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How Lehman Brothers Veered Off Course
Investment Bank Prided Itself on Real Estate Expertise

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.

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.

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