Lehman Brothers: Glenda the Good Witch and the Wicked Witch of the West?

Source: Lehman Weights Split to Shed Troubling Loans, New York Times; Lehman Credit Spreads Widen Amid KDB Speculation, Reuters

Lehman Brothers, one of the U.S. banks hit hardest by the subprime mortgage crisis, is vetting a plan to split into two banks to separate its “good” from its “bad.” The strategy would put $30 billion of poorly performing commercial mortgages and commercial real estate – the “bad” part – into its own publicly traded company. The rest of Lehman’s operations – the “good” part – could continue with the help of one or more investors.

Setting off the financially troubled portion of the bank would encourage new investors in Lehman, who have been reticent to put any more money in mortgages or real estate. Splitting the bank into two would require Lehman to seek new capital investment, as one quarter of the equity would come directly from the firm, and the rest would come from debt financed by Lehman and other investors.

This is not the first time in the history of Wall Street that banks have turned to isolating poorly performing assets. In 1989, Mellon Bank created Grant Street National Bank to get rid of bad real estate loans. The spinoff bank was financed by direct equity and junk bonds. Six years later the entity was shut down when the notes were paid off before they matured. The spinoff worked for Mellon Bank; getting rid of the troubled assets improved the quality of the portfolio and of the “good” bank overall.

The plan came a few days after doubts about whether the Korean Development Bank and Japan’s UFJ Financial Group would invest in the troubled bank led to lower-than-expected projections for Lehman on Asian and European markets. These doubts fueled higher debt insurance prices for Lehman; the price to insure $10 million of debt rose from $325,000 to $345,000 per year for five years.

Questions for Discussion:
1) Will Lehman’s isolation of its “bad” from its “good” work? Will other banks follow suit? What effect will it have on the rest of the U.S. markets?
2) How will the U.S. government’s announcement that it is preparing to take over Fannie Mae and Freddie Mac impact Lehman’s plan?