Profiting from the Carnage - Ramblings at 4:38 a.m.

Sarah Connor: "What did he just say?"

Old man: "He said there's a storm coming."

Sarah Connor: "I know..."

I couldn't sleep last night given the current chaos in financial markets. I've been falling in and out of consciousness for the last few hours, so I figured I'd just get up for an early start to what should be a wacky trading day.

September 15, 2008 will go down as one of the most memorable days in the history of finance as two former Wall Street titans have finally succumbed to the credit crunch and mortgage meltdown. Merrill Lynch (MER) will be swallowed by Bank of America (BAC) for $50 billion, while Lehman Brothers (LEH) has fallen on its sword, announcing it will file for Chapter 11 bankruptcy protection. Lehman says its subsidiaries will continue to operate as usual, though I imagine they'll have a pretty hard time retaining customers.

Besides making it a heck of a lot harder for me to find a new job, today's events will have far-reaching ramifications for the financial services business. The biggest and most immediate will be a continuation in the trend towards risk aversion as banks and hedge funds reduce leverage, focusing on survival rather than prosperity.

As such, I'm going to look at shorting some of the exchange and market infrastructure stocks. For example, I'm looking to pick up some out-of-the-money puts on Chicago Mercantile Exchange (CME), where growth is slowing down, and will slow down even further as derivatives-trading activity levels off. At 21 times a full-year 2008 earnings number that probably needs to come down, CME could have significant downside from here.

For now, I'm thankful I'm short US Global Investors (GROW), which could take a big hit today on the nasty market action and this morning's $3 decline in crude oil prices.

Another big effect today's events will have is significant market share gains by the guys who are left standing. There are plenty of firms like Lazard (LAZ), Raymond James Financial (RJF), Evercore Partners (EVR), and Greenhill (GHL), who never gorged on subprime, and so they'll be picking up a lot of the business that would have gone to firms like Lehman and Merrill. I'm not saying it's time to buy these guys though NOW is the time to do the homework.

And of course, consumer spending will take a hit as we will se even more heads roll on Wall Street. Don't forget, for every banker out there doing business, there's a lawyer, accountant, RE agent that's levered to that banker.

In particular, the luxury market could see an even greater softening as people get even stingier. One name I'm looking at on the short side is Saks Inc (SKS). Ironically, the company's flagship store, accounting for over 20% of sales, is just a few blocks from Lehman's headquarters in midtown Manhattan. That store is going to take a big hit this year, and not just from Lehman Brothers.

I'm winding this post down at a little after 5 a.m., and as I'm writing this, S&P futures are down 42, oil's down $3, and Lehman is trading at 67 cents a share. We'll get through this storm, and if we're smart, we can make some money along the way.

Happy hunting!