Wall Street Trading Gets Zero Value From Lehman, Merrill Owners

By Yalman Onaran

Sept. 8 (Bloomberg) -- Lehman Brothers Holdings Inc. is trying to sell its fund-management unit to cover further mortgage- related writedowns. If it does, what's left won't be worth much, based on how investors value the firm.

Lehman's market capitalization of $11.2 billion is almost equal to the value of its asset-management arm, which includes Neuberger Berman Inc. That leaves its main business of trading stocks and bonds as having little worth. The numbers are similar for Merrill Lynch & Co.: Take out its retail-brokerage and asset- management businesses, and the investors' valuation of the rest of the third-biggest U.S. securities firm is zero.

After being the most profitable business on Wall Street, generating more than $65 billion in pretax profits for the four largest U.S. securities firms between 2002 and 2006, trading has become a black hole. It still accounts for about half of the revenue at the Wall Street firms. Yet Lehman Chief Executive Officer Richard Fuld and Merrill CEO John Thain have been unable to convince shareholders to attach a value to the businesses.

``We're standing at one edge of the Grand Canyon, looking at the other side,'' said Brad Hintz, an analyst at New York-based Sanford C. Bernstein & Co. and a former Lehman finance chief. ``I can see a rejuvenated fixed-income market and Lehman as one of the major players in that market at the other side, but we don't know how deep the canyon is. And we have to get through the canyon to get to the other side.''

Lehman's asset-management unit is worth about $8 billion, based on the amount of cash it manages for clients, compared with publicly traded rivals such as New York-based BlackRock Inc. or Federated Investors Inc. of Pittsburgh. That leaves less than $3.5 billion for the rest of the fourth-largest U.S. securities firm.

Writedown Concerns

Merrill's retail-brokerage division is worth about $29 billion, based on earnings multiples of comparable publicly traded brokers, while its 49 percent stake in BlackRock is worth $12 billion. That equals Merrill's market value. Morgan Stanley's retail brokerage could garner $19 billion and its asset-management business $17 billion, according to the same calculations, leaving about $10 billion for the rest of the second-biggest securities firm, including its trading business. Officials at the three New York-based firms declined to comment.

The biggest reason for the depressed valuations is concern about writedowns on the companies' mortgage holdings. Merrill, Lehman and Morgan Stanley have written down $74 billion of their holdings tied to home loans, commercial real estate and leveraged finance for companies during the past four quarters, data compiled by Bloomberg show.

`Uncertainty' Discount

Goldman Sachs Group Inc. analyst William Tanona estimates another $12 billion of losses for the three firms in the third quarter. Those probably will wipe out any trading revenue for the period.

``Uncertainty requires a discount,'' said Roger Lister, New York-based chief credit officer for financial institutions at DBRS Inc., a Canadian credit-rating company. ``Equity investors are worried about writedowns resulting in more dilution. That swamps longer-term valuations. Similarly, the credit-default swaps on these banks' debt are treated like junk.''

The losses have mostly been caused by the mortgage-related positions built while packaging loans into securities to be sold off. Merrill, the largest underwriter of collateralized debt obligations, and Lehman, No. 1 in mortgage-backed securities, ended up owning too many of the bonds themselves when investor appetite waned.

Goldman Exception

Even when the credit market returns to normal, securitization will be a much smaller business for the brokers because they will have to scrutinize inventories more to prevent similar losses, said Samuel Hayes, professor emeritus of investment banking at Harvard Business School.

``They've realized they need customers to trade with and to successfully underwrite securities,'' Hayes said.

In the second quarter, trading revenue -- adjusted to exclude writedowns -- was down 41 percent from the previous quarter and 25 percent from a year earlier for Merrill, Lehman and Morgan Stanley combined. Goldman Sachs, which has managed so far to avoid the evaporation of earnings that its peers have encountered, was the exception: Its adjusted trading revenue was little changed.

Goldman's writedowns, $3.8 billion so far, have been dwarfed by those of its three smaller rivals. Strip away Goldman's asset- management business, worth about $25 billion, and the rest of the firm, including trading, is valued at $45 billion.

Fees from trading stocks and bonds for clients declined over the past three decades as improvements in technology and access to information reduced the role of brokers.

Ten-Year Recovery

To make up for the shortfall, Wall Street firms turned to proprietary trading, or taking positions with their own capital. Though more profitable, proprietary trading is also riskier, and some of those positions blew up during the credit crisis. Most of Morgan Stanley's writedowns have come from mortgage-related assets acquired, not originated, by the firm.

``Before the 1980s, trading was the poor brother of investment banking, but then it overtook everything else,'' said Charles Geisst, author of ``100 Years on Wall Street'' and a finance professor at Manhattan College in New York. ``Wall Street has to look for other profit centers for a while, but it'll never give up trading, including prop-trading.''

Between 2002 and 2006, investment banking made up less than 20 percent of average total revenue for the four largest securities firms. Trading accounted for as much as 70 percent during some quarters before declining to about 50 percent last quarter. Geisst said it may take as long as 10 years before trading revenue numbers catch up to peak levels in 2006 and 2007.

Lack of Transparency

Lehman would be crippled more than its rivals if it sold its asset-management division, he said. While Morgan Stanley and Merrill have retail-brokerage divisions to bring in revenue, Lehman would be hard-pressed to replace the income it earns from asset management.

Investors are having a hard time valuing the rest of the business at Lehman because there's no transparency about the mortgage securities on their books, said Janet Tavakoli, author of ``Credit Derivatives & Synthetic Structures.'' Lehman, Merrill and Morgan Stanley borrowed heavily to fund their mortgage investments, which is coming back to hurt them, she said. The three investment banks' total assets were about 30 times their capital levels last year.

``When you're highly leveraged, you need to be very careful about the quality of your fixed-income assets,'' said Tavakoli, president of Chicago-based Tavakoli Structured Finance Inc. ``Even if you held Treasuries, you could lose big money when interest rates moved against you. When you take credit risk as well, which was the case with mortgage bonds, then you're really in trouble.''

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net.