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A Brotherhood Unraveling

Posted on: August 25, 2008 - Email Article - Printable Version

Adam Brown

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An investment bank traditionally known for having some of the best intellectual capital on the Street, Lehman Brothers [LEH: 0.00, N/A (N/A)] finds itself desperate for answers. The company has been confronted with an onslaught of problems since the start of the credit crunch a year ago. The stock is down nearly 70% since the Bear Sterns collapse of mid-March. Seen as the next potential victim, the smallest remaining independent investment bank has a balance sheet riddled with mortgage-related products. The firm has lost its President, seen its CFO demoted, and most recently announced the head of its mortgage unit is retiring. Fearing mass departures and a ‘brain drain’, the company was forced to offer a stock incentive program to its employee base that own nearly 1/3 of the company. All of this adds up to a company in much need of help in a presently unforgiving market.

Federal Reserve Action

On July 21, the Securities and Exchange Commission ordered an emergency ban on ‘naked-sort selling’ of 19 financial stocks. The ban required short-sellers of the specified stocks to locate their borrowed shares prior to any short trade (forcing the lender to remove those shares from the market). Among the 19 firms included in the ban were Fannie and Freddie, Lehman Brothers, Morgan Stanley, and Goldman Sachs. The SEC’s rational for the law was to allow “normal price discovery” and prevent unfounded rumors from driving down the price of these stocks. In actuality, the main catalyst of the ban was likely to protect the prices of Fannie and Freddie’s stocks and avoid a government bailout. Taking as much heat as they did from the laissez-faire advocates, I think the Fed saw it as a needed quick fix to prevent an imminent bailout (and an additional $5.2 trillion in mortgages on their books). In the case of Lehman, a failure would not directly cost the government as much as the GSEs. That being said, the implications are likely the same as with Bear Sterns—a situation the Fed certainly did not want to (or could afford to) find themselves in again.

Lehman’s Future

Lehman Brothers may soon find itself a Family as Reuters reported the Korean Development Bank (KBD) is mulling over a bid for the smallest of the remaining independent broker dealers. KBD holds that they are only in the early stages of valuing the company. However, it seems the company finds this an attractive entry point and is one of the few financial institutions flush enough with cash to consider it. While management has fiercely reiterated the firm’s independence, they may have little choice with a market cap of $10 billion.

News has also surfaced that Lehman is shopping its asset-management unit, including the highly valued investment manager Neuberger Berman. This is in an effort to deleverage their balance sheet and raise the necessary cash to offset mortgage and real estate related losses. The Neuberger business unit was purchased five years ago for revenue diversification purposes, costing Lehman $2.6 billion for its $68 billion in assets under management. It presently has about double that under management at $130 billion. However, Lehman’s ability to obtain a bid double its purchase price seems unlikely in a market so strapped for cash.

All that being said, even if Lehman fetches what they consider a fair value for their asset management unit, a very fundamental question remains. Going back to a point I made in a previous article on Merrill Lynch [MER: 0.00, 0.00 (0.00%)], I have to wonder what the business model is moving forward for this investment bank. Lehman’s balance sheet is overflowing with mortgage-related products. It has basically built its growth over the past several years on the dominance of the structured mortgage market, a market that will take years to become profitable again. One has to ask themselves (as I am sure Fuld & Co. are doing on a daily basis), where does Lehman’s business model head from here?

The future for Lehman is far from certain. However, watching with anticipation, I can’t help but think the result of Lehman will have far-reaching implications on the broader financial system and the future of the independent broker dealer.

-Adam Brown

Disclaimer: The mutual fund the author is associated with is long GS

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