The following was written by guest blogger Glen Stein.
The world changed. Lehman (LEH) went extinct. What happened?
There are only four ways to increase profits:
- Increase margins;
- Increase sales volume;
- Increase leverage; and
- Control expenses.
Lehman became extinct because it evolved in the wrong direction when its environment changed.
How Lehman approached these four choices explain its problems.
Lehman’s evolutionary problem was a broken business model. The symptom of its broken business model was skinny margins.
In its heyday, Lehman was a bond house. It made markets in securities, mainly bonds. Before the internet revolution, Lehman’s competitive advantage was that its traders and sales force enjoyed access to information ahead of its clients. Lehman essentially sold the information distributed on its internal “squawk box” to its clients and trading partners in the form of wide bid-asked spreads and high commissions. This was a high margin business.
Then, two things happened.
First, Glass-Stiegel restrictions were lifted, and every big commercial bank wanted the margins of an investment bank.
Second, the internet arrived and financial information became widely disseminated on-line and through Bloomberg terminals.
The one-two punch of the internet revolution and competition from commercial banks essentially ended the juicy margins Lehman enjoyed during its heyday.
How did Lehman respond to its margin problem? It chose to enter new businesses (like mortgage lending and leverage loans), to swell its balance sheet dramatically (mainly by buying debt) and to increase leverage. These choices caused Lehman’s demise.
2. Sales Volume
Faced with margin decline in its “bond house” sales and trading business, Lehman looked for other higher margin businesses. Lehman changed its role from intermediary to principal in several of these new businesses. For example, it started as an intermediary in mortgages, lending to mortgage lenders and selling mortgage bonds. It noticed that its clients were making good money originating mortgages.
Lehman thought it could capture that margin, as well as feed its sales and trading desks. So it began to make mortgage loans and used its balance sheet to store many of the bonds it created when these mortgages were warehoused and securitized. Similarly, in its private equity and high yield businesses, it expanded from trading debt to storing more and more debt on its balance sheet. Lehman responded to its margin problem by expanding into new businesses and by expanding its balance sheet.
Responding to its margin problem, Lehman used its balance sheet and easy credit to lead it into new businesses. Its assets swelled as it bought debt, like mortgage backed securities, collateralized debt obligations and leveraged loans. Soon Lehman found itself with enormous leverage.
At February 29, 2008, Lehman had $786 billion of assets and $24.8 billion of equity. Lehman’s leverage ratio was a staggering 32:1. Lehman’s drastic expansion of leverage grew its profits for several years. Historically, it’s been virtually impossible for a finance company to survive a recessionary financial crises with so much leverage. This time was no exception.
Controlling expenses has never been Wall Street’s competitive advantage. Like a bulimic, investment banks typically feast on expenses during good times, and heave them overboard during bad times, in a predictably repetitive cycle. But operating expenses were not the cause of Lehman’s demise. With such a huge balance sheet, even small impairments in asset quality caused losses that dwarfed expenses.
In sum, Lehman’s business model was severely challenged by the changed environment of the information revolution and increased competition from commercial banks. Lehman responded (evolved) by using its balance sheet to expand into new businesses. Despite a bloated balance sheet, it successfully avoided its enemies for a few years. Eventually, its big fat balance sheet and poor sense of direction slowed it down. When the storm hit, Lehman could no longer escape its demons. It became extinct.