How Lehman Brothers Veered Off Course

This Lehman Brothers bore little resemblance to Old Lehman Brothers, other than carrying a name dating back to 1850. Distinguishing between the Lehman of legend and the Lehman of today is key to understanding Lehman's problem. This isn't an old-line firm molded by storied Wall Street patricians. It's a 14-year-old firm that's been molded by 14-year chief executive Fuld.

We wanted to talk to Fuld, a passionate Lehman lifer, about this irony and history, but he wouldn't talk to us. A Lehman spokesman said the firm wouldn't cooperate either, because our questions were "unfair and biased." It later declined to comment on a second round of questions. As you'd expect, Schwarzman and Peterson saw no upside in talking to us, and didn't.

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 a half-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 of regular old money.

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). A quick peek at a Morgan Stanley or Bear Stearns filing from 20 years ago makes clear that their balance sheets consisted mostly of securities. 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. But time can run out real quickly when you have billions of dollars tied up in private equity, apartment buildings and California real estate.

What does the demise of Glass-Steagall have to do with this? Let's talk to Chris Andersen, chief executive of investment boutique Andersen Partners and one of Wall Street's grand old men. Andersen, 70, lived through the collapse of junk bond house Drexel Burnham Lambert (where he was a partner who refused to settle charges brought by the government and prevailed in court.)

He points out that when Congress was debating the act's repeal -- which it adopted in 1999 to let Citi and Travelers (which have since split) combine -- 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," Andersen says. Investment banks such as Lehman bulked up to compete with the Citis and J.P. Morgan Chases 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 such things as leveraged buyouts.

At the end of 2003, Lehman had $11 billion of tangible capital and $312 billion of assets on its balance sheet. The ratio: 28-to-1. As of the first quarter of this year, it showed $786 billion of assets and less than $18 billion of capital. Ratio: about 45-to-1, leaving relatively little cushion to absorb losses.

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 -- the exposure it does have poses serious potential problems. Lehman's filings indicate it has about $6 billion of exposure to CDOs. About a quarter of them are BB+ rated 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 probably additional losses looming in the other three quarters of the portfolio.

We're not predicting that Lehman will fail -- it won't, because of the Federal Reserve, 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 Sept. 11, 2001, 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. 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.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com. Roddy Boyd is a reporter for Fortune. His e-mail address isrboyd@fortunemail.com. Fortune editor at large Richard Siklos contributed to this report from Bakersfield, Calif. His e-mail address isrsiklos@fortunemail.com.