How Lehman lost its way

The venerable Wall Street firm once looked like it would escape the worst of the credit crisis. Now there's talk of a Bear Stearns-like collapse - or a sale.

By Allan Sloan and Roddy Boyd

Last Updated: July 2, 2008: 8:45 PM EDT
article link

NEW YORK (Fortune) -- To understand what went wrong at Lehman Brothers, leave the canyons of Wall Street and head to the flatlands of Bakersfield, 120 miles northeast of Los Angeles.

That's where you'll find McAllister Ranch, envisioned as a 6,000-home, multibillion-dollar recreational community built around a Greg Norman-designed golf course, boating and fishing waters and a beach club. Now McAllister is three-square miles of fenced-off, almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.

So far Lehman's bets on McAllister and other real estate plays in Southern California's Inland Empire have cost Lehman at least $350 million.

None of Lehman's investment bank peers have this kind of exposure to the burst real estate bubble. Then there's the exposure all of them have: problems with collateralized loan obligations, leveraged buyouts, and mortgage-related securities. But Lehman insisted it was only minimally exposed to this kind of stuff.

Turns out, it wasn't. As a result, the bank and its shareholders have endured big losses; messy public demotions of the chief operating officer and chief financial officer; battles with short-sellers, who are betting that Lehman's share price, down about 70% on the year, will decline further; rumblings that the firm will be sold; and rumors (which we consider unfounded) that it will pull a financial El Foldo the way the late Bear Stearns did.

How has Lehman (LEH, Fortune 500) come to this? Read on, and we'll tell you Lehman's true history - and how management miscues, combined with historical forces outside Lehman's control, have put the firm in a world of hurt. We'll also tell you how we think the drama will play out.

Deals gone bad

McAllister Ranch is an apt symbol for Lehman's problems on several counts.

First, Lehman's commercial paper unit is on the hook for a $235 million loan it made to the development. Good luck trying to collect that debt. Worse, in 2006 - the height of the housing bubble - Lehman invested a total of $2 billion in deals with McAllister's developer, SunCal Cos., a Southern California firm severely spattered by the bursting of the real estate bubble. The $350 million McAllister loss looks increasingly like only a down payment.

Because it prided itself on real estate expertise - it helped popularize real estate-backed securities in the early 1970s - and investment prowess, Lehman risked far bigger proportions of its own capital doing deals than its major competitors did. Brad Hintz, a former Lehman chief financial officer who now follows the firm as an analyst at Alliance Bernstein, wrote recently that Lehman has more than 2.5 times its entire net worth tied up in complex, hard-to-value securitized products.

Only Merrill Lynch (MER, Fortune 500), among Lehman's peers, has a higher ratio, Hintz said - and Merrill is vastly larger than Lehman. What's more, Merrill has multibillion-dollar assets, such as stakes in Bloomberg LP and BlackRock, that it can sell quickly without interfering with its core businesses. Lehman has nothing similar.

Lehman's high-risk, high-reward strategy produced cash gushers during the good days - the firm reported almost $16 billion of profits from 2003 through 2007 - but those days are gone. Lehman recently reported a $2.8 billion second-quarter loss, which probably won't be its last unprofitable quarter. Two years ago Fortune lauded Lehman and its chief executive, Dick Fuld, because the firm was the best-performing investment-banking stock in the country. That was then.

Now Lehman finds itself stuck with all sorts of hard-to-sell assets and securities worth far less than what it has invested in them. For example, last October - with the credit crunch and real estate meltdown well underway - Lehman (in partnership with the Tishman Speyer real estate firm) paid $22.2 billion to do a leveraged buyout of Archstone, a big apartment developer. Lehman decided to go through with the deal rather than walk and risk paying a $1 billion breakup fee (which could presumably have been negotiated down, as happened in subsequent busted LBOs).

Lehman's Archstone losses could ultimately exceed what a breakup fee would have cost. The firm disclosed a $350 million Archstone charge to earnings last month, and that could be only the start.

"Archstone is the preeminent apartment developer, but the timing was off," says Craig Leupold, president of Green Street Advisors, a real estate consulting firm. "I'm looking at a decline of 10% to 15% in value for apartment complex values, which amounts to $2 billion to $3 billion off the purchase price."

That would be a staggering hit for Lehman, whose total capital is only $19 billion ($36.9 billion if you count its recent preferred-stock issues and subordinated debt). Founded in 1850 as a cotton trading firm in Montgomery, Ala., Lehman Bros. had a storied reputation for prudence and sound management.

So how did it end up in this pickle?

In part because, irony of ironies, CEO Fuld, who prevailed in a decades-long battle for Lehman's soul, adopted the policies of the people that he and his trading floor allies fought so bitterly in Wall Street's most famous civil war of the 1980s.

The trading faction, which included Fuld and was led by his then-boss, Lew Glucksman, wanted the firm to stick to its traditional knitting of trading and underwriting securities. The banking faction, led by Steve Schwarzman and Pete Peterson, wanted to use the firm's capital aggressively to do risky deals.

The traders prevailed then - but Fuld ultimately adopted large elements of the bankers' proposed strategy. It's as if Jack Welch had decided during his GE days that the touchy-feely school of management was right after all and began walking the halls to ensure that people were happy. Lehman eventually sold itself to American Express in 1984. Schwarzman and Peterson left to start Blackstone Group and become multibillionaires. Fuld stayed at Lehman.

After ten mediocre-to-awful years as part of American Express's failed financial supermarket strategy, an undercapitalized, independent company called Lehman Brothers emerged in 1994 with Fuld as CEO.

Neither Fuld, a passionate Lehman lifer, Schwarzman or Peterson would speak with Fortune. A Lehman spokesman said the firm wouldn't cooperate either, because our questions were "unfair and biased."

It's tempting to blame Fuld for everything that's gone wrong at Lehman. After all, the man took credit for the firm's successes (while throwing the occasional victim under the bus when there were problems) and got a corporate rock star compensation package.

By Fortune's math, Fuld has realized almost half-a-billion dollars in cash - $489.7 million, to be precise - by cashing in stock options and restricted stock that he was granted. (That's a pretax number.) He's also knocked down wads and wads of regular old money.

Done in by a financial arms race

But a significant part of Lehman's problem doesn't stem from Fuld's management - it's because the firm suffered collateral damage from Washington's decision a decade ago to repeal the Glass-Steagall Act, adopted during the Great Depression to separate investment banking from commercial banking.

Until Glass-Steagall disappeared, one of the attractions of owning a piece of an investment bank was that it was asset-lite. The major asset - the firm's people - went home at night. The financial assets were generally liquid (which means easily sellable at the market price). And because they weren't burdened with multibillion-dollar investments in real estate or corporations, investment banks had staying power and could wait for bad markets to recover.

The repeal of Glass-Steagall would change that. Ask Chris Andersen, chief executive of investment boutique Andersen Partners and, at 70, one of Wall Street's grand old men. When Glass-Steagall was adopted in 1999 to let Citi and Travelers (which have since split apart) combine, Andersen notes, commercial banks promised not to use their balance sheet to compete with investment banks, which traditionally had far smaller capitalizations.

"Of course, the minute Glass-Steagall was repealed, the commercial banks began using their balance sheets to compete, offering loans if they also got to do equity offerings as well as arranging public debt financials for transactions," says Andersen.

So investment banks like Lehman bulked up to compete with the Citis and J.P. Morgan Chases (JPM, Fortune 500) of the world, setting off a financial arms race to compete on size and scope.

The arms race - and the associated risk for Lehman - has grown exponentially more intense since 2004, when the world began to find itself awash in cheap short-term money, and globalization and dealmaking increased the call on Lehman's capital for things such as leveraged buyouts-and real estate.

At the end of 2003, Lehman had $11.9 billion of tangible capital and $308.5 billion of assets on its balance sheet. The ratio: just under 26 to 1. As of the first quarter of this year, it showed $786 billion of assets and less than $18 billion of capital. Ratio: around 44 to 1, leaving relatively little cushion to absorb losses.

Lehman also has self-inflicted wounds.

When firms like Citi (C, Fortune 500) and Merrill and Morgan Stanley (MS, Fortune 500) began fessing up to big problems related to the real estate bubble popping and the ensuing worldwide credit squeeze, Lehman insisted all was well. It even managed to show a $489 million profit for its first quarter, but only with accounting so aggressive and bizarre (albeit legal) that it undercut faith in Lehman's numbers.

Lehman took a $722 million paper profit in the value of its so-called Level 3 equity holdings - stocks that don't trade publicly and for which there aren't liquid markets. This means that Lehman claimed a 9% profit on its private-market stocks during the same period the Standard & Poor's 500 index of publicly traded stocks fell by 10%. Hmmmm.

David Einhorn, a short-seller whose questions about Lehman's balance sheet have confounded its management, says the firm's since-deposed chief financial officer, Erin Callan, told him $400 million to $600 million came from writing up the value of electric generating plants in India - Einhorn feels that only about $65 million was justified. (Lehman, as we've said, declined comment.)

Lehman also showed a $600 million profit because of the decline in the market value of its own debt obligations, whose price was falling because of perceptions that the company was in trouble. That's permissible accounting - but these are ugly, low-grade earnings, not unlike the "profit" you make when your house is foreclosed at a value lower than your mortgage.

And finally, we found that Lehman created another $176 million by almost doubling (to $365 million) the value it ascribed to certain mortgage servicing rights. Servicers get paid by mortgage holders for collecting payments and handling paperwork, and valuing servicing rights is notoriously tricky.

Until recently Lehman managed to raise capital without getting its stock price killed. The neatest move came on April 1, when Lehman sold $4 billion of preferred stock convertible into common stock. For arcane reasons we won't bore you with, when a company sells a big convert issue, convertible arbitragers - who make money exploiting differences between the prices of convertible issues and their underlying common stock - short the common like mad, driving down its price.

But Lehman kept the arbs at bay by placing the vast majority of the issue with large, long-term holders of its common. This helped precipitate a short squeeze, and Lehman's stock rose 18% (to $44.17 from $37.50) the day of the issue, rather than declining as the market expected.

But in a second sale last month Lehman seemed to have lost its touch - or gotten desperate. It sold $4 billion of common stock and $2 billion of convertible preferred, but seems to have placed much of the preferred with hedge funds and arbs that shorted the common, which promptly plummeted. That bummed out investors who bought the common, and the declining price increased the talk about Lehman's problems.

While we won't get bogged down in the minutiae of collateralized debt obligation exposures - which Lehman has done a better job of avoiding than Merrill, Citi or UBS (UBS) - the exposure it does have poses serious potential problems.

Lehman's filings indicate it has about $6 billion of CDO exposure. About a quarter of them are rated BB+ or below. These low-rated arcane, illiquid bonds-made-from-other-bonds are worth maybe 10 cents on the dollar. That indicates a loss of at least $1 billion. There are likely additional losses looming in the other three quarters of the portfolio.

What's next for Lehman

We're not predicting that Lehman will fail - it won't because of the Federal Reserve Board, which has let it be known that it will lend Lehman (and any other investment bank it deems worthy) enough money to avoid collapsing, the way Bear Stearns did.

Lehman has been in trouble before - the collapse of the Long Term Capital Management hedge fund in 1998 started rumors it was insolvent, the 9/11 terrorist attacks traumatized employees and made its headquarters near Ground Zero unusable - and it somehow managed to escape and prosper and stay independent.

But this time we suspect that because of pressures we foresee both from the capital markets and regulators, Lehman will ultimately end up owned, once again, by a much larger institution.

So let's close by going back to where we started: McAllister Ranch. An official with SunCal, the project's developer, says the company "remains committed to seeing that this community becomes a reality." When we tried to get a tour of the property, a man in a Hawaiian shirt and shorts, who clearly isn't an investment banker, emerged from deep inside the development's darkened sales office.

His final words as he shooed us off: "This is not a public business." Which may be said of Lehman soon.

Northeren Rock: Pulling the plug

The market has said what it thinks of Northern Rock. The British government should listen

Getty Images

EVERY banker knows John Paul Getty's dictum: “If you owe the bank $100 that's your problem. If you owe the bank $100m, that's the bank's problem.” What then of a bank that owes taxpayers some £24 billion ($49 billion), with another £18 billion or so of deposits underwritten by the public purse? Northern Rock, it seems, is everyone's problem.

The bank, once Britain's fastest-growing mortgage lender, is now a wreck. Having turned to the Bank of England for an emergency bail-out in August, it is unable to repay its loans unaided. Its debt to the central bank is growing. A mortgage book that was the envy of the industry looks less robust by the day. Its share price plummeted this week to less than £1, down from more than £12 at the beginning of the year.

The government finds itself in a deeply unenviable position. It is propping up Northern Rock's liabilities, yet the bank's assets belong to its shareholders. European rules prohibiting state aid to industries require ministers to cut the lifeline by March, or come up with a plausible reason not to. The Treasury is desperately casting around for buyers to take the bank and its problems off official hands, but none of the financial world's best and brightest is willing to assume full responsibility for it. All bidders so far have valued the bank well below even its current market capitalisation; all have asked for public-sector credit lines or loans.

There can be no good ending to this sorry saga, which had its origins in slack supervision, bad central-bank calls and a panic-stricken rescue that left offending bank bosses in charge for too long. But some outcomes are better than others.

Any solution must have two main goals in mind. The first is maintaining the stability of the financial system. For all that the first panic of the credit crunch seems past, there are too many uncertainties abroad to ride rough-shod over fairly fragile sentiment. The second is to get the taxpayer off the hook as fast and as thoroughly as possible. Depositors are protected by the guarantee the government has extended. It is hard not to feel sorry for the 145,000 retail investors who still hold Northern Rock stock; but they are entitled to no such guarantees and they must be aware that share prices go down as well as up.

There are three broad options confronting Alistair Darling, the chancellor of the exchequer, who will, in the end, decide Northern Rock's fate. The first is to sell the bank. The main bidders propose pumping more capital into Northern Rock, organising private lines of credit, repaying part of the government's loan quickly and keeping at least some jobs. Such a deal would annoy the bank's shareholders, who would be bought out for some variation of a pittance; but if Mr Darling could find a private-sector buyer with a firm promise to repay taxpayers quickly, it would be a tidy solution.

The problem is that no such private-sector buyer seems to exist; everybody relies on Mr Darling underwriting the deal for a considerable amount of time. Such a subsidised sale would give the bank's new owners most of the upside, should gains emerge, while leaving the taxpayer with most of the risk, if losses ensued instead. This asymmetry is more than galling: it might well create a perverse incentive for the bank's new owners to gamble even more recklessly than its old ones. And other banks would rightly complain of unfair competition.

A second option is to force the bank into bankruptcy. This too holds few attractions. Deposits would most likely be frozen for weeks or even months. News of savers struggling to get their money back could spark runs on other banks. In the resulting firesale, Northern Rock's assets would probably fetch less than they are worth. And administration would trigger the winding-up of Granite, a vehicle that holds half the bank's mortgages as collateral against bonds issued. If it is liquidated, its cash would be used to pay those bondholders first. Some £7 billion in extra assets that it holds could be tied up for years.

Take it over

This newspaper has, to put it mildly, never been a fan of nationalisation. But with Northern Rock this increasingly looks like the least bad option from a taxpayer's point of view (unless a credible buyer appears). And, in any case, the damage is half-done: in effect the state already owns a chunk of it.

Were the government a distressed-debt hedge fund, it would be trying to assume control, squeeze out existing shareholders and get back the money it is owed. State control, with a view not to running the bank (a terrifying thought) but to running it down, would allow value to be extracted for taxpayers through the orderly sale of assets. Bankers could take some comfort from the government's ability to pace disposals according to the mood of the markets. And nationalisation would let the state retain any future gains by going slowly—or even entering into a private-sector partnership—in the somewhat unlikely event that credit markets, house prices and Northern Rock's reputation recovered soon.

To be sure, nationalisation would be messy. Shareholders might well sue. The lesson from other crises (France, Mexico, Sweden, Japan and so on) is that emergency state ownership should be brief and at arm's length; Mr Darling might meddle, keeping unprofitable parts of the business open to safeguard jobs in the relatively poor (and Labour-voting) north-east. Nevertheless, nationalisation looks the best choice of a bad lot, for it aligns risks and rewards most closely and keeps control in the hands of those who have most invested. But there should be no illusions that it is anything but a mercy killing.

As oil nears $100, look out below

A discussion on the most intriguing topic of today:



Oil prices are soaring. Having jumped 40% since August, crude prices hit another historic high on November 6, rising to $96.70 a barrel. The factors sparking the $2.72 rally this time: bad weather in the North Sea that could force production cuts, the dollar’s continued fall, more violence in the Middle East, and fears that US crude supplies are low. But is there a sharp fall just ahead? Analysts say that the oil market looks overheated, and a number of factors could puncture the price bubble.

Most important, speculators have played a key role in driving up crude prices this year, and if the trend reverses they’ll get out fast. Certainly, global demand remains strong for now. But a number of factors—technical indicators, an economic slowdown, lower demand— could prompt investors to exit en masse. “Oil prices are in uncharted territory,” says Peter Fusaro, co-founder of the Energy Hedge Fund Centre, which tracks commodities hedge funds. “My worry is that if the market tanks, everyone will want out at the same time.

The market would collapse, and who knows what the bottom is.” Much Trading Remains Opaque Speculators have played a growing role in the oil market in recent years. There are 595 hedge funds that are engaged in at least some energy trading now, more than triple the 180 funds involved just three years ago. Fusaro estimates the assets involved in such trading total more than $200 billion, up more than 60% from the beginning of the year. It’s tough to get a firm handle on the speculation.

A large portion of trading takes place in the unregulated, over-thecounter market. Still, some of the trading in crude oil takes place on the New York Mercantile Exchange (NYMEX), and there the market is approaching a record in terms of the number of crude oil contracts that predict a price rise. Traders have committed to 135,000 contracts— each representing 1,000 barrels of crude—betting that prices will continue to rise. That’s just shy of the record 155,000 contracts reached this summer. Some analysts say that if the number of contracts rises sharply, oil prices could fall. “The exit signal for investors could be breaking through the 150,000 or 160,000 contract barrier,” says Joel Fingerman, president of OilAnalytics.net, an energy consulting firm. “At that point investors could feel they’re using all their bullets.”

For Now, It’s Full Steam Ahead In the meantime, however, investment continues to flood the crude oil market, as well as commodities in general. “The mentality now is very bullish,” says Fingerman. “As long as money keeps flowing in, people will keep buying [oil] as though it’s going to go to the moon.” The optimism has helped the stocks of the oil majors. ConocoPhillips is up nearly 40% over the past year. ExxonMobil, Chevron, British Petroleum and Royal Dutch Shell have posted similar if somewhat smaller gains. Still, some analysts say the psychological impact of $100 oil could mark the beginning of a slip in prices. “The professionals will get out of the market at $98.50 or $98.99,” says Peter Beutel, president of the energy risk management firm Cameron Hanover in New Canaan, Conn. “They’re not going to wait for $100 to materialise.” But is there anything special about the $100 mark? Some experts think not. “The barrier was supposedly $70, $80, then $90, and we’re past that. Why would $100 suddenly cause a reversal?” says Stephen Schork, an energy consultant in Villanova, Pa., and editor of the Schork Report, a daily energy newsletter. “$100 is not the death knell to the bull market.”

A Correction Is Inevitable Beutel says that regardless of the exit signal for investors, the oil market is due for a correction. “Historically speaking, we see that every time there is a sustained vertical [price] rise, there is a 20% correction,” says Beutel, adding that the serious threat of a recession could take 40% off oil prices. “It’s a beautiful thing that people forget: The market moves more quickly on the downside than it does on the upside.” It’s also possible that ballooning oil prices will begin to fall when demand responds to price signals, as it happened in the 1980s. “The uptick in crude hasn’t caused the same drag on the economy as it did 28 years ago,” says Ray Carbone, owner of the trading firm Paramount Options. “But once we’re past all-time highs in oil prices, things could change.”

Courtesy: BusinessWeek