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.
——-
——-
COMMENT:
AUTHOR: Ross
EMAIL: ross.greenspan@gmail.com
URL:
DATE: 08/31/2008 11:58:05 AM
On a company basis, who stands to benefit the most from these types of reorganizations? Will the spin-offs be attractively valued for existing shareholders? What kind of incentives will outside minority investors get to invest?
Also, won’t the bad banks have to be extremely well (over) capitalized to protect against future write downs, thus offering a lousy comparative return?
And finally, do you think Lehman eventually intends to re-absorb the “bad bank” into the “good bank?”
——-
COMMENT:
AUTHOR: Roger
EMAIL: roger@informationarbitrage.com
URL: http://www.informationarbitrage.com
DATE: 08/31/2008 10:26:04 PM
Ross, I think all shareholders stand to benefit from this reorganization. I firmly believe that assets of entire firms are being widely mis-priced due to lack of transparency and uncertainty around how certain assets (read: mortgage-related) will impair the value of the whole.
“Bad banks” will have to be capitalized based upon what the market will bear, which either means lots of capital to cushion write-downs or more thinly capitalized if substantial write-downs are taken at the time of transfer. In either case the return will be the same - it is simply an issue of pay-me-now or pay-me-later. The market is pretty efficient in this regard.
Will Lehman re-absorb spun-out assets? I doubt it. I don’t see a compelling strategic case for doing so, and once they go through the pain and suffering of such a reorganization I believe they’ll spiritually move on and focus on businesses with more attractive risk/return characteristics closer to their core competency.
Thanks for commenting.
——-
COMMENT:
AUTHOR: john beck
EMAIL: sunny00006@hotmail.com
DATE: 12/26/2008 01:24:20 AM
ross i am here with the same question On a company basis, who stands to benefit the most from these types of reorganizations? Will the spin-offs be attractively valued for existing shareholders? What kind of incentives will outside minority investors get to invest?
——-
————
2 years ago
| view comments
| Wall Street
