Fuld again

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Sep 11th 2008 | NEW YORK
From The Economist print edition

A new financial storm threatens to lash American finance

AFP
THIS hurricane season, one storm has hit after another. It is the same in financial markets. Just as they were basking in the dramatic rescue of Fannie Mae and Freddie Mac, America’s giant mortgage agencies, a fresh storm was brewing over Wall Street. The pummelled shares of Lehman Brothers, led by the pugnacious Dick Fuld, lost almost half their value between September 8th and 10th. Suddenly, six months after the loss of Bear Stearns, loomed the prospect of another big investment bank buckling. Shares of Washington Mutual (WaMu), a battered savings-and-loan bank and the nation’s largest, also tumbled, amid fears that the imperilled are running out of rescuers.

Lehman’s latest problems stemmed from the desertion of a South Korean suitor, undermining its efforts to raise enough capital to ride out big losses on property, mortgages and leveraged loans. It sought to limit speculation by moving forward news of a $3.9 billion loss for the third quarter, much worse than expected, and unveiling a number of strategic moves. These included spinning off up to $30 billion of commercial-property assets into an independent, publicly traded company. It also said it was close to agreeing on the sale of a majority stake in its prized fund-management unit, including Neuberger Berman.

This was thin gruel. Lehman had not completed the deals. The scheme to sell more than half of the asset-management division while retaining more than half of its profit smacks of sleight-of-hand. Without a sale, it is not clear what the alternatives are so, as an obviously desperate seller, Lehman has handed the advantage to potential buyers. Even if it pulls off a deal, it will still need more capital.

Lehman’s shares have sunk so low that its market value of $5 billion now languishes some way below what it hopes to get from Neuberger Berman. But if anyone has spotted an opportunity to buy the entire firm for a song, they have yet to reveal themselves. Perhaps with reason: several bottoms to the market have already been called, and there is massive uncertainty over the value of Lehman’s exposure to illiquid securities. There are still piles of these assets, too. Even if its plans succeeded, Lehman would have $53 billion of mortgage assets and leveraged loans on its books—almost double its shareholders’ funds.

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Mr Fuld has brought Lehman back from the brink before—dramatically so after the collapse of Long-Term Capital Management, a hedge fund, in 1998. This time, however, he has done his shareholders few favours. His early handling of the crisis was good, but he has balked at selling assets at less than book value, even though the bank’s shares have for some time traded at a steep discount to that measure.

To some, this brings disturbing echoes of Jimmy Cayne, Bear’s former boss, who refused to sell until it was too late. There are, however, important differences. Lehman has built a formidable $42 billion pool of liquidity and it is less reliant than Bear was on American mortgages. Most importantly, it has access to the Federal Reserve’s credit line, opened just after Bear’s sale to JPMorgan Chase, enabling it to use securities as collateral to raise funds.

Does this window make a death-spiral inconceivable? Until recently the market thought so. But a sharp jump in the cost of protecting against a Lehman debt default suggests that doubts are creeping in.

Lehman has not yet suffered the client and counterparty defections that spelt doom for Bear. Indeed, other Wall Street firms, dubbed the “friends of Lehman”, would far sooner keep trading with it. This is not out of altruism (though Mr Fuld’s firm is a lot more liked than Mr Cayne’s us-and-them outfit ever was). Rather, there is genuine fear that a second failure would devastate markets and leave other investment banks vulnerable. At some firms, instructions to keep trading with Lehman are coming from the top.

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That may not last. Standard & Poor’s, a rating agency, said this week it may downgrade Lehman’s debt. If so, the bank would have to put up billions of dollars in extra collateral. That would lead some dealers to rethink the relationship—if only out of fear that others may be about to break ranks.

The best solution from a regulator’s standpoint would be a forced marriage. But it is already clear that there would be few enthusiastic takers. JPMorgan Chase was extremely wary of taking on Bear, despite coveting its prime brokerage and headquarters—and market stress has deepened since then.

Even if Lehman can claw its way back, it will be a shadow of what it once was—shorn of its lucrative fund manager, and with leverage (and thus profit) curtailed by regulation. The business of investment banking may remain depressed for years.

That grim prognosis does not apply to Lehman alone. Merrill Lynch is still struggling to cauterise its wounds, even after taking $46 billion of write-downs and parachuting in John Thain, the former head of NYSE Euronext. Mr Thain must be hoping more than anyone that Lehman survives. If it does not, Merrill will become the obvious straggler of the herd, though its wealth-management business provides some protection.

Nor is Lehman alone in needing more capital. Despite raising $265 billion already, listed financial institutions in America and Europe need at least $75 billion more, reckon analysts at UBS (which knows about these things first-hand). With almost every investment to date under water, contributions have been drying up. Ominously, an insurer belonging to Warren Buffett, an astute investor, has stopped guaranteeing bank deposits above the federally insured limit of $100,000.

Mr Fuld struck a characteristically defiant tone, even if he did sound tired. Lehman, he said, had “a long track record of pulling together” in hard times. But as anyone who has bought a mortgage-backed bond will tell you, in these markets past performance is not much of a guide.