Lehman Follows Good Bank/Bad Bank to Redemption 12 comments
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Lehman Brothers (LEH) recently announced that it is taking a Good Bank/Bad Bank approach to tens of billions of dollars of illiquid real estate assets, hiving them off from the rest of the firm. Nice to see someone is listening. As previously discussed, I firmly believe that segregating toxic, hard-to-value assets from the rest of bank balance sheets is the only way true healing can take place and additional investment can be secured. Here is what I said about the benefits of such an approach a month ago:
The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.
What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi (C) taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital.
Otherwise, investors will continue to be surprised and disappointed, much like those SWFs that have spent billions by investing in the equity of Citigroup, Merrill (MER), Lehman and others, well before their balance sheets had the transparency and simplicity necessary for making an investment with a Graham & Dodd "margin of safety." Who knows what cheap really is in the absence of objective, verifiable data? This is the basis on which many purportedly "smart" investors have been deploying capital, much to the curiosity of people like me. Sure, they say "We take a long-term view." Well, I'd rather take a long-term view by establishing a basis 50% lower than those at which they invested. But that's water under the bridge at this point.
From Saturday's Wall Street Journal:
For the real-estate assets, Lehman has set up a so-called good bank/bad bank structure. Such a deal is likely to involve a spinoff of the holdings to shareholders as well as an investment by outside investors.
Details of the plan weren't clear. One option may be a "sponsored spin." That would involve bundling some of the troubled assets into a new entity, which would then be spun off to Lehman holders on a tax-free basis. Also, a new investor or group of investors could take a big minority stake in the new company, thus "sponsoring" it.
Lehman, according to one person close to the deal, is expected to provide at least some financing. Lehman was sitting on $40 billion in commercial real estate at the end of the last fiscal quarter and another $24.9 billion in residential assets.
If Lehman goes with this plan, it will differ from the one Merrill Lynch & Co. opted for in August when it sold more than $30 billion in toxic mortgage-related assets at just 22 cents a dollar. That deal was done with just one buyer: private-equity firm Lone Star Funds but Merrill provided financing.
The WSJ piece does a god job highlighting the differences between the Lehman plan and the Merrill deal, one for which I had much less enthusiasm than I do the Lehman structure. The degree to which Merrill retains recourse due to the seller financing it provided to the single buyer, Lone Star Funds, together with the uncertainty around how much of its distressed real estate assets were actually represented by the assets "sold" makes its strategy akin to putting a band-aid on a deep wound.
Is the Merrill transaction a "true sale," either in substance or in form? The company is definitely walking a fine line, but analysts must sharply discount how much risk has truly been transferred when arriving at the true economic effect of the transaction.
The Lehman deal seemingly has far less ambiguity. This deal might become the true bellwether of how banks should deal with troubled asset portfolios. If Lehman is able to sell a meaningful percentage of its asset management business, and is successfully able to raise capital in order to jettison its $60 billion+ real estate portfolio, it will be well on its way to surviving what many felt has been a losing battle. Say what you may about Dick Fuld and his aggressive expansion into some dicey asset classes late in the game, but his toughness and focus in dealing with Lehman's problems lays in stark contrast to the denial and delay of Bear Stearns's management in handling its brush (and eventual capitulation) with death.
Lehman may just make it, and if it does, it will be because of a smart, aggressive approach to risk reduction, the centerpiece of which is the Good Bank/Bad Bank asset transfer. I would posit that its approach to balance sheet repair (read: survival) will be replicated many times by many firms over the next 24 months, unlike the finger-in-the-dike strategy favored by their friends over at Merrill Lynch. It is hard to do the right thing, to take drastic measures in the face of crisis. But sometimes, it is the only path to survival.
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Richard
Richard, I didn't forget to tell you anything; I simply don't agree with your thesis. It's not as if the real estate assets are simply vanishing. Either existing shareholders will benefit from fresh cash being injected into Lehman, or they will receive another share of stock representing their proportionate ownership interest in the spun-out entity. My contention is that under either of these scenarios, an investor will be better off because of increased transparency associated with the core franchise and the ability to tap into a larger pool of investors for the real estate assets. So I don't actually see value destruction here - I see value creation.
Roger
I like your good bank/bad bank thesis. It isolates the problem, which is the fear based valuation of over the counter illiquid assets. Following the Enron debacle, the FASB implemented mark-to-market imperatives which in concept made sense, but in reality had only unintended negative consequences. When fear and uncertainty become the dominant characteristics in an illiquid over the counter market, the next bid is "no bid."
Further, as a response to Richard, the "heart of the company" referring to Lehman Brothers is its people (employees, traders, sales personnel) who generate substantial profits. Separating the assets, deemed to be unpriceable at any realistic valuation allows a return of focus to the real "heart of the company."
I would expect a separation of assets under the good bank/bad bank concept espoused by Roger to be worthy of an increase in the share price of Lehman stock. In such an event, I would look for a return to the $20+ range for their shares.
IMO.
Turbo
Credit derivative contracts may be a problem. Selling them off to these shell companies could invoke lawsuits from those who sought their protection benefits. I can't see anyone getting out of those. Getting them off the balance sheets is one thing, removing the responsibility is another.
Thowze, it's all about knowing what you are investing in. I don't think most of Lehman is near dead. I think it's doing really well. Some really, really stupid decisions were made in an asset class that is killing the entire firm. Better to hive it off, face facts and move on. Your point about credit derivatives is fair, and actually gets to the fraudulent conveyance issue Squashnut raised earlier. Lehman can't simply walk away from their counterparty exposure by transferring contracts to a less credit-worthy entity. This is a non-starter. I can't imaging they'd be stupid or aggressive enough to try this. They would be vilified.
How exactly would the mechanisms of this take place though? Obviously this is a model that many may follow, but what would the likely effect on the stock price be, there has to be some pain for dealing with all this garbage either when selling it or spinning it off?
thanks