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Toxic Lehman

by PETER MORICI

Lehman Brothers 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, Vikram Pandit at Citigroup, John Thane at Merrill Lynch, and others can’t let go of the delusion that their 35-year old MBAs are 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 and Merrill Lynch. They will likely be reorganized, acquired, broken up or go through bankruptcy.

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.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

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PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.

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