How Lehman Brothers Veered Off Course

By Allan Sloan and Roddy Boyd
Thursday, July 3, 2008

If you want to see what's wrong with Lehman Brothers, the investment bank with a storied name but a troubled present, you need to leave the canyons of Wall Street and head to the flatlands of exurban Bakersfield, Calif., some 120 miles northeast of Los Angeles. That's where you find McAllister Ranch, envisioned as a 6,000-home, multibillion-dollar recreational community.

As you approach the "ranch" after a nearly two-hour drive from L.A., you come across an expanse of rough scrub dotted with tumbleweed, intermittent oil derricks and the odd skittering rodent. You pass a billboard -- "opening soon" -- pitching new homes built around a Greg Norman-designed golf course and promising boating, fishing and a beach club. Finally, you make it to McAllister: 2,070 fenced-in acres, which is more than three square miles. Look past the fence -- you're not allowed inside -- and you see a half-finished clubhouse and a golf course gone to weeds. You don't see any happy homeowners, who were supposed to have started moving in two years ago. You don't even see any homes. All you see is an almost-lunar landscape with no construction going on. So far, this development alone -- part of a major bet on Southern California's Inland Empire -- has cost Lehman $350 million. None of Lehman's peers, such as Merrill Lynch and Morgan Stanley, has this kind of exposure.

Then there's the exposure all of them have: problems with collateralized loan obligations, leveraged buyouts and mortgage-related securities. But Lehman, with its 158-year-old name and prestigious history, insisted it was only minimally exposed to this kind of stuff. Turns out it wasn't. As a result, it's now engulfed in problems: big losses; messy public demotions of its chief operating and chief financial officers; battles with short-sellers, who are betting that Lehman's share price, down about 70 percent on the year, will decline further; rumors (which we consider unfounded) that it will pull a financial el-foldo the way the late Bear Stearns did.

Even if you're fortunate enough not to be a Lehman shareholder, you have a big stake in this game. Lehman's travails have roiled the world's financial markets, and that market malaise is breaking down the economy. How has Lehman come to the point where many people mention it in the same breath as Bear Stearns? 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 Lehman drama will play out.

For now, let's talk a bit more about McAllister Ranch and how it symbolizes Lehman's problems. 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, 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 1/2 times its entire net worth tied up in complex, hard-to-value securitized products. Only Merrill Lynch, among Lehman's peers, has a higher ratio, Hintz said -- and Merrill is vastly larger than Lehman.

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, Richard S. Fuld Jr., because the firm was the best-performing investment-banking stock in the country. But 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.

How did Lehman, which had a reputation for prudence and sound management, end up in this pickle? Because, irony of ironies, 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, Lewis 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 faction's proposed strategy.

Fuld's reversal isn't just some tactical change. It's huge. It's as if Jack Welch had decided during his General Electric days that the touchy-feely school of management was right after all and began walking the halls to ensure that people were happy.

Lehman resolved its various internal disputes by selling itself to American Express in 1984. Schwarzman and Peterson left to start Blackstone Group and become multibillionaires. Fuld stayed at Lehman. After 10 mediocre-to-awful years as part of American Express's failed financial supermarket strategy, an undercapitalized, independent company called Lehman Brothers emerged in 1994.

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