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 3, 2008: 5:02 PM EDT

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 capital is only around $27
billion (including recent preferred-stock issues).

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? Next: What went wrong

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How Lehman lost its way
By Allan Sloan and Roddy Boyd
Last Updated: July 3, 2008: 5:02 PM EDT

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 equity and $308.5 billion
of tangible assets on its balance sheet. The ratio: just under 26 to 1. As of the
first quarter of this year, it showed $782 billion of tangible assets and $20
billion of equity. Ratio: around 39 to 1, leaving relatively little cushion to
absorb losses, and forcing the company to shed assets and raise capital in the
second quarter.

Lehman also has self-inflicted wounds. Next: Lehman's paper profits

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How Lehman lost its way
By Allan Sloan and Roddy Boyd
Last Updated: July 3, 2008: 5:02 PM EDT

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.

Editor's Note: An earlier version of this story gave multiple figures for Lehman's
capital and leverage. This version eliminates the inconsistency.

Editor at large Richard Siklos contributed to this story from Bakersfield, Calif.
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First Published: July 2, 2008: 3:34 PM EDT
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