Fuld's plight

For almost a year now, rumors of Lehman Brothers Inc.'s imminent demise have rattled the markets. The firm's oversized exposure to mortgage-backed securities and a struggling investment banking business have raised concerns about its capital position and its ability to perform as a viable counterparty in anxious markets. But despite the steady grind of the rumor mill, Lehman has so far avoided the fate of Bear Stearns Cos.

How long can it go on? Lehman's stock has fallen 70% in the past year, and several industry watchers argue there's no way Lehman CEO Richard Fuld can avoid taking some significant steps. "He's got to cut a deal," says Ladenburg Thalmann & Co. bank analyst Richard X. Bove. "If he tries to get through untouched, then the stock will implode."

But what kind of deal? Fuld is boxed in by Catch-22s. Do nothing, the situation worsens. But every action involves some pain and uncertainty, perhaps enough to trigger a downward spiral.

"The hole just keeps growing," says a lawyer close to the situation, referring to mark-to-market losses from mortgage investments and a shrinking market capitalization. In such a negative environment, a banker says, some of Lehman's higher-profile employees will inevitably begin to leave and some customers or counterparties will lose confidence. "It's really hard to get business done when everyone feels your business is imploding," he says.

There is no shortage of scenarios. Rumors have recently swirled about an imminent sale, in whole or in part. One involves a consortium of South Korean banks, which was first confirmed by the state-owned Korea Development Bank's governor, then pooh-poohed by Korea's banking regulators. Also tossed out as interested buyers are Japanese bank Mitsubishi UFJ Financial Group Inc. and the U.K.'s HSBC Holdings plc.

One source close to Lehman calls the rumors, at this point, misguided. "I've never seen such inaccurate reporting," the source says, particularly in the Korean and U.K. press, which has been dutifully repeated around the world. He asserts there's no looming announcement of a takeover, although he won't deny that Fuld has been courting banks in Korea. According to press reports, Fuld's most likely successor, president and COO Herbert McDade III, has been leading the Korea talks, which seem to have stalled over price. There are risks to a deal, from the dilution of shareholders to regulatory uncertainties.

Another option involves creating a so-called bad bank, which Lehman could use to house its toxic securities. That step, however, would force Lehman to funnel equity capital into the "bad" entity and replenish capital at the "good." It's unclear, given the difficult experience of funds that have recapitalized the likes of Citigroup Inc. and Merrill Lynch & Co. this year, whether Lehman will be able to entice any investors to back such a structure.

Lehman is also apparently considering a sale of its asset management subsidiary, Neuberger Berman Inc., to private equity buyers. The unit pulled in about $500 million in revenue in the second quarter and is a steady cash flow generator. Analysts expect Neuberger to be worth anywhere between $9 billion and $13 billion. "It's noncore and it performs well," a knowledgeable source says. "[Selling it] is the best way to
raise capital."

Of course, selling would deprive Lehman of a steady source of income, albeit one dependent on notoriously skittish money managers that may easily flee. Selling would also effectively reverse Lehman's long-term strategy of diversification. As Anton Schutz, portfolio manager of the Burnham Financial Industries Fund, puts it, "If you get rid of asset management, then what do you have?" The answer, of course, is a small-scale investment bank and a troubled fixed-income business.

Whether such an entity can survive in a turbulent world is an open question. One financial institutions banker feels that the investment banking model will change, with firms taking on less leverage and fewer risks, which means smaller profits. In such a world, scale is everything, which makes it unlikely that a shrunken Lehman will exist for much longer, even if it survives the current turmoil.

"They're trying to buy time," the source says. "But the less diversified they become, the less chance that they'll survive." Catch-22.