsed and, as I predicted last week, the problems were not confined to Lehman.

As Money Morning detailed yesterday, Merrill Lynch & Co. Inc. (MER) has been taken over in a rescue by Bank of America Corp. (BAC), while the mortgage bank Washington Mutual Inc. (WM) and the derivatives-happy insurance company American International Group Inc. (AIG) remain in deep trouble. But what does it mean for the rest of us, as investors in particular?

Looking, first, at the investment banks themselves, the main problem as I discussed last week was that the so-called “Big Five” investment banks (soon to be the “Big Two”) were thoroughly over-levered – with total assets-to-capital ratios of 30:1 or more – compared with the traditional brokerage house ratio of less than 20:1.

Investment banking is an intrinsically cyclical business, but Wall Street’s greedy-and-aggressive top management forgot about that as they chased profits and bonuses during a stretch in which money was always easy to obtain. The commercial banks – even giant Citigroup Inc. (C) – were fortunately much less levered. For once, we must all bless government regulations, which are much stricter for deposit-taking institutions – meaning the government rules have so far prevented big commercial banks from following the investment banks into collapse.

AIG shouldn’t have had problems, at all; it’s primarily an insurance company, and those firms typically operate with very little leverage. However, when you look at AIG’s balance sheet, it has leverage of about 15:1 – similar to the big commercial banks – and it has also made a specialty of speculative trading in derivatives. That was an attractive business for many years but like other such businesses has recently run into trouble. AIG is currently seeking a federal bailout; it is fairly unlikely to get it – although an AIG bankruptcy would certainly cause turmoil in the various derivative markets.

On the commercial banking side, things aren’t very rosy either, despite the fact that big commercial banks are less levered. Citigroup has had huge subprime problems, but is so large and internationally diversified that, in the long run, it may be able to ride out the storm. JPMorgan Chase & Co. (JPM) appears solid, and its top executives must, right about now, be congratulating themselves for having received a $30 billion subsidy from the Fed to take over Bear Stearns – before the government turned ornery and parsimonious.

Wachovia Corp. (WB) had historically been one of the strongest banks in the U.S. market, but due to its spectacularly ill-timed $20 billion purchase of a California home mortgage company in 2006, it now has serious asset quality problems.

Bank of America is an interesting case. It has a retail banking franchise similar to that of Wachovia that had been active in home mortgages and had the usual problems. It also made a big home-mortgage-market push with its purchase of Countrywide Financial Corp., but that purchase was undertaken back in January, when prices were far below those of 2006, so Bank of America probably got a bargain. On the other hand, Countrywide had been the largest and most aggressive of the home-mortgage lenders, so there is a very decent chance that its portfolio is substantially worse than others, possibly giving Bank of America an agonizingly difficult decision of whether to continue supporting it if new problems continue to appear.

As for BofA’s proposed buyout of Merrill Lynch, one must admire the cool and savvy of Bank of America Chairman Kenneth D. Lewis in rejecting the more-obvious possibility of bailing out Lehman – in favor of the much-more-attractive opportunity presented by Merrill Lynch.

Merrill Lynch has the largest retail brokerage operation in the United States – providing it with a huge branch network; it thus provides superb synergy with the primarily retail-oriented nationwide branch network of Bank of America. The only caveat is that with $1 trillion in assets Merrill is a big bite to swallow. And with the Merrill buyout following Countrywide, as it does, there’s always the chance for some post-deal indigestion.

Going forward, I’m happy to say, it’s not all gloom and doom, meaning we must be approaching the end of what we’re calling the “fail-and-bail” cycle.

Both Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), the two remaining investment banks, appear less vulnerable – although in Goldman’s case its ability to sail serenely through the first year of the current mortgage-fallout morass is a bit more disquieting than reassuring, suggesting there could be hidden problems.

Overall, however, it may be well-worth looking at the financial-services firms that seem likely to survive – particularly in the insurance area, were risk management is generally better than in banking (because it’s a more-central part of the insurance business), or in Asia, where growth continues and the exposure to U.S. financial problems is limited. [Please click here for a news story detailing the latest developments in the U.S. financial-services sector, elsewhere in today’s issue of Money Morning.]

[Editor’s Note:When it comes to investment banking and the international financial markets, Money Morning Contributing Editor Martin Hutchinson brings readers a unique brand of expertise. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo. In a Money Morning column last week, Hutchinson predicted that Lehman Brothers would fail. Subscribers to our affiliated monthly newsletter, The Money Map Report, will be ahead of the game on his next prediction, thanks to a column he’s written for the upcoming Oct. 1 issue, which should appear in the next several days.]

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• Money Morning Investigative Analysis:
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  Bank of America Will Buy Countrywide for $4 Billion in Stock.

In one of its wildest and weirdest stretches ever, Wall Street entered a weekend awaiting a government bailout of Lehman Brothers Holdings Inc. (LEH) and exited with Merrill Lynch & Co. Inc. (MER) agreeing to sell itself to Bank of America Corp. (BAC) for nearly $50 billion – and Lehman announcing it will seek bankruptcy in a bid to avoid a total liquidation after it was unable to find a buyer.

And this real-life version of the game show “Let’s Make a Deal,” is far from over: Like a once-great prizefighter who’s clawing for the ropes after being staggered by a shot to the chin, U.S. insurance giant American International Group (AIG) is trying to keep from dropping to the canvas. AIG leaders begged the U.S. Federal Reserve for a $40 billion lifeline – without which the insurance giant probably won’t last the week, The New York Times reported.

There’s even conjecture that the beleaguered Washington Mutual Inc. (WM) – the nation’s largest savings and loan – may get pulled down by this financial undertow.

“The tectonic plates beneath the world financial system are shifting, and there is going to be a new financial world order that will be born of this,” Peter Kenny, managing director at Knight Capital Group Inc. (NITE), the New Jersey-based brokerage firm that handles $4 trillion in stock transactions a year, told Bloomberg News. “It’s an ugly and painful process.”

With Wall Street’s leaders huddled in meetings at the encouragement of the Bush Administration, yesterday’s fourth-down wheeling and dealing capped a weekend of furious, round-the-clock negotiations that demonstrate one very critical point – the credit crisis isn’t over.

In fact, it may actually be getting worse.

Many experts now worry that the U.S. financial sector faces a “crisis of confidence,” a potentially devastating psychological impasse from which there’s no easy escape. The stunning-and-sweeping moves, which are permanently reshaping the U.S. financial sector, are the latest chapter in a financial crisis that has resulted in hundreds of billions of dollars in losses – ostensibly due to bad real-estate loans, The Times reported.

“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I’ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm The Blackstone Group LP (BX), who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration – and whose new foundation is sponsoring the documentary, IOUSA, which warns of the looming U.S. government debt crisis.

In a move that mirrored the step taken by hedge fund Long-Term Capital Management 10 years ago this week, 10 major banks will create an emergency fund of $70 billion to $100 billion that financial institutions can use to protect themselves from the fallout of Lehman’s collapse. And the Fed expanded the emergency loan program it created for Wall Street banks, a move that The Times and other media outlets concluded will increase what each U.S. taxpayer will owe as a result of this crisis.

But it remains to be seen whether the sale of Merrill Lynch, the “controlled demise” of Lehman and the intervention into the fate of other key U.S. financial giants will be enough to keep the broader U.S. economy from getting swept into a stagflationary recession.

And Then There Were Two

The five New York-based securities firms that dominated Wall Street have been reduced to two: Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS). Both firms will report a profit decline for the third quarter – but unlike Merrill Lynch and Lehman, Goldman and Morgan Stanley have remained profitable throughout the year.

“I think highly of Morgan Stanley and Goldman Sachs, so I expect them to ride this out,” Roger Altman – the CEO of investment banker Evercore Partners Inc. (EVR) and a former deputy treasury secretary – said during an interview on CNBC. “But as to whether we’ve seen the last of this crisis, I think the answer to that is clearly: ‘No.’ And exactly where it goes from here and how it unfolds, I’m unsure.”

But how did it get this far?

The financial-sector convulsions that started in the summer of 2007 already have eliminated The Bear Stearns Cos., which in March was forced into a government-supported, cut-price sale to JPMorgan Chase & Co. (JPM). Last weekend, the U.S. Treasury Department took control of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) – placing them into a conservatorship – after concerns that foreign central banks would stop buying our bonds actually forced the government’s hand [For a full report on that dilemma, take a look at our report, Foreign Bondholders - and not the U.S. Mortgage Market - Drove the Fannie/Freddie Bailout].

Fed and U.S. Treasury officials met in an emergency session as Barclays PLC (ADR: BCS), the U.K.’s third-largest bank, and Bank of America abandoned talks to acquire Lehman after failing to win government guarantees against losses. The companies were considered leading candidates to acquire the 158-year-old investment bank after record losses erased 94% of its stock value this year.

The first in a series of weekend meetings began at 6 p.m. Friday at the Federal Reserve building in Lower Manhattan. The Fed called the emergency session. U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. attended, as did key banking-industry executives.

Because the central bank and the Treasury had already intervened with the “shotgun” marriage of Bear Stearns and JPMorgan – underwriting $29 billion in assets as part of the deal – and with the conservatorship for Fannie and Freddie, most observers expected the financial sector’s dynamic duo to work their magic yet again.

But it was not to be.

News reports say that the bankers were told that – this time around – the government would not bail out Lehman and that Wall Street had to solve its own problems. Lehman’s stock plunged last week, as worries about its financial condition escalated. When counterparties became wary of doing business with Lehman, its ability to survive as a standalone company in that form was all but over.

Without the safety net of government backing, Lehman sought a buyer, focusing on Barclays and Bank of America. But Barclay’s abandoned talks to acquire Lehman after failing to win government guarantees against losses for the big British bank.

That’s where the takeover talks took an odd turn. Although Merrill and Lehman are both investment banks – Merrill focuses on the brokerage business while Lehman keys on the institutional portion of the market – both firms made an ill-fated foray into real-estate-related investments.

Understanding that global investors would lump Merrill in with the other troubled companies as the crisis worsened, new CEO John A. Thain began buyout talks with Bank of America CEO Kenneth D. Lewis, published reports state. One person briefed on the negotiations said Thain had rebuffed Bank of America when it approached Merrill earlier this summer. But understanding how a Lehman bankruptcy would whipsaw the markets, Thain realized a deal was the best answer this time around, The Times reported.

Bank of America will swap 0.8595 shares of its stock for each Merrill share. That works out to $29 a share, based on Bank of America’s closing price of $33.74 on Friday.

“A merger between Merrill and Bank of America is a good idea,” Richard Bove, an analyst at Ladenberg Thalmann & Co. in Lutz, Fla., told Bloomberg. “If Lehman fails, the next bank to be attacked would be Merrill. They are attempting to forestall that attack by linking with Bank of America.”

AIG, once the world’s largest insurer, is struggling to raise cash to avoid a credit-rating downgrade that could cripple its business.

Early today (Monday), Lehman filed the biggest bankruptcy claim in history. The 158-year old firm filed a Chapter 11 petition with the U.S. Bankruptcy Court in Manhattan, listing more than $613 billion in debt.

That makes Lehman’s failure the largest of any investment bank since the collapse of Drexel Burnham Lambert 18 years ago, The Associated Press reported. The credit crisis has forced the world’s biggest banks to take more than $510 billion in write-downs, Bloomberg News reported.

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Lehman Bros. Holdings Inc.’s (LEH) will announce “key strategic initiatives” early today (Wednesday), just one day after its stock nosedived to its lowest level in almost a decade.

Lehman also will announce its expected third-quarter earnings – a week earlier than expected.

Once the fourth largest Wall Street investment bank, Lehman has seen its market capitalization shrink from over $47 billion at its stock’s 52-week high of $67.73 down to just $5.4 billion at today’s new 52-week trading low of $7.64 per share.

By the New York close, Lehman shares had recovered slightly to trade at $7.79, down nearly 45% for the day on reports that negotiations for a capital infusion from state-controlled Korea Development Bank (KDB) had ended without plans for investment.

Korea’s Financial Services Commission refused to confirm that talks with Lehman had ended, but the report was enough to send Lehman shares into a tailspin.

The stock’s slide was enough to cause Standard & Poor’s to revaluate Lehman’s counterparty credit risk.

“The CreditWatch listing stems from heightened uncertainty about Lehman’s ability to raise additional capital, based on the precipitous decline in its share price in recent days,” S&P analyst Scott Sprinzen wrote, Bloomberg News reported. S&P said there is a chance of “lowering the ratings by more than one notch.”

If S&P were to lower Lehman’s credit ratings significantly, the investment bank’s ability to do business, and its very existence, would be in jeopardy. It’s hard not to draw comparisons with the Bear Stearns collapse, which ultimately ended with JPMorgan Chase & Co.’s (JPM) purchase of what was at that time the fifth largest Wall St. investment bank for just $10 per share.

A hypothetical offer of $10 per share for Lehman would represent a 28% premium over yesterday’s closing price.

Richard Bove, an analyst with Ladenburg Thalmann, has been critical of Chief Executive Richard Fuld’s management of the beleagured investment bank for quite some time. Two weeks ago Bove suggested Lehman could find itself the victim of a hostile takeover if Fuld was not able to negotiate an emergency liquidity boost.

“Buyers seem to believe that Lehman is overvaluing its assets and refuse to hit the bid,” Bove wrote in a research note, BusinessWeek reported. “The net result is no action.”

As the list of potential saviors continues to dwindle, so does investor confidence in Lehman Brothers.

After taking $8.2 billion in subprime credit-related losses and writedowns in the past 12 months, Lehman stock is down over 88% year-to-date and is 88.5% off its 52-week peak.

Hungry for substantive news of how Fuld plans to shore up Lehman’s $60 billion mortgage-related portfolio, all investors have been offered so far is some management changes. But the clock is ticking and Fuld will have to face the music soon and come clean with his plans for the future of Lehman Brothers.

Lehman had been slated to announce fiscal third quarter results early next week. But the firm apparently opted to announce its expected results in conjunction with the new initiatives. Shareholders will be looking for reassurance from Fuld and President Bart McDade that the bank has been able to sell assets or obtain necessary capital infusions to bolster a bleeding balance sheet.

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Lehman Brothers Holdings Inc. (LEH) is scrambling to find a much-needed capital injection prior to announcing fiscal third quarter results this month.

State-controlled Korea Development Bank, or KDB, confirmed it would take a 25% stake in the struggling Wall St. investment bank if it could find enough private sector partners to form a consortium in order to get government approval for the deal.

“In order to become competitive as a global investment bank, KDB has been looking into an M&A deal with overseas investment banks, including Lehman Brothers, as well as an asset management company, but nothing specific has been decided,” KDB said in a statement, Forbes reported.

KDB’s Chief Executive Officer Min Euoo Sung, a former Lehman employee, is eager to make the deal. But the Korean government believes plans for KDB’s privatization must take presidence over any potentially risky Lehman stake.

Earlier speculation of a buyout by KDB was quickly put to rest by Financial Services Commission (FSC) spokesman Yoo Jae Hoon, who said, “Deals deviating from government guidelines won’t get a green light.”

Some question Min’s motives in aggressively pursuing the Lehman deal, when so much work still needs to be done in order to take the government-owned KDB private.

“The name of the game now is hoarding resources to prepare for the winter,” banking analyst Chang H. Lee at Daiwa Securities, told BusinessWeek. “It certainly is not a time to seek glory through expansion.”

Lehman Bros. is slated to announce third-quarter earnings on Sept. 15. A writedown of up to $4 billion is expected, making Chief Executive Richard Fuld eager to iron out the details for the potential $5.3 billion investment from the KDB-led consortium.

A report in the South Korean daily Chosun Ilbo, citing an anonymous source, yesterday (Wednesday) said HSBC Holdings PLC (ADR: HBC) and an unnamed China bank could also potentially be interested in making an investment in Lehman Brothers. However, HSBC refused to comment on the report.

Lehman Brothers stock rose over 5% with a gain of 81 cents to close at $16.94 yesterday on news of the potential foreign investors. 

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Lehman Brothers Holdings Inc. (LEH) was forced to raise fresh capital yesterday (Monday), evidence that the subprime-fueled credit crisis is still far from over.

“I am very disappointed in this quarter’s results,” Chairman and Chief Executive Officer Richard S. Fuld, Jr. said in a company statement released yesterday. “Notwithstanding the solid underlying performance of our client franchise, we had our first-ever quarterly loss as a public company.”

The fourth-largest U.S. investment bank announced it would raise $6 billion to offset an expected $2.8 billion loss in its fiscal second quarter. Lehman said it expects a loss of $5.14 per share in the period ended May 31, compared to a profit of $489 million, or 81 cents a share, for the same period a year ago, MarketWatch reported.

The loss was much higher than expected and due in large part to a $3.7 billion write-down of mortgage-backed assets.

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“It’s kind of sobering for people who have been listening to the company these last six to nine months that they had everything under control,” David Hendler, an analyst at CreditSights Inc. in New York, told Bloomberg News. “It shows that the market continues to be difficult. I would say Lehman’s probably not the only broker that has these kinds of pressures.”

Lehman will offer 143 million shares of common stock at $28 apiece, expanding the bank’s shares outstanding by 25% and raising $4 billion. The investment bank will also offer $2 billion in preferred shares that will carry an 8.75% yield and be convertible into common stock in a price range between $28 and $33 each, DowJones reported.

The sales should close Thursday. And unlike many financial firms such as Citigroup Inc. (C) and Merrill Lynch & Co. Inc. (MER), which have turned to international sovereign wealth funds for capital infusions, most of Lehman’s buyers were U.S. institutional investors.

“The loss was greater than expected but the capital raise is also a little bit greater than people had anticipated, which I think makes for a net positive,” David Killian, a portfolio manager at Stoneridge Investment Partners in Malvern, Pennsylvania, told Bloomberg.

Lehman stock dropped immediately following the release. Shares shed $2.81, a decline of 8.7%, to close at $29.48 yesterday. The stock is down over 54% year-to-date and has traded between $20.25 and $82.05 over the past 52 weeks.

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