Lehman: Following Good Bank/Bad Bank to Redemption

Lehman Brothers recently announced that they are taking a Good Bank/Bad Bank approach to tens of billions of dollars of illiquid real estate assets, hiving them off from the rest of the firm. Nice to see someone is listening. As previously discussed, I firmly believe that segregating toxic, hard-to-value assets from the rest of bank balance sheets is the only way true healing can take place and additional investment can be secured. Here is what I said about the benefits of such an approach a month ago:

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital.

Otherwise, investors will continue to be surprised and disappointed, much like those SWFs that have spent billions by investing in the equity of Citigroup, Merrill, Lehman and others, well before their balance sheets had the transparency and simplicity necessary for making an investment with a Graham & Dodd "margin of safety." Who knows what cheap really is in the absence of objective, verifiable data? This is the basis on which many purportedly "smart" investors have been deploying capital, much to curiousity of people like me. Sure, they say "We take a long-term view." Well, I'd rather take a long-term view by establishing a basis 50% lower than those at which they invested. But that's water under the bridge at this point.

From today's Wall Street Journal:

For the real-estate assets, Lehman has set up a so-called good bank/bad bank structure. Such a deal is likely to involve a spinoff of the holdings to shareholders as well as an investment by outside investors.

Details of the plan weren't clear. One option may be a "sponsored spin." That would involve bundling some of the troubled assets into a new entity, which would then be spun off to Lehman holders on a tax-free basis. Also, a new investor or group of investors could take a big minority stake in the new company, thus "sponsoring" it.

Lehman, according to one person close to the deal, is expected to provide at least some financing. Lehman was sitting on $40 billion in commercial real estate at the end of the last fiscal quarter and another $24.9 billion in residential assets.

If Lehman goes with this plan, it will differ from the one Merrill Lynch & Co. opted for in August when it sold more than $30 billion in toxic mortgage-related assets at just 22 cents a dollar. That deal was done with just one buyer: private-equity firm Lone Star Funds but Merrill provided financing.

The WSJ piece does a god job highlighting the differences between the Lehman plan and the Merrill deal, one for which I had much less enthusiasm than I do the Lehman structure. The degree to which Merrill retains recourse due to the seller financing it provided to the single buyer, Lone Star Funds, together with the uncertainty around how much of its distressed real estate assets were actually represented by the assets "sold" makes its strategy akin to putting a band-aid on a deep wound. Is the Merrill transaction a "true sale," either in substance or in form? They are definitely walking a fine line, but analysts must sharply discount how much risk has truly been transferred when arriving at the true economic effect of the transaction. The Lehman deal seemingly has far less ambiguity. Theirs might become the true bellwether of how banks should deal with troubled asset portfolios. If Lehman is able to sell a meaningful percentage of its asset management business, and is successfully able to raise capital in order to jettison its $60 billion+ real estate portfolio, it will be well on its way to surviving what many felt has been a losing battle. Say what you may about Dick Fuld and his aggressive expansion into some dicey asset classes late in the game, but his toughness and focus in dealing with Lehman's problems lays in stark contrast to the denial and delay of Bear Stearn's management in handling their brush (and eventual capitulation) with death.

Lehman may just make it, and if they do it will be because of a smart, aggressive approach to risk reduction, the centerpiece of which is the Good Bank/Bad Bank asset transfer. I would posit that their approach to balance sheet repair (read: survival) will be replicated many times by many firms over the next 24 months, unlike the finger-in-the-dike strategy favored by their friends over at Merrill Lynch. It is hard to do the right thing, to take drastic measures in the face of crisis. But sometimes, it is the only path to survival.

On the Unfair Treatment of Certain Common Equity Holders

Events of the past several months have been very disconcerting, particularly as it relates to the risks and rewards conveyed to common equity holders. It has become evident that due to political pressures, separate and apart from plain economics and market forces, that the returns to certain common equity holders have been subsidized to the detriment of other investors competing in an ostensibly free market. Further, many in the media and among the general public have viewed the sharp drops in certain issues to be "unfair" and due to "mismanagement" and "ganging up" by mean-spirited, money-hungry investors (read: hedge funds). In sum, the U.S. Government and its charges have willingly skewed free-market forces in the name of protecting the broader market. The problem is, the U.S. Government as well as many others are mixing up dampening systemic risk with protecting the interests of common stockholders. By mis-interpreting the essence of what it means to be a common stockholder, policy-makers run the risk of creating a set of problems far larger than those they are seemingly protecting against.

Investing in common stocks, particularly those of financial institutions, is akin to holding the "z-bond" - the residual - of a pool of mortgage-backed securities. It is a massively leveraged interest, one that rides extremely high when things go well and falls precipitously when things go poorly. This leverage is even more than what is appears on the balance sheet, where 30:1 is not an uncommon ratio of assets to equity, due to the prevalence of derivatives and other off-balance sheet exposures. Investors in such shares should know these facts, and understand the risks they are bearing. I didn't hear anybody complaining or read any stories about disgruntled investors when shares of BSC (Bear Stearns), FNM (Fannie Mae) and FRE (Freddie Mac) were top-ticking in the wake of low interest rates, calm markets and rising real estate prices. But when conditions turned, liquidity dried up and counterparties got scared, managements and investors started crying foul. Negative press. Coordinated short-selling by hedge funds. But why? Because losing money feels really, really bad. But this is part and parcel of being a common equity holder. An investor could have bought senior securities. They could have reduced risk by selling calls. They could have pared down their long positions when things started to sour. But all this is forgotten in the shell-shock of a rapidly falling share price. Deer in the headlights. Can't. Move. Can't. Sell. But sure can complain. And managements could have done a far better job financing their books. Liquidity cures a world of ills; it also lets you play another day. But by the time money is scarce and the price is dear, it is already too late. Bear Stearns found this out. But if you live in a highly leveraged world and don't provide for a rainy day, the inevitable downpour will wash you out. But in Bear Stearn's shareholder's case, they got precisely $10 per share too much for their common. They should have gotten zero. And that window dressing supported by the Fed and agreed to by JP Morgan sent the wrong message.

And the situation with Fannie Mae and Freddie Mac is even worse. Far worse. And might get much, much worse. In this case not only should common shareholders get zero, but certain subordinated investors might also deserve zero. But again, the U.S. Government has and will continue to pull strings to ensure that this doesn't come to pass. Why? Politics and other non-market oriented reasons. We, the U.S. taxpayer, will end up subsidizing these common stockholders and subordinated investors, and to what end? It will only further embolden managements of large institutions, thought of as "too big to fail," to take imprudent risks and swing for the fences. Because if things work out management and common stockholders get handsomely paid. And if they don't, management simply loses their jobs while common stock investors get some undeserved residual interest in the enterprise.

I don't fault our Government leaders from trying to ward off a massive systemic meltdown by providing credit to ensure the orderly disposition of obligations and maintenance of a functioning credit market. But no such obligation is owed to common equity holders. And every time policy-makers elect to bail out their interests, it lays the foundation for an even greater disaster down the road.

Back to the Future: Are Banks Getting Religion?

Credit pricing and appetite based upon the market's gauge of a bank's cost of capital? Numerous examples of firms' moving away from the "universal bank" model towards one that is better focused and more streamlined? Suffice it to say, these are basic building blocks of sounds financial management and business strategy, yet have not been the hallmarks of most financial institutions' decision-making over the past 20 years. Get big. Build market share. "Diversify" by adding seemingly uncorrelated business lines, yet somehow extract synergies by having all these capabilities under one roof? What a joke. The detritus left in the wake of these poor decisions is not very funny, however.

Pricing Loans Based on a Firm's Cost of Capital? Duh.

This is simply not revolutionary, my friends. In theory, and now in practice, you need to be able to mark your books to market. Banks using the credit derivatives market as a vehicle for pricing and risk managing loan portfolios is not new. I can't tell you how many times, when either looking at large credit-bearing derivatives trades or friends in leveraged finance evaluating large underwriting positions, have tapped the credit derivatives market either for outright credit protection or for a benchmark of how much spread to build into a transaction. This from Sunday's Financial Times:

Morgan Stanley and Goldman Sachs are responding to the credit crisis with systems that use the market's view of their own creditworthiness as a basis for lending decisions, according to people familiar with the matter.

********************

Morgan Stanley is essentially tying its promise to provide financing to hedge fund clients to the prices of credit insurance on its own debt. If the cost of the protection rises to a certain level, that would trigger a reduction in Morgan Stanley commitments to hedge funds. Goldman Sachs is understood to have a similar arrangement that uses its bond prices as a reference point for credit commitments to hedge fund clients.

This is simply common sense. If this really didn't happen before, well, it's about time. Its not as if you can easily buy credit protection on a hedge fund that has not publicly listed securities. Further, the value of internal capital is so high in this uncertain environment that banks need to spend it wisely, and only at times when exporting it (via client default risk) is more valuable than retaining it (to avert firm default risk). Bottom line, this is a straight-forward and common-sensical concept. If this is news to senior bank management and/or risk managers, the out to be shown the door. Immediately.

All Things to All People? It Didn't Work for Sears, So Why Should it Work for Banks?

The "universal bank" craze was crazy from the get-go. There was a time when conglomerates were all the rage - ITT, Gulf & Western, and so many others. This was the 1960s. Expert centralized management and financing creating synergies for myriad operating companies, regardless of synergies among them. "Give us your money, and we'll diversify it for you" was the mantra. This is NOT Berkshire Hathaway, either. Warren buys companies that meet his criteria for shareholder value creation. Period. No synergies expected. With very few exceptions, the conglomerate model has been proven to be a failure. Do what you're best at, do it exceptionally well, and win in the marketplace. Let investors diversify themselves; they can do it much better than you can, anyway. Yet this is not the approach taken by many of the financial institutions across the globe. Give them personal and mortgage loans. Give them credit cards. Give them investment products. Advise their companies. Finance their companies. Insure their companies. And on and on. Firms that started to look more like governments than private enterprises. And if we know anything about government, enterprises that spread themselves too thinly ultimately do badly at pretty much everything. And this is what we've seen over the past several years.

Good times mask a lot of problems. Bad times, well, we're seeing that right now. Correlations go up. The benefits of diversification are illusory. All you see is a mismanaged pile of assets, the problems of which are of stratospheric proportions due to the sheer size of the enterprises in question. American Express Shearson Lehman Hutton. Anyone remember them? Citicorp Travelers Salomon Smith Barney? Another winner. Sears Dean Witter? A beauty. UBS Swiss Bank O'Connor Brinson Warburg Dillon Read? Oh, baby. The list goes on and on. Value creation? When a rising tide is lifting all boats, sure. In times of distress. Forget about it.

Anyway, hopefully some of these "forward-thinking" firms will get back to basics. Because I don't think the global financial system can take any more expressions of growth-at-all-costs machismo. It's really about growing and protecting shareholder value. Really.

Valleywag, Monitor110 and Telling it Straight

Few things irk me more than shoddy journalism, lousy research and bad intentions, and these three neatly came together in a piece by Nicholas Carlson published today in Valleywag. The thesis: Monitor110 wasn't brought down by the issues I raised in my post-mortem, but because our lead VC failed to live up to a financing commitment. This was the story-line Mr. Carlson was hell-bent on writing about, and that he did. He reached out to me, people that know me and people that might know me concerning the lead he had gotten from somebody, and received a "no comment" from everyone I know that he touched. Somehow my "no comment" was twisted into a "he did not deny (the "facts" of his article)." Nice inference, Nick. But that didn't stop him. A paucity of facts and understanding of the situation together with a total lack of knowledge of early-stage operations made for a most forgettable article. But I can't forget it. Because words have power, even in the tabloids, be they off-line or online in nature. And using that power irresponsibly pisses me off.

Here is a total cut-and-paste of the article that ran today:

Why did investor-news aggregator Monitor110 go under, taking $20 million in funding with it? Read early investor Roger Ehrenberg's surprisingly humble and informative blog post about the ordeal, titled "Monitor110: A Post Mortem," and it sounds like the startup fell prey to the usual pratfalls — too much PR, weak leadership, and a confused product vision. Probably all that's true. But what's also true, a source tells us, is that Monitor110's own investors, specifically Draper Fisher Jurvetson, which invested most of that $20 million, ensured Monitor110's failure during its final months.

A source familiar with the venture capitalists tell us that after Monitor110's last funding round, the company began to burn through cash faster than expected. Fortunately for Monitor110 CEO Brennan Carley, the company's primary investors at DFJ were very understanding. They promised — "truly promised," our source tells us — Monitor110 a bridge loan to get the startup through until its next funding round. Monitor110 went ahead and spent the money, "with DFW's "assurance the bridge was coming," our source says. But it never came.

Instead, DFJ killed the bridge loan and — as is being reported today — funded Monitor110's direct competitor Skygrid instead, leaving Monitor110's other investors, like Ehrenberg, with nothing better to do than write humble postmortems. Ehrenberg, reached for comments, did not deny any of the particulars of this story.

The real lesson of Monitor110, then, is this: Never trust a venture capitalist. Why isn't Ehrenberg telling us this story? He wouldn't say, but the most likely explanation is that he knows he might do business with Draper Fisher Jurvetson again, and he doesn't want to be blackballed. Far easier to play the humble martyr, and gain popularity by licking his wounds and sharing anodyne lessons learned.

Here are the real facts:

• Monitor110 was burning cash more quickly than expected, not due to cost overruns but due to revenues falling short of projections.

• We did have a disagreement with our VCs about a bridge. The contingencies they thought were baked into the commitment were different than those we perceived. Did this suck? Yes, it certainly did from management's side of things. But did it cause Monitor110's ultimate demise? No. Poor execution did. And I'm not sure simply adding more capital would have enabled us to grow out of our deeply-seated problems.

• If the company had generated revenues within spitting distance of our revised projections, the issue of a misunderstanding concerning the bridge would have been moot because our VCs would have gladly come up with the money required. They're not stupid; they invested to make money, not drop millions on a neat idea that couldn't be successfully commercialized.

• The new CEO, Brennan Carley, came into a very difficult situation and played the hand he was dealt the best he could. His was the role of rationalizing the business, increasing efficiency and reducing costs in order to provide some extra runway for achievement of revenue milestones. He did a great job; it was just too little, too late.

• Skygrid is a fine company and Kevin Pomplun is a smart young guy doing some interesting stuff. I have sought to provide him input and counsel as a member of the same community, facing similar challenges and possessing similar interests over the past 18 months. I hope he has better results than we did, and I trust my input has and will be helpful in this regard. I begrudge both him and his investors nothing and wish them only success.

• I don't need DFJ to do my next deal or any other deal and the issue of being "blackballed" is beyond a red herring. It's moronic. I have money. I have access to lots of money. I have access to plenty of non-VC money. If someone (such as myself or any of those at Monitor110 with whom I've worked) is smart, ethical and acts with honesty and integrity then the "blackballing" of which Mr. Carlson speaks is a non-issue.

• I am not "playing" the role of martyr or anything else, and the popularity issue is almost hilarious. Nobody was more shocked than me at the response to my earlier post. The fact that many found it helpful was terrific, surprising and fulfilling. And if Mr. Carlson had ever read my blog, he'd know that the post-mortem was completely in-character and consistent with both the intent and ethos of my writing over the past two years.

• I am an angel investor with a portfolio of 25 investments, several of which are undeniably successful, some of which have achieved successful exits, and precisely one of which was a total write-off: Monitor110. Am I really licking my wounds, Nick? Is that really what I'm doing?

Why should I care what a muckraking reporter wants to print? Because words have power. And with that power comes responsibility, at least as far as I'm concerned. Mr. Carlson chose a single issue in a much larger, more complicated situation as a vehicle for both damning our VCs and implying that my post-mortem was something less than ingenuous. It's writing like this that gives Internet journalism a bad name. Issues of reputation and relevance are paramount in separating the good from the crap (and this is an area I know pretty well), and it's hard enough separating the good from the really good than having to deal with the lousy masquerading as good. My post will do absolutely nothing to stop the tabloid-style journalism that seems so popular today, but if you are shooting for lots of clicks then at least get the facts straight, ok? And if you lack the facts may I suggest a three-step process: stop; breathe; and think. Either get more facts or don't write the story. This is what real journalists do.