After Bear Stearns, Is Lehman Next To Collapse?

This week's hot investment banking story is the vulnerability of one of the remaining weak sisters among publicly-owned investment bank/brokerages, Lehman Brothers. I last wrote about this issue here in April.

Nearby is a price chart of Lehman, Goldman Sachs, Morgan Stanley, Merrill Lynch and the S&P500 Index for the past five years.

Goldman is clearly the class of the class, especially distinguishing itself since late 2006- months before last summer's mortgage finance-fueled fixed income markets crisis.

Of the other three investment banks, Lehman has the relatively 'best' performance. Of course, that's not saying very much, since none of the three could give an investor a better return than the S&P500 did over the period.

As I read yesterday's Wall Street Journal piece about Lehman's new difficulties, I noticed the article making a really big deal about how Lehman's leverage has recently been lowered from 31.7 to 27.3. Today's Journal has a lead piece in the Money & Investing section about Lehman looking abroad for capital.

In my opinion, this completely misses the point. As I wrote here in late March,

"Looking beyond simply Bear Stearns, can anyone truly justify the existence of all four of Goldman Sachs, Merrill, Lehman and Morgan Stanley? Especially in the modern world of large private equity firms and hedge funds? The former provide additional underwriting, M&A advisory and asset management, while the latter focus on providing trading capacity and investment management.

Other than emotional reaction of former employees seeing their old firm's name vanish, what would be different if one or more of those names were bought by or merged with a commercial bank?

Contrary to Andy Kessler's view, in the Wall Street Journal this past January, about which I wrote here, it's unlikely now that an investment bank will do the buying. With their high leverage and dependence upon commercial banks for funding, I suspect the investment banks are the more vulnerable. Now having access to the Fed discount window, it's only a matter of time before the regulators get around to levying a new regulatory framework on the investment banks."

It's not whether Lehman reduces their leverage right now by a pithy 4 or 5 percentage points. That's going to be irrelevant if/when their big meltdown comes. Bear Stearns saw billions of dollars of client assets, and customer business, vanish in days.

Quite simply, as I wrote in that prior post, Lehman exists at the pleasure of its commercial bank Broker Loan divisions to fund them beyond the current maturity of outstanding liabilities. Whether the leverage is 30, or 25, 20, 15, won't matter when customers leave within two days.

At that point, anything above 1:1 spells dissolution. The mechanics of profitability, risk management and leverage have simply changed for long term survival of most publicly-held investment banks.

A plethora of hedge funds and private equity shops have trimmed profit margins in virtually every investment banking business except asset management. There, the best managers head for private firms ASAP anyway. Meaning the publicly-held investment banks, with the exception, still, for now, of Goldman, are largely the province of the lesser-skilled bankers at the mercy of commercial bank funding and the need to take ever-larger risks to offset declining profit margins.

A recipe for long term death of these firms? You bet.

As I wrote later in that March post,

"A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk."

And, as I wrote in my recent post on Wachovia CEO Ken Thompson's demise,

"To me, the pecking order of smart management in financial services begins with the best private equity and hedge funds. After them would come Goldman Sachs. Then.....well..I don't know if there is anyone else thereafter."

So to me, this breathless watch over Lehman's viability is sort of misplaced. As soon as confidence begins to erode, it's 'game over.' Bear's situation proves this. As I wrote in the earlier linked post, why doesn't Fuld just take the opportunity to sell to a commercial bank and retire gracefully, while his image is still in good shape?