Thursday, June 12, 2008 The Activist Investor: Lehman's Fuld Under Fire

by Eric Jackson
06/12/08 - 12:59 PM EDT

CFO Erin Callan has been the public face for Lehman Brothers (LEH - Cramer's Take - Stockpickr) over the past six months, trying to convince shareholders that all is well with the smallest of the big investment banks. She failed, and that's why she got sent back to the firm's Investment Banking group this morning and why COO Joseph Gregory got ousted.

CEO Richard Fuld has a sterling reputation on Wall Street, and he has seen trouble before and navigated through it. The Long-Term Capital Management imbroglio from 1998 has been often cited as the last example of Lehman fighting off predictions of its demise. Fuld was there then and is firmly in command now. However, after what he allowed to transpire, particularly between Callan and hedge-fund manager David Einhorn over the past several weeks, he needs to be put under the spotlight now.

It was only in December that investors were congratulating Lehman for side-stepping the credit crunch that had hit their competitors between the eyes. That good fortune vanished when the ball dropped in Times Square to herald in 2008. Lehman has been under fire ever since, because of a number of poor decisions which began to show themselves.

Fuld yielded the spotlight to the CFO, who only took the position last November, and that's been a mistake. You might have thought he was playing bridge with Jimmy Cayne this whole time, based on how little we've seen or heard from him.

For the Icarus-like Callan, her brief CFO stint has seen lavish media praise and now a harsh fall from grace in the most public way. Four months after her promotion to CFO, Portolio magazine called her "Wall Street's most powerful woman". (Zoe Cruz relinquished that title when she left Morgan Stanley (MS - Cramer's Take - Stockpickr) amid large losses from her group last year.) Fellow women execs from the financial world voiced support for Callan. 85 Broads, a Web site for women in the financial industry, declared Callan a "rock star" CEO who is "drop-dead gorgeous with a brain to match."

The public attention that comes with the label of "most powerful woman on Wall Street" is a double-edged sword; ask Cruz or Citi's (C - Cramer's Take - Stockpickr) Sallie Krawcheck, who also was moved out of the CFO post at that firm. The press often praises women on the way up with glossy profiles, only to pounce immediately when trouble comes.

Callan's big undoing in these last six months has been her penchant for bravado-laden predictions, which she has had to continually back-track.

Here's a recap:

Earlier this year, Lehman bought up $2 billion in Alt-A loans (i.e., riskier mortgages). "We saw a great opportunity," said Callan in March. The current quarter has had more than $2.8 billion in losses of these loan types.

In January, she predicted that Lehman's return on equity would average in the mid- to high-teens this year. It's around 9%.

In February, Lehman raised $1.9 billion. Callan said at the time that it "took care of our full year needs." In late March, it raised an additional $4 billion and then another $6 billion earlier this week.

Additionally, for several days in March, many worried that Lehman was the next Bear Stearns, further adding to the market's turmoil. Its stock price plummeted from $45.99 on March 13 to $31.75 on March 17, the day before the release of its first-quarter earnings.

After Lehman exceeded expectations with those results, its stock snapped back 46% and the Callan swagger returned. She walked down to the trading desk following the call and, according to The Wall Street Journal, "high-fived" her colleagues. It seemed as though the storm clouds would pass.

The Einhorn Factor

David Einhorn, founder of the $6 billion Greenlight Capital, became Callan's nemesis.
Einhorn is the anti-Callan. He hasn't been perfect in his calls (being on the board of New Century, which was one of subprime's first big casualties), but he knows how to make money with average annual net returns of 25% since 1996. Einhorn puts substance before style.

Einhorn began questioning Lehman three weeks ago, after Greenlight's analysis showed that the firm had booked an unusually large number of unrealized gains in the first quarter -- 10 times the average from previous quarters -- which marked up equity positions that were not publicly traded.

Activist investing is typically practiced by long-only hedge funds. They use their "ownership" in the company as justification for calling for improvements that will increase shareholder value. Although companies can respond by trying to paint such investors as "short-termists," it's hard to disparage a fellow owner of the company. Activists will typically encourage the company to take actions meant to benefit all stock holders (including management).

With his Lehman investment, Einhorn might have created a template for a new type of activist investor: the activist shorter. Einhorn made his case for why Lehman would drop through a series of speeches and media appearances. With a good argument and his own track record as credibility, people listened.

Shorts are unfairly vilified in the press for not being true owners and for wanting to drive down the stock. Yet, as Einhorn and another prominent shorter, contributor Doug Kass, have pointed out: Are management, stock analysts or stockholders of a company who talk up a stock not guilty of the same bias that a short has when talking down a stock?

All long and short holders of stock deserve to make money if they can articulate a point of view before the fact and see it borne out. Einhorn simply had a better argument than Callan and the market sided with him. Lehman's stock dropped 16% between the time when Einhorn first made his public remarks on the bank's problems on May 22 and last Friday.

Lehman Shows Its Hand

Callan was forced into damage control. She immediately questioned Einhorn's credibility, reminding investors that he was a short-seller. "Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm's financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain," said Lehman in a statement.

Yet, days later, by its actions, Lehman demonstrated that it was in exactly the position Einhorn said it was. On Monday, Lehman raised $6 billion -- higher than what market observers expected. The stock has dropped another 17% this week and is down 64% year to date.

Said Einhorn succinctly, "They just raised $6 billion that they said they didn't need to cover losses they said they didn't have."

Who was picking cherries?

Market observers didn't necessarily blame Callan for Lehman's poor investment decisions, but she lost all credibility for her serial back-tracking.

Callan still didn't lack confidence in announcing the capital raise on Monday, sold at 20% off the firm's book value. She jawboned, saying: "The discussions at this point aren't about our viability or the fact that we will be here or the fact that we have sufficient liquidity. I think we put that to bed on a number of different levels through our own actions."

Her words simply did not match up to the reality Lehman is facing and that's why she deserved to be removed. She committed the cardinal sin of overpromising and under-delivering -- repeatedly. Einhorn, by contrast, has walked softly and carried big returns for his investors.

Yet, neither Callan nor Gregory is completely responsible for the mess Lehman finds itself in. Where was Dick Fuld?

Why Should Fuld Get a Pass?

It's inconceivable that if such problems were facing Citi or Goldman (GS - Cramer's Take - Stockpickr) that Vikram Pandit or Lloyd Blankfein wouldn't be held to account. Why have analysts, investors and the press given Fuld a pass? Callan alone didn't sign off on those Alt-A loans earlier this year.

Dick Fuld clearly needs to step out of the shadows and demonstrate there is a path forward that Lehman investors can believe in. Most expect that Lehman will have to sell itself in whole or part in the coming months.

Fuld's greatest asset through this mess has been his mystique that he's been here before and can help the firm get through this again. You don't lead through abstention though.

Lehman shareholders need Fuld to step up -- or sell out.

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