Business | Markets
Archstone deal was one risk too many
On May 29 2007, with the clock ticking on one of the greatest global property booms in history, Richard Fuld rolled the dice on the US real estate market one more time.
- By Henny Sender, Francesco Guerrera, Peter Thal larsen and Gary Silverman, Financial Times
- Published: 23:42 September 19, 2008
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On May 29 2007, with the clock ticking on one of the greatest global property booms in history, Richard Fuld rolled the dice on the US real estate market one more time.
The odds were not good for the chairman and chief executive of Lehman Brothers investment bank. It had been nearly a year since the US Federal Reserve brought an end to the era of cheap money with a series of interest rate increases that took its over-night lending rate from 1 per cent in June 2003 to 5.25 per cent in June 2006.
It had been more than three months since HSBC became the first big global bank to reveal multi-billion-dollar losses on subprime mortgage loans. The credit cycle was turning, as it had so many times before during Mr Fuld's four decades at Lehman, but he still felt lucky.
As a result, Lehman, a bank with a little more than $20 billion (Dh74 billion) in equity at the time, joined Tishman Speyer, a developer, and Bank of America to spend $15 billion (Dh55 billion) for Archstone-Smith Trust, a property investment company that owned a giant portfolio of apartments in "the most desirable" neighbourhoods of large US cities.
Lehman had its reasons for believing that it could still make money in US property. Blackstone, a private equity firm run by former Lehman executives Steve Schwarzman and Pete Peterson, had just stunned Wall Street by sealing a string of profitable deals to sell several upscale office towers acquired as part of its highly leveraged $36 billion (Dh132 billion) buyout of Equity Office Properties a few months previously.
'The gorilla'
The Archstone deal was also consistent with the high-risk, high-reward culture that had taken root at Lehman. With less capital than rivals such as Goldman Sachs and Morgan Stanley, Lehman was known for punching above its weight and being quicker than others to seize opportunities. Fuld, a former bond trader known to associates as "the gorilla", was the embodiment of this culture. A man of military mien known for his direct management style, he was determined, having re-established the bank's independence from American Express, to return it the pinnacle of Wall Street.
He almost got there. In the months preceding Archstone, Lehman was worth $60 billion (Dh220 billion) and was seen as one of Wall Street's best-run banks. Fuld had also showed himself very much aware of the storms gathering over the financial system. At Lehman's 2006 Christmas party visitors noted his cautious outlook for the year ahead. A month later at last year's World Economic Forum in Davos he talked openly about being "really worried" about the risks posed by property valuations, excess leverage and the rise in oil and commodity prices. "We're taking some money off the table," he said.
But while Fuld may have been aware of danger and prepared to take precautions, within Lehman, as one insider remembers, "the acquisition machine rolled on".
Archstone was a millstone for Lehman, part of a crippling $30 billion (Dh110 billion)-plus in property assets that the bank could not sell and investors could no longer tolerate. The bank's stock market capitalisation crumbled to the point where it stood at $2 billion (Dh7.4 billion) last Friday. Last week it was seeking protection from its creditors.
Yet the bet that left Lehman with a massive illiquid property portfolio was hardly out of character for a bank built in the image of its pugnacious 62-year-old chief executive. Fuld was known as a canny operator, leveraging his bank's prowess in the fixed-income markets and its small pile of capital to take big risks and earn bigger returns than larger rivals. Lehman thought of itself as the smart, scrappy underdog, not just good at spotting chances but also nimble enough to get out in time.
It was a formula that was prone to trouble. In 1998, when Wall Street executives and regulators met at the New York Federal Reserve to rescue the Long-Term Capital Management hedge fund, Lehman was allowed to chip in less money than most of its competitors, an unspoken acknowledgement that it had problems of its own.
With the Fed keeping interest rates low to stave off a recession after the terrorist attacks, Lehman grew rapidly, playing an outsized role in the securitisation market and the leveraged lending businesses, and produced quarter after quarter of record earnings from 2005 to 2007. Fuld was feted as a visionary and paid as such, with Lehman awarding him a $186 million (Dh683 million) 10-year stock award bonus in 2006, prompting criticism that the bank's board of directors had grown too cosy with their chief executive.
Leadership issues
But as Lehman grew bigger, signs of internal tensions emerged. In 2004, Fuld picked Joe Gregory, a former commercial paper trader, as president and chief operating officer, effectively his successor. Gregory personified Lehman's loyal, co-operative culture. But former colleagues say he became obsessed with the administrative processes and recruiting practices, while neglecting risk management.
They also accuse him of ratcheting up the appetite for risk and forcing out executives who disagreed. One of the Lehman bankers who urged caution, former colleagues say, was Mike Gelband, former head of fixed-income.
It could be argued that clearer-eyed commentary on Leh-man came from hedge fund managers such as David Einhorn of Greenlight Capital, who repeatedly questioned whether the bank's problems were deeper than many thought. Lehman tried to wave off such criticism but investors drove the bank's shares lower.
In June, Lehman stunned the market with a $2.8 billion (Dh10.3 billion) loss. The bank demonstrated its connections in the financial world, however, by raising $6 billion (Dh22 billion) in new capital.
But for its critics, Lehman's earnings report contained further reasons to worry. Despite the loss, it was marking its Archstone holdings at 85 cents on the dollar - far higher than bearish critics thought appropriate.
What the hedge funds did not know was that Lehman's search for new capital was going international. Before raising $6 billion (Dh22 billion) from domestic sources, Lehman had sought an investment from Korea Development Bank, a South Korean lender.
Lehman's insiders argue that KDB never tabled a formal offer and that the prolonged discussions prevented them from seeking other suitors. In their view, Lehman's downfall was so fast that Fuld had little time to look for alternatives.
Lehman did begin talks with potential buyers for all or part of its property book, including Blackstone and Colony Capital, another savvy player in the market. A week ago the bank said it planned to sell its $4 billion (Dh15 billion) UK portfolio to private equity group BlackRock - while providing 75 per cent of the financing - but found no takers for other holdings.
It also initiated talks with several parties about its asset management business - its crown jewel, including Neuberger Berman. Carlyle, a private equity firm, was willing to buy the whole thing for about $7bn (Dh26bn) and give Lehman the right to buy it back. But Lehman held out for a better deal and spurned Carlyle's offer, according to sources.
Two weeks ago, Fuld tried a different tack, saying Lehman would try to sell a 55 per cent stake in the asset management arm and spin off $30 billion (Dh110 billion) of commercial property into a separate "bad bank" structure that would enable the rest of Lehman to survive. However, his efforts were quickly viewed as a last-ditch attempt to sell the entire bank.
When Lehman's end did come, it was swift. As Hank Paulson, US Treasury secretary, and Tim Geithner, president of the New York Fed, summoned the heads of some of the world's largest banks to crisis talks, it did not take long for them to realise that Lehman was doomed.
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