State of independence

What a difference a few years can make. In late 1998, Richard Fuld, chairman and chief executive officer of Lehman Brothers Holdings, was forced to personally call on his firm’s lenders and counterparties to assure them that Lehman was not about to file for bankruptcy. The Wall Street rumour mill had circulated exaggerated estimates of Lehman’s exposure to Long-Term Capital Management and the emerging markets, causing its stock to plummet.


Two and a half years later, the firm not only remains independent but it is, by most measures, thriving. Its return on equity – which once languished in the high single-digits – is now the industry’s second-highest. Its revenue growth rate averaged 26% between 1997 and 2000, second only to Goldman Sachs. And, while many firms are faced with the prospect of cutting staff due to the markets’ downturn and the ballooning compensation costs in recent years, Lehman has just announced plans to expand its head count by 10% this year.

Lehman officials say the firm does not covet the market volumes that many of its competitors have achieved through mergers. But the question of whether bigger is better is central to the firm’s fortunes. Lehman officials argue that the firm uses capital more efficiently than many of its larger competitors, and that the confusion that inevitably follows a merger gives it an advantage in recruiting and business development. For example, Lehman hired three interest rate marketers and an options trader in February, and a synthetic collateralised debt obligation (CDO) trader last month, all from JP Morgan Chase.

Ken Umezaki, co-head of global high-grade credit trading at Lehman in New York, says he welcomes mergers among his competitors, since these usually set the merged entity back months or more in forming and executing an effective business plan. “It doesn’t scare me that these guys are merging, in fact it’s a good thing – their eyes are off the ball,” he says.

Lehman is certainly no minnow. Although, in the cash bond markets, it remains outside the “super-bulge” bracket, it placed ninth in Thomson Financial Securities Data’s 2000 international bond book-runner league table, with 5.15% market share. (Merrill Lynch, holding the top slot in that table, had a 10.59% share.)
Lehman’s over-the-counter derivatives businesses have all grown in the past several years, but the firm is not yet showing up regularly in Risk’s global derivatives rankings. These, admittedly, only rank the top three banks in each category, and have recently been dominated by firms with both large structured and high-turnover vanilla businesses. Lehman did appear in two categories of the last rankings, published in September. It was the number-one dealer in US dollar repurchase agreements and tied for second place in sterling repos with UBS Warburg.

Kaushik Amin, global co-head of interest rate products in New York, says Lehman has more than doubled the head count in its interest rate derivatives department in the past two years. While he admits that reliable estimates of market share in the OTC market are hard to find, Amin estimates Lehman’s share of the interest rate product market at 6% globally and 8% in the US. “We’ve always had good market share in fixed-income, and now our derivatives market share is catching up,” he says.

Lehman has also moved in the past year to integrate its cash and derivatives businesses. In recent months, it formalised this move in the interest rate business by putting governments, agencies and derivatives under one group, run by Amin in New York and his co-head, Andy Morton in London.

The structured credit trading group, which handles credit derivatives and CDOs, is also aligned with Lehman’s cash credit business. Like its interest rate counterpart, Lehman’s credit derivative business has grown substantially in the past two years, according to the firm’s counterparties. One US protection seller that specialises in investment-grade single-name default swaps said he has seen Lehman’s market-making activities double in that sector of the market in the past 12 months. Umezaki says that, in the firm’s fixed-income business, credit derivatives contribute about a third of the revenues of the non-mortgage credit business.
Umezaki says that while the firm has seen significant growth, it is not chasing volume. “We’re not going forward with the sole objective of being a top-three market maker. We view the credit derivative product line as a part of the overall portfolio of credit products,” he says. “We want to marry what our clients want with the market and products.” The firm has 40 bankers in structured credit trading globally, and another 50 in CDO origination.

Umezaki says that roughly 70% of the firm’s business is client-driven and 30% is done on the back of that flow. “It just happens to be that the market has grown dramatically over the last two years, so it should be expected that our volumes have also grown,” he says.

Lehman’s equity derivatives business, like those of its competitors, has also done well recently, benefiting from the high levels of market volatility in the past 12 months. “Like several other firms, last year equity derivatives was a big winner for Lehman,” says Peter Nerby, vice-president and senior credit officer for financial institutions at Moody’s Investors Service in New York.

The growth of Lehman’s derivatives businesses comes at a time when there is growing shareholder, regulator and counterparty scrutiny of investment banks’ off-balance-sheet activities. But Lehman’s risk management department, run by Maureen Miskovic, gets high marks for both keeping the firm out of trouble and providing tools for efficient capital allocation.