Special Situation: Lehman Subprime Unit Shutdown

Yves Smith of Naked Capitalism submits:

The securities industry is highly cyclical, and like the markets they trade in, Wall Street firms are prone to overshoot and undershoot. Executives cut too deeply in downturns, resolve not to repeat that mistake when they rebuild staffs in recoveries, keep hiring even when markets look overheated, and then repeat.

To illustrate how extreme swings are: after the bloody 1991-1992 recession, most major Wall Street firms were convinced M&A would never come back in a serious way and disbanded their M&A departments, folding the few professionals they retained into their financing units.

Yesterday, Lehman Brothers announced that it was exiting subprime mortgage origination. Note that subprime origination (aka mortgage brokerage) is hardly a core business for the Street. Most firms entered recently, backward integrating to capture extra profits. Thus, predictably, the Wall Street Journal indicates that other firms are likely to withdraw:

Wall Street firms, which had raced to buy mortgage originators to feed their lucrative business of packaging the loans as securities, marked a retreat from that tattered field yesterday when Lehman Brothers Holdings Inc. said it will close its unit that lent to riskier borrowers....

"I don't think we're going to see much of a Wall Street presence going forward" in originating home mortgages, said Tom LaMalfa, a managing director at Wholesale Access, a mortgage-research firm in Columbia, Md. Mr. LaMalfa said while he expects Wall Street firms to focus on their traditional roles in packaging and trading mortgage securities, those businesses will be smaller as lenders retain more of their loans as long-term investments or sell them to government-sponsored investors Freddie Mac and Fannie Mae.

While it's a no-brainer to say that it doesn't make sense to be in a business when there is no business to be done, it's unlikely other firms will follow Lehman's move and shut down their businesses. BreakingViews (free subscription required) tells us their cost of exit will be much higher:

Lehman Brothers' rivals became ardent imitators of its integrated mortgage business....But they might not be so keen to follow the Wall Street firm's lead in shuttering their subprime lending units. Lehman had the advantage of getting in early, and cheaply, at the start of the decade. So it's not costing too much to throw in the towel.

Shutting its BNC mortgage unit will cost Lehman $52m after tax - just over half of which is a goodwill write-down....

Compare that to the sums others handed over last year to cement their foray into mortgage lending. Deutsche Bank forked over some $500m for two platforms, while Fortress's duo came to almost $700m. Merrill Lynch splashed out $1.3bn for First Franklin. And ResCap accounted for roughly half the lending book in GMAC, which Cerberus took a majority stake in for $7.4bn.

These businesses are suffering the same problems as BNC: loan volume has plummeted, profitability has disappeared, and the secondary market has evaporated. But because of the whopping price tags, shuttering them would be painful. The $860m charge Capital One is paying to fold its mortgage business is a much better indication of what Wall Street's jonny-come-latelys would have to fork over. That could be more than enough to stay their hand - at least until after bonus season.

Whether other players formally close the businesses, or keep them in a zombie state to avoid painful writedowns, will be a case-by-case decision. However, Merrill Lynch, Deutsche Bank, Barclays, and Morgan Stanley all took advantage of the subprime distress to acquire mortgage companies, hoping to make headway on Bear Stearns as the leader in the subprime origination. That now looks tantamount to catching a falling safe. Moreover, those acquisitions were so recent that it would be particularly embarrassing to close them down now.

Indeed, Bloomberg reported that

Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal was willing to lose $230 million to catch Bear Stearns Cos. and the shakeout is just beginning.

Looks like he got what he wanted and then some.

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