Reasons to Cheer Lehman’s Demise

Lehman Brothers (LEH) appears headed for liquidation and that may hasten needed reforms on Wall Street.

Efforts to find a buyer or dismember the company in an orderly fashion failed this weekend for the same reasons that CEO Richard Fuld’s earlier proposal to reorganize Lehman generated little enthusiasm.

Lehman has a negative net worth. Any accounting that said otherwise to create a deal would have been a fantasy of Wall Street bankers who refused to reckon with the full scope of their conundrum.

Fuld proposed selling Lehman’s toxic real estate and mortgage-backed securities and taking huge write downs, and selling its lucrative investment management unit, which includes Neuberger Berman, to offset those losses.

That would have left intact Lehman’s investment banking business.

An investment bank really only has three things—working capital, smart finance guys and client trust.

Capital can be raised and American business schools educate lots of sharp minds. Trust is tougher to find.

In the world of mergers and acquisitions, initial stock and bond offerings, and the like, clients often navigate complicated, perilous transactions requiring complete confidence in the integrity of their investment bankers.

After all of Fuld’s shenanigans in real estate and mortgage-backed securities, only a foolish CEO would trust Lehman to handle his prized assets. Hence, Lehman’s investment banking business is not worth much in the hands of its current management.

Less its toxic real estate assets and investment management unit, Lehman’s only real value is its client relationships. Those must be transferred to a more trustworthy firm to have any value.

No other large firm could buy Lehman whole—its toxic real estate and securities are too difficult to value. Only a fool would think he could fairly assess their value, unless those are assigned them a value of zero.

Most of the major banks hold similar toxic assets. If another major financial firm enters similar straits as Lehman, which is likely, the second fire sale would mandate an even lower book value for Lehman’s mortgage-backed securities than could be assigned now.

This explains why one of the solutions offered stalled—peeling off Lehman’s investment bank and investment management unit for sale, creating another bank holding with its toxic assets, and shoring up the latter with cash injections from other banks.

Most other banks need all the cash they have to cover their own bad securities, and any money they put into a crippled holding company would likely just be lost.  

Federal Reserve loans to such a holding company would have led to bailing most of the money center banks and securities companies out with subsidies up to $400 billion. Broadly speaking, several Wall Street firms are likely as insolvent as Lehman, and its demise may siren a broader financial sector restructuring.

Sunday, the International Swaps and Derivatives Association held a special trading to help banks and securities companies unwind their counterparty deals with Lehman. It remains to be seen how successful that effort was, but stock market turbulence is certain to follow.  Nevertheless, that turbulence is a necessary cost to force positive reforms in the U.S. financial sector.

Lehman executives will find it difficult to replicate their generous compensation elsewhere but the readjustment of banking compensation to more realistic levels and responsible schemes is necessary to return Wall Street to sanity.

Performance-based compensation practices at Lehman and throughout Wall Street, which pay big bonuses when bankers bet right but only imposes losses on shareholders when they bet wrong, has propagated the kind of toxic financial engineering that caused mortgage-backed securities meltdown, general credit crisis, and the near death experience of many Wall Street banks and securities dealers.

Paying bankers more reasonably is as necessary to restoring the normal operation of credit markets as the general deleveraging Ben Bernanke talks about.

Sadly, as I've said previously, Vikram Pandit at Citigroup (C), John Thane at Merrill Lynch (MER), and others can’t let go of the delusion that their 35-year-old MBAs are not worth as much as New York Yankee shortstop Derek Jeter and they in turn are worth multiples of that.

The shareholder value they have destroyed repudiates that conclusion.

As Lehman exits, attention now turns to AIG (AIG) and Merrill Lynch. They will likely be reorganized, acquired, broken up or go through bankruptcy [Editor's note: See updates on MER and AIG].

Sooner or later after enough dominos fall, compensation structures and business practices will return to more conservative norms of ten and twenty years ago. Only then will the credit crisis resolve and the economy have a decent shot at full recovery.

Disclosure: none

Comments

[Kevin Lamson:]

READ EM AND WEEP AND LET THE CHIPS FALL WHERE THEY LAY!

In my opinion it is high time that these Wall Street executives and their respective firms are exposed for what THEY, not the "shorts", have done to their companies and American finance by playing it fast and loose with the TRUTH. The truth about how much bad debt they flipped into the domestic and international markets and the truth about how much there executives reaped by reporting false profits tied to this mortgage loan flipping scheme. Flooding the markets with phony paper. The American public should be outraged at how our government regulators, politicians and the Bush administration allowed Wall Street to get away with this international fleecing of investors. It is an international embarrassment that America’s bankers ripped off the world in the new "global economy". But, we must now "let the cards read and the chips fall where they may". We need to turn out these crooks, their companies and their disastrous scheme in order in order to regain trust and return international confidence in the American business and banking practices. Not continue to hold our cards and pretend we have a winning hand .

2008 Sep 15 03:02 AM

[Dirtt:]

The " shenanigans in real estate and mortgage- backed securities" go far beyond the CEO's and the "Three Stooges" as suggested by another contributor to Seeking Alpha - two of the "Three Stooges" being Bernanke and George Bush.

Well. Okay. Either that contributor is the tail end of the election manipulation that is at the core of what almost no one is willing to acknowledge or his hubris ranks right up there with the Harvard and Yale genius that designed the 'house of cards' falling from (false)grace. Good work chaps (or is it lads). I could have found someone from Cal State Northridge who could have created this 100-year calamity FOR FREE and in less time.

Would the employment of an independent regulator of the GSE's in 2006 have curtailed the malfeasence yet to come home to roost?

Who installed the lobbyists in upper management at the GSE's?

Why were the GSE's donating soft money to influence congressional elections? And why did the GSE's feel compelled to influence anything at all let alone elections?

And the "three stooges?"...Your contributor failed to include Jamie Gorelick, Frank Raines and Susan Molinari not to mention a former FBI hack. That's four excluding Bernanke and Bush. Shall we begin to tally up those in Congress. If we add the list IBD just compiled of RNC & DNC looters then three DOZEN doesn't even scratch the surface.

Mr. Morici is right about the collateral damage. But what about the root of the malfeasance.

Who in the hell would put lobbyists in control of an operation which demands experience in finance? And why can Barney Frank speak publically about matters that the SEC would normally find dubious if not flat out illegal?

America is waking up because a few true patriots remember 1764 and the commencement of the Taxation Without Representation grass roots movement. Centuries later we are no better. REVOLTING.

2008 Sep 15 03:40 AM

[Steven Hansen:]

as a student (not an expert) of the great depressions of the 1930's, i see nothing to cheer about. the government then, as well as the government now, reacted to the shoes dropping - instead of being proactive.

i really hope that there is a road map the government is following as the failures of the investment banks probably will continue. the government has had months since bear stearns to analyze and plan its moves.

i hope nobody thinks that the void left by Lehman will fall to other usa based investment banks. this is just one more industry we can pack up and send to the rest of the world.

having said that i am beginning to wonder why we needed investment banks anyway. maybe they created a volatility in the market, as well as destruction in capital.

in any event i cannot cheer what is happening. we are drifting into uncharted territory which too closely resembles the early events of the great depressions of the 1930's.

2008 Sep 15 04:11 AM

[Boubou:]

The annoying thing is, weiss, schiff, roubini, rogers et al have been telling us what was going to happen and what to do with our money for a year or more.
Unfortunately i didn't beleive them well enough either.
The cheer leading from the deception masters and their media was too loud

2008 Sep 15 08:18 AM

[Kevin Lamson:]

I completely agree with the contributor who suggested that politicians and regulators were bought off. I mean come on getting an executive postion with Fannie Mae and Feddie Mac was completely political. Look at the millions Johnson and Raines pulled out of Fannie Mae and Freddie Mac during their "Reigns" over those fiefdoms. Its been reported that Mr. Johnson used Fannie Mae money and spread it around the Beltway like it was his own. He even set up a Fannie Mae foundation to dole out millions to his favorite causes.

Contrary to widespread beleif the U.S. Federal Reserve did take action piror to the crash of 1929 and after the crash. First lowering interest rates to spur the economy then rasing them to sow the economy. These steps resulted in the incredible, for that time,

First it was the end of war-related inflation and booming exports for war reparations, next artificially low interest rates in 1925 and 1927 and booming exports due to a reduced value of the Dollar vs. the Pound. There were major tax reductions instituted by the Republicans under Hoover and finally in June of 1929 an international accord was struck with the Germans (albeit short-lived) over the financing of war reparations, a major issue of the decade.

By Monday, October 28, 1929 the Dow had fallen 20% to 300. It fell 40 more points that day and another 30 on Tuesday (Tragic Tuesday) to reach a temporary bottom at 230.07. It was down 40% from the peak 56 days earlier.

The head of the New York Federal Reserve at the time of the crash, George Harrison, bravely stepped in to provide tremendous amounts of credit to the banking system. This action prevented immediate bank failures and bankruptcies and a total collapse. The market recovered a good bit of ground but began to fall again before year-end. By mid-1930 this liberal credit policy was to be reversed affecting a money supply crisis. Once again the government intervened, but could not stop the bank from failing because people has lost confidence a system which had obviously failed.

It is generally agreed today that the "money supply", which refers to the total amount of money circulating in the economy, should grow at the same rate that the economy grows. Any faster is inflationary and any slower is deflationary. When a bank fails the Fed has the option to either bailout that bank by lending it money or to lend more money to other banks to fill in the shrinkage in the money supply. Otherwise the amount of money in circulation shrinks and the economy limps along like a person parched for water.

I think the Fed has continued to keep the money supply tap open. It just isn't going into some of the Wall Street firms who have betrayed the public's confidence through dishonest and greed driven business practices.

2008 Sep 15 03:53 PM