Lehman Brothers: no buyers yet

By Edward Harrison On Sep 14, 2008

Update: 800PM EDT: DealBook is now reporting that Lehman is expected to file bankruptcy as soon as tonight. (See post). Merrill, fearing for its continued existence, is now in takeover talks with BofA (see story)
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The latest development on Lehman is that no buyers have emerged in around the clock dealmaking sessions involving multiple parties. The Fed is desperately looking for a deal that does not involve government guarantees, but given Lehman’s balance sheet, many players are uncomfortable with that risk.

So, I will try to pull a number of threads together about Lehman Brothers here.

Around the clock rescue attempt

This weekend, the NY Federal Reserve called together a number of securities firm executives for around the clock negotiations in an effort to save Lehman Brothers from collapse. Barclays had emerged as the most likely suitor for Lehman Brothers amongst a number of potential suitors. However, U.S. Treasury Secretary Hank Paulson and the Federal Reserve have been very much against providing government guarantees to support a Lehman takeover, wanting to avoid the moral hazard of the Bear Stearns collapse and subsequent guarantee offered JP Morgan Chase. As a result, Barclays is reported by several news sources to have pulled out of negotiations. Bank of America too does not want the credit risk on its balance sheet, being already heavily exposed to the real estate sector through its purchase of Countrywide Financial. Therefore, no new leading suitor is available as of the writing of this post.

Prior success

Think back to early 2007, before the February writedown announcement by HSBC that was the first warning shot of trouble in the financial sector. At that time, Lehman Brothers was one of the five largest investment banks in the United States, with a history that dates back over 150 years. The venerated firm had finished the previous fiscal year 2006 with an equity base of nearly $20 billion on assets of over $500 billion. However, Lehman became caught up in the credit crisis spectacle that began last August. In the previous year, it had lavished its shareholders with almost $4 billion in income, well above a 20% return. However, this was before the credit crisis had begun.

Risk taking

In fact, Lehman Brothers had taken on a large degree of risk and leverage to achieve those gains and when the credit crisis began in August of that year, it was one of the large firms most vulnerable to a protracted crisis. Lehman, which had been known mostly for its fixed-income and investment banking practice, had added heft in its investment management division (IMD) in the form of Neuberger Berman. But it also added
risk in the form of huge investment in property and real estate, both residential and commercial.

Credit crisis and financial sector pain

When the U.S. subprime housing market collapsed, creating large writedowns for securities firms around the world, Lehman was heavily exposed. However, they were still able to book a profit of over $4 billion in 2007. But, the subprime situation continued to deteriorate and mortgage defaults in subprime increased. Then, the bottom fell out for Lehman Brothers when the U.S’s fifth-largest securities firm, Bear Stearns suddenly collapsed in March of this year.

Lehman in the hotseat

The Bear Stearns collapse and rescue by JP Morgan, with help and guarantees from the New York Fed, spooked the market and put Lehman into focus as another troubled institution. Later, in April, the hedge fund investor David Einhorn came out with research highlighting the deteriorating situation at Lehman and claiming that the firm was smoothing earnings to mask the state of affairs. Einhorn took a large bet against the firm in the markets — a bet which would prove to be worth a considerable deal as Lehman has fallen 90% since that time.

In the interim, Lehman Brothers was forced to writedown tens of billions of dollars in investments in Residential Mortgage Backed Securities (RMBSs), raise capital, and sell assets in order to de-leverage and reduce risk. Yet, its efforts were not enough. The company’s shares continued to come under pressure. So much so that it was forced to enter into talks to sell the firm or raise capital with several suitors, prominent among them the Korean Development Bank (KDB).

When a likely deal with KDB hit the rails, it was obvious to everyone that Lehman could not raise enough capital to stop the bleeding. Therefore, it moved up the release of its third quarter earnings to quell market speculation and loss of investor confidence. In that timeframe, the credit crisis had also spread to Alt-A residential mortgages (the class between subprime and prime mortgages) and Commercial Real Estate (CRE).

The third quarter earnings report earlier this week was a disaster. Lehman lost $3.9 billion on $6 billion in writedowns, mostly on Alt-A securities. the loss and writedown were larger than was expected and Lehman had a restructuring plan which was not well received (see story). Moreover, most of its losses had been recorded in Alt-A mortgage backed securities, not in subprime. The firm carried huge additional risk in the CRE sector as well. A number of banking analysts downgraded Lehman Brothers and wrote scathing reports on the firm’s future prospects. Things looked very grim.

Fannie and Freddie put investors on edge
Lehman’s fate may have been sealed by the bailout of the GSEs by the U.S. Federal Government. Last weekend, days before Lehman’s ill-fated earnings report, the U.S. government had bailed out Fannie Mae and Freddie Mac in the largest bailout in U.S. history. The securities markets were extremely volatile and everyone was on edge. In this environment, no one was willing to take a risk. Washington Mutual and Lehman Brothers have been the worst hit firms in the fallout. Shares in Lehman have sold off to near zero and Lehman totters on the verge of bankruptcy.

So that’s where we stand — waiting nervously for one of Wall Street’s titans to be bailed out, taken over or declared insolvent. This is the state of the U.S. financial system in 2008.

Very worrying, indeed.