Thursday, June 26, 2008

Abigail Hofman: Hindsight is 20/20

by Abigail Hofman

It’s a truism that hindsight is 20/20 vision. But those who spot the signals of turning markets are visionaries and those who act on these signals are true geniuses.

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Abigail's biography

Dick Fuld - Erin Callan - Lehman Brothers - Business class etiquette - Barclays - Real estate

Something about the jut of his chin and his unflinching expression tells me that Dick Fuld is a fighter. Ten years ago, he battled like a demonic sumo wrestler to save Lehman Brothers from the funeral pyre of illiquidity associated with Russia’s domestic bond default and the demise of hedge fund LTCM. The flames fanned Fuld’s feet and apparently he never forgot the experience. Or did he? A mole whispered in 2006 that Lehman had been slow to join the throng of bankers in Moscow because Fuld was cautious about re-entering the Russian market. In March 2007, he changed his mind: Lehman hired Nick Jordan from Deutsche Bank to reignite the firm’s Russian effort. At the time I instinctively felt that this might be a market top. ‘When the Bear meets the Eagle, can any good come of it?’ I wrote.

It’s a truism that hindsight is 20/20 vision. But those who spot the signals of turning markets are visionaries and those who act on these signals are true geniuses. Joseph Kennedy apparently sold his entire portfolio a few months before the 1929 crash after a shoeshine boy gave him a stock tip. Philippe Jabre, the well-known hedge fund manager, is perhaps another example. In early 2007, he told me that the US housing market was about to decline precipitously. A few months earlier, Jabre had been dining in a fashionable New York restaurant. The service was appalling. After an unseemly interval, the waiter reappeared and apologized: he had popped out to place a deposit on a flat.

Bloated albatross

Dick Fuld, however, didn’t see the signs or, if he did, he committed a terrible error of judgement. Fuld should have sold Lehman Brothers early last year when the share price hovered around the heady $85 level and highly leveraged financial firms were the stock market’s sweetheart. The founders of US hedge fund Fortress and Steve Schwarzman of Blackstone were smarter than Fuld. They had the perspicacity to sell at the top.

In June 2008, Lehman’s share price had shrivelled to 30% of its value a year earlier and the firm announced the first quarterly loss since it went public. Fuld is tiptoeing gingerly across a thin layer of ice that covers a very deep lake. Will he make it to the other side? Market participants are divided. Some say that Fuld will prove smarter than the short-sellers and that this is a screaming buy opportunity for the shares. Others argue that Lehman has lost too much credibility (the firm keeps saying it has plenty of capital and then it raises more) and has too many dodgy assets on its balance sheet. At the moment, investment banks can borrow from the Fed by providing eligible collateral: the Primary Dealer Credit Facility was introduced on March 17 after Bear Stearns buckled. What will happen when the Fed becomes less accommodative? One could argue, though, that the Fed will be accommodative as long as Lehman needs it to be! As at May 31, Lehman had more than $70 billion of real estate exposure. A 10% fall in the mark-to-market valuation of that exposure (not unlikely) would wipe out the $6 billion of capital the firm recently raised. Merrill Lynch’s analyst, Guy Moszkowski, who downgraded Lehman in mid June to neutral, a week after issuing a “buy” call on the stock, notes: ‘visibility on ‘09 estimate no longer solid enough to value shares beyond near term ROE potential”.

In June 2008 Fuld also felled two of his senior management team – the president, Joe Gregory, and the CFO, Erin Callan. This hints at decision-making on the hoof. Surely these resignations should have been announced at the same time as the second-quarter loss and capital replenishment rather than three days later? In a heartbeat, the firm lost its succession plan and the person who was meant to understand the numbers. I am also unimpressed that compensation expenses were 26% higher in the second quarter of 2008 than in the first quarter. Surely that graph should go the other way? Second-quarter 2008 compensation expense dropped by 15% compared with a year earlier but net income declined by 300%. Am I the only person who finds this invidious? Indeed, according to Lehman’s second-quarter results press release, the firm has shed only 2,134 employees during the past year (7.5% of the workforce). It now has 17% fewer employees that Goldman Sachs. Yet Goldman made a $2 billion profit in the second quarter while Lehman made a $2.8 billion loss. This makes Lehman look like a bloated albatross.

Ms Callan is far from bloated. She is super-slender but might be suffering from the stigma of “successful woman on Wall Street syndrome” that I wrote about in June. She engaged with the media perhaps a little too often, especially as my sources whisper that Fuld is not in favour of underlings having a high press profile. A public relations specialist mused: ‘That lengthy profile in the Wall Street Journal raised some eyebrows. Was the photograph with the figure-hugging black top and stiletto shoes appropriate? And the reference to her personal shopper at retailer Bergdorf Goodman grated. Could you imagine a male CFO referring to that stuff?’

I am a big believer that women in business are different and not just men in heels. However, even for me, Callan’s interview with the Wall Street Journal, three weeks before she sashayed off the management floor, was ill advised. The article was almost hagiographic in tone. Discussing the earnings conference call in March, journalist Susanne Craig cooed: “After sifting through the numbers for nearly an hour, Ms Callan coolly answered more than 20 analyst questions. Then she strode down to Lehman’s bond-trading desk and high-fived trading executive Peter Hornick. Later that day, bond traders gave her a standing ovation.” A mole mouths: “Might there be an element of sexism in the ousting of Erin? This woman is smart. She successfully ran one of the most complex product groups at Lehman for several years.”

Lehman Brothers retains the essence of a family firm. It is telling that although Gregory and Callan have lost their high-profile posts, they are still employed by Lehman Brothers in unspecified roles. Some 30% of Lehman stock is owned by employees, which was great for morale in the boom times but has a boomerang effect in the bad days. A senior banker at another firm relates: “The phone is ringing off the hook with calls from Lehman guys. People were petrified by the Bear Stearns experience. The only thing worse than losing all your savings is losing all your savings and your job. Anyway, do you really want to work for the fourth-largest Wall Street broker/dealer?”

A source at a US investment bank has another perspective: he tried to hire a managing director, Lenny, from Lehman several months ago. The job description was agreed, the contract was about to be dispatched when Lenny stalled. “I’m very sorry,” he told Mole. “I know I’ve messed you around. But Lehman Brothers is in trouble. They need me and I want to stay and help them get back on top.” That’s a significant anecdote, especially on Wall Street, where most employees are mercenaries.

In an early column, I examined the board of Lehman Brothers. “In an industry that worships youth, the Brothers’ board is a shining beacon of non-ageism,” I wrote. “Sprightly seniors abound and half the board are septuagenarians.” I am intrigued that two years later the ages of the board members no longer appear on the website. Nevertheless, half the board preface their titles with the words “retired” or “former”, and few are financial heavyweights although I’m sure Roger Berlind, a theatrical producer, adds a sense of drama to board proceedings. And talking of weight, I’m pleased to see that the lone female, United States Navy Rear Admiral (retired) Marsha Johnson Evans remains on the board. Marsha is a director of Weight Watchers International but does a knowledge of calories or battleships add weight to her views on mark-to-market valuations? Both Berlind and Evans sit on the finance and risk committee.

So there you have it: a weak board, a powerful (some would say overweening) chief executive, a tarnished franchise (although second-quarter investment banking and investment management earnings were creditable) and a loyal but demoralized workforce. A mole mutters about a clique surrounding Fuld, the so-called Friends of Fuld or FOFs. Apparently FOFs are now out of favour: “Given the share price swoon,” grumbles Mole, “The model is broken and it’s off with their heads.”

Will Lehman Brothers survive? I think so. But maybe not for long. Mole again: “Fuld will try to get the share price up, say 30%, and then sell it.” What do you think?

Business class etiquette

There were strong rumours in early June that Korean investors might take a stake in Lehman Brothers. And these days you are an investment banking nobody if you are not loitering in an Asian airport VIP lounge. Bankers such as Lehman’s chief legal officer, Thomas Russo; Barclays’ chairman, Marcus Agius; and Citi’s Vikram Pandit are busking for money from sovereign wealth funds. I wonder what the proper etiquette is? For example, should you fraternize with your fellow bankers (who are competing for desperately needed cash) over a glass of champagne? Or should you sip a tepid tomato juice (to show you’re treating the assignment with monk-like asceticism) and refuse to acknowledge your rival? Indeed, should you fly first class at all? Granted, a senior banker cannot be expected to fly economy with “the little people” but perhaps business class is a good idea? It shows you recognize that times have changed and your firm has a grip on expenses. Then there is the tricky topic of the limousine. Should you hire one? It’s awfully hot in Asia or the Middle East in summer. And can a top investment banker be at his most persuasive if he arrives sweaty and crumpled from a mad dash in a grubby taxi through the back streets of Beijing? Probably better to hire an air-conditioned limo but insist that the driver parks a couple of blocks away. But then what do you do if the solicitous Sovereign Wealth Fund offers to call you a taxi to take you back to your hotel after the meeting? Do you jettison the limousine driver, hoping to call him from the back of the taxi, or insist that you need some fresh air and will walk? This latter option might be inadvisable as your host will think you have gone mad: who wants to stroll around in 95 degrees heat and hellish humidity? And that’s before you even get to the “thank-you for seeing me” note. Should you send one? Or is that too reminiscent of a supplicant? But then again, you are a supplicant. Is a small but tasteful Tiffany trinket appropriate or does a gift imply venality? The pitfalls are myriad and if you commit some fatal cultural faux pas (after all, one is so jet-lagged with all this zooming around the world that sometimes you forget whether you’re in Seoul or Singapore), your net worth will plunge even further. Never has a chief executive had to work so hard for his $4O million pay cheque.

It is good to see Barclays taking my criticism of “dithering” to heart and finally doing something about raising capital. Nevertheless the whole “will we, won’t we?” operation has appeared anaemic and aimless and has crucified shareholders. “Barclays' shares have tracked RBS's shares down,” a well-briefed banker told me. “But in the meantime, RBS has managed to raise £12 billion from shareholders and Barclays is still out there with the begging bowl.” Chief executive John Varley and chairman Agius are not paid to prevaricate. If they had done what I suggested and moved first (in early April 2008), instead of last, they could have purchased Lehman Brothers by now. This is hugely ironic given that one of Barclays’ management’s stated objectives is expansion in the US.

'For sale' signs

And talking of the US, might Ken Lewis, the taciturn chief executive of Bank of America, be having problems with his property portfolio? I first wrote about Bank of America in May 2006 when I mused: “The bank is heavily exposed to the faltering American housing market and the indebted US consumer who during the past decade has been busy converting his home into an ATM.” However, in August 2007, Ken decided to double up and invested $2 billion in Countrywide Financial, the largest US mortgage lender. In the press release, Lewis said: “We believe that in the current turmoil, the stock market has been underestimating the value in Countrywide’s operations and assets.” By January 2008, Countrywide shares were trading 5O% lower than in August 2007, so Ken decided to purchase the whole company. Countrywide shares are now worth less than a quarter of what Ken paid last summer and the deal is due to be approved by Countrywide shareholders in late June. Countrywide has lost some $2.5 billion in the past three quarters and there are rumours of a federal investigation into lending practices. It would appear that Bank of America’s own shareholders are not enthusiastic about the acquisition: BoA’s own shares have lost 50% of their value since the peak in late 2006 compared with a 30% drop for JPMorgan shares.

Nevertheless, someone somewhere loves Ken. That person is Sir Fred Goodwin, chief executive of Royal Bank of Scotland. You may recall that in the heat of the battle for ABN, Rick Groenink sold the supposed US jewel in the crown, LaSalle to Bank of America. When RBS purchased ABN, the British bank received the proceeds of the LaSalle sale. Might Ken have saved Fred’s bacon? Without the LaSalle proceeds, RBS might have had to raise even more capital. Given RBS’ £12 billion rights issue was the largest ever in the UK market, a larger deal probably would not have been feasible.

However, I fear trouble looms for Lewis in the UK market. Last May, at the peak of the UK property bubble, Jon Hunt, founder of estate agency Foxtons, sold out for an undisclosed sum rumoured to be £360 million. The purchaser was the private equity firm BC Partners. Bank of America and Mizuho of Japan provided the funding package of some £250 million. The UK housing market is unravelling fast: volumes are down some 45% and prices some 10%. Might the financiers of Foxtons live to regret their decision? Probably. Indeed Hunt might eventually buy his business back for a morsel of what he sold it for. This brings me back to where I started. Hunt is one of those geniuses who saw the signs and acted upon his instincts. This is more than can be said for the rest of us. What a difference a year makes!

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Sovereign wealth funds

Selling short

Abigail Hofman: Hindsight is 20/20

It’s a truism that hindsight is 20/20 vision. But those who spot the signals of turning markets are visionaries and those who act on these signals are true geniuses.

Email a Friend

Add Your Comment

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