US investment bank Lehman Brothers Holdings Inc. looks set to report dismal second quarter earnings next month. Some analysts even expect it to lose money. Hedges the firm has in place haven’t worked out well, and new business has been slow in the wake of Bear Stearns Companies Inc.’s collapse. The question is whether this marks the trough for Lehman, or whether it will spark calls for the Wall Street firm to go looking for a deep-pocketed partner.
Lehman is no stranger to being told it’s too small to survive. Many regarded the firm as a basket case after it split off from American Express Co. in 1994, in the wake of a previous housing-related credit squeeze. When the collapse of Long-Term Capital Management sent the markets into another downward spiral four years later, it was assumed Lehman was on the brink of insolvency due to its reliance on short-term funding.
That’s what prompted chief Richard Fuld and his executives to prepare for the next crisis. That essentially meant always having enough cash on hand to run the firm for a year without being forced to sell assets. In this current credit crunch that has been only partly successful. Lehman had a stronger capital base than Bear, and better contingency plans.
But investors still worried it was vulnerable, which is why the stock dropped to just two-thirds of book value—depths it hadn’t plumbed since 1998.
Fuld blames scaremongering short sellers for that. Perhaps he’s right. Either way, it doesn’t matter—the common assumption now is that it was the US Federal Reserve offering emergency funding for brokers and not the firm’s well-laid plans that ultimately stopped Lehman following Bear into the mire.
Since then, Lehman still felt it should raise more capital—some $4 billion (Rs17,280 crore) of preferred equity—to quell any lingering doubts it lacked access to liquidity. That’s smart crisis management. But it will inevitably crimp returns.
The investment bank has also been shedding assets. That wasn’t supposed to be part of the plan either, but a wise move considering traders have been hunting and punishing any leverage they consider excessive.
Lehman has acted swiftly, selling tens of billions of dollars of assets this quarter alone. That’s impressive—compare it to the five years Citigroup Inc. executives reckon they may need to shed $400 billion of assets.
But it leaves Lehman with a dilemma: its balance sheet might be cleaner, but it has fewer assets earning a return, its new capital was expensive, and there is always the chance regulators may want financial firms to raise an even larger cushion as quid pro quo for their effective intervention after Bear. What’s more, business has slowed. The upside of a credit crunch is that returns on assets improve, but right now not enough to make up the shortfall. The firm successfully diversified into equities, mergers and acquisitions, and money management in recent years, but these areas, too, have been cowed by turmoil in the credit markets.
Lehman is hardly alone in this. But Goldman Sachs Group Inc.’s risk-taking culture has remained successful enough to keep cranking out decent results, while Morgan Stanley benefits from being stronger in fee-income businesses such as retail brokerage.
What else could Lehman do? Selling to a commercial bank would certainly reduce funding costs, and a big balance sheet would make it easier to store less-liquid assets it couldn’t shift quickly. But that’s no guarantee of making good returns, as multi-billion dollar losses at Citi and UBS AG have proved.
Lehman’s experience dealing successfully with past credit crises should give it some breathing room. The firm has a track record of winning market share during and after downturns. And its stock recovers well: it rose some 145% within a year of hitting its lows in 1998, and by nearly 450% within two years.
But if the fallout from this most recent credit crunch is too widespread for Lehman to recover quickly—and there is a good chance this will be the case—the lure of deep pockets may prove to be stronger than the appeal of remaining independent.