When the founding fathers declared our independence, they could not have imagined that, 232 years later, the United States would be so spectacularly dependent on foreign countries. It would be roughly eight more decades before oil gushed from a well in Titusville, Pa., marking the beginning of the global oil economy; it took eight decades more for the United States to become a net oil importer. But the republic's disastrous dependence on foreign oil has increased by leaps and bounds ever since.
In 1973, when OPEC imposed its oil embargo, U.S. oil imports composed 30 percent of our needs; today, they make up more than 60 percent, with a growing proportion of that crude coming from the world's least stable regions. At around $145 a barrel, the United States, by my calculations, will spend more on imported oil this year than it will spend on its own defense budget, and much of that money will flow into the coffers of those who wish us ill.
Since oil dependence is so unappealing, you'd think that energy independence would be an easy sell, especially on this Fourth of July weekend. But in fact, very few policy ideas have been so ridiculed. A 2007 report by the National Petroleum Council, a privately funded group that offers advice from the oil and gas industries to the federal government, calls energy independence "unrealistic"; a recent book, "Gusher of Lies," by Robert Bryce, a former fellow at a think tank funded in part by energy interests, described energy independence as a "dangerous delusion"; and a 2006 Council on Foreign Relations task force went so far as to accuse those promoting energy independence of "doing the nation a disservice by focusing on a goal that is unachievable over the foreseeable future."
Ignore them. Energy independence does not mean that the United States must be entirely self-sufficient. It simply means reducing the role of oil in world politics -- turning it from a strategic commodity into merely another thing to sell.
Is energy independence a pipe dream? Hardly. In the electricity sector, the mission has already been accomplished. Remember President Jimmy Carter in his cardigan during the oil crises of the 1970s, urging Americans to save electricity? It took us just one decade to wean the electricity sector from oil. Today, only 2 percent of U.S. electricity comes from oil, according to the Energy Department. Could we do something similar with transportation, where American cars and trucks still gulp oil-based fuel greedily? At least four very different countries -- dictatorships and democracies alike -- are already making serious headway toward that goal. It's past time to pay attention to their example.
The first country, surprisingly enough, is Iran. The Islamic republic has lots of crude but little capacity to refine it, leaving Tehran heavily dependent on gasoline imports. The country's blustery president, Mahmoud Ahmadinejad, is fully aware that this is Iran's Achilles' heel and worries that a comprehensive gasoline embargo could cause enough social unrest to undermine his regime.
So Ahmadinejad has launched an energy-independence program designed to shift Iran's transportation system from gasoline to natural gas, which Iran has plenty of. "If we can change our automobiles' fuel from gasoline to [natural] gas during the next three-four years," he said last July, "we won't need gasoline anymore." His plan includes a mandate for domestic automakers to make "dual-fuel" cars that can run on both gasoline and natural gas, a crash program to convert used vehicles to run on natural gas and a program to convert Iranian gas stations to serve both kinds of fuel. According to the International Association of Natural Gas Vehicles, more than 100 conversion centers have been built throughout the country: Iranians can drive in with their gasoline-only cars, pay a subsidized fee equivalent to $50 and collect their newly dual-fuelled cars several hours later. Ahmadinejad's plan, which has been largely ignored by the West, means that within five years or so, Iran could be virtually immune to international sanctions.
While Iran is moving quickly toward energy independence, Brazil is already there. It's a striking turnaround; three decades ago, the country imported 80 percent of its oil supply. But since the 1973 Arab oil embargo, the Brazilians have invested massively in their sugar-based ethanol industry and created a fleet of vehicles that can run on the resulting fuel. According to the Sugar Cane Industry Union (Unica), 90 percent of the new cars sold this year in Brazil will be flexible-fuel vehicles that cost an extra $100 to make but can run on any combination of gasoline and ethanol.
Lest anyone think that can't be done in the United States, many of those new cars are made by General Motors and Ford. All it really takes to turn a regular car into a flex-fuel one is a fuel sensor and a corrosion-resistant fuel line.
Discovering how to make hydrocarbons and carbohydrates happily cohabit in the same fuel tank isn't all that Brazil has done; it has also increased domestic oil production. Its efforts have not only broken the yoke of Brazil's oil dependence but also insulated the country's economy from the pain of the current spike in global oil prices. Gasoline prices have nearly doubled elsewhere since 2005, but in Brazil, they have been almost frozen. This year, more ethanol will be sold in Brazil than gasoline. Sounds pretty good, doesn't it?
Like Brazil, China has decided to replace gasoline with alternative fuels. But unlike the United States and Brazil, where the favorite substitute is ethanol, China has embraced a different alcohol: methanol. Several provinces in China already blend their gasoline with methanol, a clear, colorless liquid also known as wood alcohol, and scores of methanol plants are currently under construction there. The Chinese auto industry has already begun to produce flex-fuel models that can run on methanol. Shanxi, a province in central China that produces much of the country's coal, has even issued stickers granting cars that use pure methanol free passage on the province's toll roads.
The distinction between methanol and ethanol is just one letter (but then, so is the difference between Iran and Iraq). Both biofuels should be in our basket of options. True, ethanol packs more energy per gallon and is less corrosive than methanol. But methanol is cheaper and far easier to produce in bulk. While ethanol can be made only from agricultural products such as corn and sugar cane, methanol can be made from natural gas, coal, industrial garbage and even recycled carbon dioxide captured from power stations' smokestacks -- an elegant way to reduce greenhouse gas emissions.
Israel offers a fourth testament to what leadership, ingenuity and audacity can achieve. Last year, it launched an electric-car venture designed to turn Israel -- which obviously has some tensions with the region's big oil producers -- into an oil-free economy. Israelis will soon be able to replace their gasoline-fueled cars with battery-operated ones, which they'll plug into the hundreds of thousands of recharging points planned to be erected throughout the country. Israeli motorists, the government hopes, will be able to swap their batteries in a matter of minutes at dedicated stations or recharge them at home or at work. "Oil is the greatest problem of all time -- the great polluter and promoter of terror," said Israeli President Shimon Peres, the project's political patron. "We should get rid of it."
For each of the four countries, knocking oil off its pedestal is no longer a theoretical proposition but a reality in the making. But despite the lip service our own politicians pay to the need to reduce our oil dependence, none of the solutions offered by Iran, Brazil, China and Israel are even under consideration in the land of the free and the home of the brave.
Just go down the list. Natural-gas vehicles are nowhere to be seen. Brazilian sugar-cane ethanol is barred from the country by a steep 54-cent-per-gallon import tariff, courtesy of ethanol protectionists and their representatives in Congress. (No tariff is imposed on imported oil, of course.) For similar reasons, flex-fuel cars sold in the United States are certified to run only on ethanol, keeping methanol and other viable biofuels off the market -- even though they are cheaper and can be made from a wealth of coal and biomass resources. The kind of electric cars deployed in Israel have never returned to U.S. showrooms since General Motors' mass crushing of its EV1 -- the subject of the documentary "Who Killed the Electric Car?"
It's time to get serious. Policies such as "drill more" and "drive smaller cars" all keep us running on petroleum. At best, they buy us a few more years of complacency, while ensuring a much worse dependence down the road when America's conventional oil reserves are even more depleted -- whether or not we drill in the Arctic National Wildlife Refuge.
The hard truth is that real energy independence can be achieved only through fuel choice and competition. That competition cannot take place as long as (according to the Department of Transportation) we continue to put 16 million new cars that run only on petroleum on our roads every year, each with an average street life of 16.8 years -- thereby locking ourselves into decades more of petroleum dependence.
So let's remember the old saying: When in a hole, stop digging. If every new car sold in the United States were a flex-fuel vehicle and if millions of Americans could plug in their electric cars, gasoline would be facing fierce competition at the pump and the socket. Moreover, our money would have migrated from Exxon to Pepco, from the Middle East to the Midwest -- as well as to scores of poor, biomass-producing countries in Africa, Latin America and South Asia, including the few countries that don't yet hate our guts. This, and no other, is the road to independence.
The venerable Wall Street firm once looked like it would escape the worst of the credit crisis. Now there's talk of a Bear Stearns-like collapse - or a sale.
By Allan Sloan and Roddy Boyd July 3, 2008
NEW YORK (Fortune) -- To understand what went wrong at Lehman Brothers, leave the canyons of Wall Street and head to the flatlands of Bakersfield, 120 miles northeast of Los Angeles.
That's where you'll find McAllister Ranch, envisioned as a 6,000-home, multibillion-dollar recreational community built around a Greg Norman-designed golf course, boating and fishing waters and a beach club. Now McAllister is three-square miles of fenced-off, almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.
So far Lehman's bets on McAllister and other real estate plays in Southern California's Inland Empire have cost Lehman at least $350 million.
None of Lehman's investment bank peers have this kind of exposure to the burst real estate bubble. Then there's the exposure all of them have: problems with collateralized loan obligations, leveraged buyouts, and mortgage-related securities. But Lehman insisted it was only minimally exposed to this kind of stuff.
Turns out, it wasn't. As a result, the bank and its shareholders have endured big losses; messy public demotions of the chief operating officer and chief financial officer; battles with short-sellers, who are betting that Lehman's share price, down about 70% on the year, will decline further; rumblings that the firm will be sold; and rumors (which we consider unfounded) that it will pull a financial El Foldo the way the late Bear Stearns did.
How has Lehman come to this? Read on, and we'll tell you Lehman's true history - and how management miscues, combined with historical forces outside Lehman's control, have put the firm in a world of hurt. We'll also tell you how we think the drama will play out.
Deals gone bad
McAllister Ranch is an apt symbol for Lehman's problems on several counts.
First, Lehman's commercial paper unit is on the hook for a $235 million loan it made to the development. Good luck trying to collect that debt. Worse, in 2006 - the height of the housing bubble - Lehman invested a total of $2 billion in deals with McAllister's developer, SunCal Cos., a Southern California firm severely spattered by the bursting of the real estate bubble. The $350 million McAllister loss looks increasingly like only a down payment.
Because it prided itself on real estate expertise - it helped popularize real estate-backed securities in the early 1970s - and investment prowess, Lehman risked far bigger proportions of its own capital doing deals than its major competitors did. Brad Hintz, a former Lehman chief financial officer who now follows the firm as an analyst at Alliance Bernstein, wrote recently that Lehman has more than 2.5 times its entire net worth tied up in complex, hard-to-value securitized products.
Only Merrill Lynch, among Lehman's peers, has a higher ratio, Hintz said - and Merrill is vastly larger than Lehman. What's more, Merrill has multibillion-dollar assets, such as stakes in Bloomberg LP and BlackRock, that it can sell quickly without interfering with its core businesses. Lehman has nothing similar.
Lehman's high-risk, high-reward strategy produced cash gushers during the good days - the firm reported almost $16 billion of profits from 2003 through 2007 - but those days are gone. Lehman recently reported a $2.8 billion second-quarter loss, which probably won't be its last unprofitable quarter. Two years ago Fortune lauded Lehman and its chief executive, Dick Fuld, because the firm was the best-performing investment-banking stock in the country. That was then.
Now Lehman finds itself stuck with all sorts of hard-to-sell assets and securities worth far less than what it has invested in them. For example, last October - with the credit crunch and real estate meltdown well underway - Lehman (in partnership with the Tishman Speyer real estate firm) paid $22.2 billion to do a leveraged buyout of Archstone, a big apartment developer. Lehman decided to go through with the deal rather than walk and risk paying a $1 billion breakup fee (which could presumably have been negotiated down, as happened in subsequent busted LBOs).
Lehman's Archstone losses could ultimately exceed what a breakup fee would have cost. The firm disclosed a $350 million Archstone charge to earnings last month, and that could be only the start.
"Archstone is the preeminent apartment developer, but the timing was off," says Craig Leupold, president of Green Street Advisors, a real estate consulting firm. "I'm looking at a decline of 10% to 15% in value for apartment complex values, which amounts to $2 billion to $3 billion off the purchase price."
That would be a staggering hit for Lehman, whose capital is only around $27 billion (including recent preferred-stock issues).
Founded in 1850 as a cotton trading firm in Montgomery, Ala., Lehman Bros. had a storied reputation for prudence and sound management.
So how did it end up in this pickle?
What went wrong
In part because, irony of ironies, CEO Fuld, who prevailed in a decades-long battle for Lehman's soul, adopted the policies of the people that he and his trading floor allies fought so bitterly in Wall Street's most famous civil war of the 1980s.
The trading faction, which included Fuld and was led by his then-boss, Lew Glucksman, wanted the firm to stick to its traditional knitting of trading and underwriting securities. The banking faction, led by Steve Schwarzman and Pete Peterson, wanted to use the firm's capital aggressively to do risky deals.
The traders prevailed then - but Fuld ultimately adopted large elements of the bankers' proposed strategy. It's as if Jack Welch had decided during his GE days that the touchy-feely school of management was right after all and began walking the halls to ensure that people were happy. Lehman eventually sold itself to American Express in 1984. Schwarzman and Peterson left to start Blackstone Group and become multibillionaires. Fuld stayed at Lehman.
After ten mediocre-to-awful years as part of American Express's failed financial supermarket strategy, an undercapitalized, independent company called Lehman Brothers emerged in 1994 with Fuld as CEO.
Neither Fuld, a passionate Lehman lifer, Schwarzman or Peterson would speak with Fortune. A Lehman spokesman said the firm wouldn't cooperate either, because our questions were "unfair and biased."
It's tempting to blame Fuld for everything that's gone wrong at Lehman. After all, the man took credit for the firm's successes (while throwing the occasional victim under the bus when there were problems) and got a corporate rock star compensation package.
By Fortune's math, Fuld has realized almost half-a-billion dollars in cash - $489.7 million, to be precise - by cashing in stock options and restricted stock that he was granted. (That's a pretax number.) He's also knocked down wads and wads of regular old money.
Done in by a financial arms race But a significant part of Lehman's problem doesn't stem from Fuld's management - it's because the firm suffered collateral damage from Washington's decision a decade ago to repeal the Glass-Steagall Act, adopted during the Great Depression to separate investment banking from commercial banking.
Until Glass-Steagall disappeared, one of the attractions of owning a piece of an investment bank was that it was asset-lite. The major asset - the firm's people - went home at night. The financial assets were generally liquid (which means easily sellable at the market price). And because they weren't burdened with multibillion-dollar investments in real estate or corporations, investment banks had staying power and could wait for bad markets to recover.
The repeal of Glass-Steagall would change that. Ask Chris Andersen, chief executive of investment boutique Andersen Partners and, at 70, one of Wall Street's grand old men. When Glass-Steagall was adopted in 1999 to let Citi and Travelers (which have since split apart) combine, Andersen notes, commercial banks promised not to use their balance sheet to compete with investment banks, which traditionally had far smaller capitalizations.
"Of course, the minute Glass-Steagall was repealed, the commercial banks began using their balance sheets to compete, offering loans if they also got to do equity offerings as well as arranging public debt financials for transactions," says Andersen.
So investment banks like Lehman bulked up to compete with the Citis and J.P. Morgan Chases of the world, setting off a financial arms race to compete on size and scope.
The arms race - and the associated risk for Lehman - has grown exponentially more intense since 2004, when the world began to find itself awash in cheap short-term money, and globalization and dealmaking increased the call on Lehman's capital for things such as leveraged buyouts-and real estate.
At the end of 2003, Lehman had $11.9 billion of tangible equity and $308.5 billion of tangible assets on its balance sheet. The ratio: just under 26 to 1. As of the first quarter of this year, it showed $782 billion of tangible assets and $20 billion of equity. Ratio: around 39 to 1, leaving relatively little cushion to absorb losses, and forcing the company to shed assets and raise capital in the second quarter.
Lehman also has self-inflicted wounds.
Lehman's paper profits
When firms like Citi and Merrill and Morgan Stanley began fessing up to big problems related to the real estate bubble popping and the ensuing worldwide credit squeeze, Lehman insisted all was well. It even managed to show a $489 million profit for its first quarter, but only with accounting so aggressive and bizarre (albeit legal) that it undercut faith in Lehman's numbers.
Lehman took a $722 million paper profit in the value of its so-called Level 3 equity holdings - stocks that don't trade publicly and for which there aren't liquid markets. This means that Lehman claimed a 9% profit on its private-market stocks during the same period the Standard & Poor's 500 index of publicly traded stocks fell by 10%. Hmmmm.
David Einhorn, a short-seller whose questions about Lehman's balance sheet have confounded its management, says the firm's since-deposed chief financial officer, Erin Callan, told him $400 million to $600 million came from writing up the value of electric generating plants in India - Einhorn feels that only about $65 million was justified. (Lehman, as we've said, declined comment.)
Lehman also showed a $600 million profit because of the decline in the market value of its own debt obligations, whose price was falling because of perceptions that the company was in trouble. That's permissible accounting - but these are ugly, low-grade earnings, not unlike the "profit" you make when your house is foreclosed at a value lower than your mortgage.
And finally, we found that Lehman created another $176 million by almost doubling (to $365 million) the value it ascribed to certain mortgage servicing rights. Servicers get paid by mortgage holders for collecting payments and handling paperwork, and valuing servicing rights is notoriously tricky.
Until recently Lehman managed to raise capital without getting its stock price killed. The neatest move came on April 1, when Lehman sold $4 billion of preferred stock convertible into common stock. For arcane reasons we won't bore you with, when a company sells a big convert issue, convertible arbitragers - who make money exploiting differences between the prices of convertible issues and their underlying common stock - short the common like mad, driving down its price.
But Lehman kept the arbs at bay by placing the vast majority of the issue with large, long-term holders of its common. This helped precipitate a short squeeze, and Lehman's stock rose 18% (to $44.17 from $37.50) the day of the issue, rather than declining as the market expected.
But in a second sale last month Lehman seemed to have lost its touch - or gotten desperate. It sold $4 billion of common stock and $2 billion of convertible preferred, but seems to have placed much of the preferred with hedge funds and arbs that shorted the common, which promptly plummeted. That bummed out investors who bought the common, and the declining price increased the talk about Lehman's problems.
While we won't get bogged down in the minutiae of collateralized debt obligation exposures - which Lehman has done a better job of avoiding than Merrill, Citi or UBS (UBS) - the exposure it does have poses serious potential problems.
Lehman's filings indicate it has about $6 billion of CDO exposure. About a quarter of them are rated BB+ or below. These low-rated arcane, illiquid bonds-made-from-other-bonds are worth maybe 10 cents on the dollar. That indicates a loss of at least $1 billion. There are likely additional losses looming in the other three quarters of the portfolio.
What's next for Lehman We're not predicting that Lehman will fail - it won't because of the Federal Reserve Board, which has let it be known that it will lend Lehman (and any other investment bank it deems worthy) enough money to avoid collapsing, the way Bear Stearns did.
Lehman has been in trouble before - the collapse of the Long Term Capital Management hedge fund in 1998 started rumors it was insolvent, the 9/11 terrorist attacks traumatized employees and made its headquarters near Ground Zero unusable - and it somehow managed to escape and prosper and stay independent.
But this time we suspect that because of pressures we foresee both from the capital markets and regulators, Lehman will ultimately end up owned, once again, by a much larger institution.
So let's close by going back to where we started: McAllister Ranch. An official with SunCal, the project's developer, says the company "remains committed to seeing that this community becomes a reality." When we tried to get a tour of the property, a man in a Hawaiian shirt and shorts, who clearly isn't an investment banker, emerged from deep inside the development's darkened sales office.
His final words as he shooed us off: "This is not a public business." Which may be said of Lehman soon.
They say that if you put a frog into a pot of boiling water, it will leap out right away to escape the danger.
But, if you put a frog in a kettle that is filled with water that is cool and pleasant, and then you gradually heat the kettle until it starts boiling, the frog will not become aware of the threat until it is too late. The frog's survival instincts are geared towards detecting sudden changes.
This is a story that is used to illustrate how people might get themselves into terrible trouble. This parable is often used to illustrate how humans have to be careful to watch slowly changing trends in the environment, not just the sudden changes. Its a warning to keep us paying attention not just to obvious threats but to more slowly developing ones.
An example:
Let's say that every year, the local well had an inch less of water in it. A person might realize there's a problem if there's suddenly NO water, but a slowly dropping level might not be an obvious crisis until it's too late!
4 comments:
GIC and Temasek are so rich, yet one can often see old Singaporeans picking up old cardboards and drink cans to make a living.
Iran and Brazil Can Do It. So Can We.
By Gal Luft
July 6, 2008
When the founding fathers declared our independence, they could not have imagined that, 232 years later, the United States would be so spectacularly dependent on foreign countries. It would be roughly eight more decades before oil gushed from a well in Titusville, Pa., marking the beginning of the global oil economy; it took eight decades more for the United States to become a net oil importer. But the republic's disastrous dependence on foreign oil has increased by leaps and bounds ever since.
In 1973, when OPEC imposed its oil embargo, U.S. oil imports composed 30 percent of our needs; today, they make up more than 60 percent, with a growing proportion of that crude coming from the world's least stable regions. At around $145 a barrel, the United States, by my calculations, will spend more on imported oil this year than it will spend on its own defense budget, and much of that money will flow into the coffers of those who wish us ill.
Since oil dependence is so unappealing, you'd think that energy independence would be an easy sell, especially on this Fourth of July weekend. But in fact, very few policy ideas have been so ridiculed. A 2007 report by the National Petroleum Council, a privately funded group that offers advice from the oil and gas industries to the federal government, calls energy independence "unrealistic"; a recent book, "Gusher of Lies," by Robert Bryce, a former fellow at a think tank funded in part by energy interests, described energy independence as a "dangerous delusion"; and a 2006 Council on Foreign Relations task force went so far as to accuse those promoting energy independence of "doing the nation a disservice by focusing on a goal that is unachievable over the foreseeable future."
Ignore them. Energy independence does not mean that the United States must be entirely self-sufficient. It simply means reducing the role of oil in world politics -- turning it from a strategic commodity into merely another thing to sell.
Is energy independence a pipe dream? Hardly. In the electricity sector, the mission has already been accomplished. Remember President Jimmy Carter in his cardigan during the oil crises of the 1970s, urging Americans to save electricity? It took us just one decade to wean the electricity sector from oil. Today, only 2 percent of U.S. electricity comes from oil, according to the Energy Department. Could we do something similar with transportation, where American cars and trucks still gulp oil-based fuel greedily? At least four very different countries -- dictatorships and democracies alike -- are already making serious headway toward that goal. It's past time to pay attention to their example.
The first country, surprisingly enough, is Iran. The Islamic republic has lots of crude but little capacity to refine it, leaving Tehran heavily dependent on gasoline imports. The country's blustery president, Mahmoud Ahmadinejad, is fully aware that this is Iran's Achilles' heel and worries that a comprehensive gasoline embargo could cause enough social unrest to undermine his regime.
So Ahmadinejad has launched an energy-independence program designed to shift Iran's transportation system from gasoline to natural gas, which Iran has plenty of. "If we can change our automobiles' fuel from gasoline to [natural] gas during the next three-four years," he said last July, "we won't need gasoline anymore." His plan includes a mandate for domestic automakers to make "dual-fuel" cars that can run on both gasoline and natural gas, a crash program to convert used vehicles to run on natural gas and a program to convert Iranian gas stations to serve both kinds of fuel. According to the International Association of Natural Gas Vehicles, more than 100 conversion centers have been built throughout the country: Iranians can drive in with their gasoline-only cars, pay a subsidized fee equivalent to $50 and collect their newly dual-fuelled cars several hours later. Ahmadinejad's plan, which has been largely ignored by the West, means that within five years or so, Iran could be virtually immune to international sanctions.
While Iran is moving quickly toward energy independence, Brazil is already there. It's a striking turnaround; three decades ago, the country imported 80 percent of its oil supply. But since the 1973 Arab oil embargo, the Brazilians have invested massively in their sugar-based ethanol industry and created a fleet of vehicles that can run on the resulting fuel. According to the Sugar Cane Industry Union (Unica), 90 percent of the new cars sold this year in Brazil will be flexible-fuel vehicles that cost an extra $100 to make but can run on any combination of gasoline and ethanol.
Lest anyone think that can't be done in the United States, many of those new cars are made by General Motors and Ford. All it really takes to turn a regular car into a flex-fuel one is a fuel sensor and a corrosion-resistant fuel line.
Discovering how to make hydrocarbons and carbohydrates happily cohabit in the same fuel tank isn't all that Brazil has done; it has also increased domestic oil production. Its efforts have not only broken the yoke of Brazil's oil dependence but also insulated the country's economy from the pain of the current spike in global oil prices. Gasoline prices have nearly doubled elsewhere since 2005, but in Brazil, they have been almost frozen. This year, more ethanol will be sold in Brazil than gasoline. Sounds pretty good, doesn't it?
Like Brazil, China has decided to replace gasoline with alternative fuels. But unlike the United States and Brazil, where the favorite substitute is ethanol, China has embraced a different alcohol: methanol. Several provinces in China already blend their gasoline with methanol, a clear, colorless liquid also known as wood alcohol, and scores of methanol plants are currently under construction there. The Chinese auto industry has already begun to produce flex-fuel models that can run on methanol. Shanxi, a province in central China that produces much of the country's coal, has even issued stickers granting cars that use pure methanol free passage on the province's toll roads.
The distinction between methanol and ethanol is just one letter (but then, so is the difference between Iran and Iraq). Both biofuels should be in our basket of options. True, ethanol packs more energy per gallon and is less corrosive than methanol. But methanol is cheaper and far easier to produce in bulk. While ethanol can be made only from agricultural products such as corn and sugar cane, methanol can be made from natural gas, coal, industrial garbage and even recycled carbon dioxide captured from power stations' smokestacks -- an elegant way to reduce greenhouse gas emissions.
Israel offers a fourth testament to what leadership, ingenuity and audacity can achieve. Last year, it launched an electric-car venture designed to turn Israel -- which obviously has some tensions with the region's big oil producers -- into an oil-free economy. Israelis will soon be able to replace their gasoline-fueled cars with battery-operated ones, which they'll plug into the hundreds of thousands of recharging points planned to be erected throughout the country. Israeli motorists, the government hopes, will be able to swap their batteries in a matter of minutes at dedicated stations or recharge them at home or at work. "Oil is the greatest problem of all time -- the great polluter and promoter of terror," said Israeli President Shimon Peres, the project's political patron. "We should get rid of it."
For each of the four countries, knocking oil off its pedestal is no longer a theoretical proposition but a reality in the making. But despite the lip service our own politicians pay to the need to reduce our oil dependence, none of the solutions offered by Iran, Brazil, China and Israel are even under consideration in the land of the free and the home of the brave.
Just go down the list. Natural-gas vehicles are nowhere to be seen. Brazilian sugar-cane ethanol is barred from the country by a steep 54-cent-per-gallon import tariff, courtesy of ethanol protectionists and their representatives in Congress. (No tariff is imposed on imported oil, of course.) For similar reasons, flex-fuel cars sold in the United States are certified to run only on ethanol, keeping methanol and other viable biofuels off the market -- even though they are cheaper and can be made from a wealth of coal and biomass resources. The kind of electric cars deployed in Israel have never returned to U.S. showrooms since General Motors' mass crushing of its EV1 -- the subject of the documentary "Who Killed the Electric Car?"
It's time to get serious. Policies such as "drill more" and "drive smaller cars" all keep us running on petroleum. At best, they buy us a few more years of complacency, while ensuring a much worse dependence down the road when America's conventional oil reserves are even more depleted -- whether or not we drill in the Arctic National Wildlife Refuge.
The hard truth is that real energy independence can be achieved only through fuel choice and competition. That competition cannot take place as long as (according to the Department of Transportation) we continue to put 16 million new cars that run only on petroleum on our roads every year, each with an average street life of 16.8 years -- thereby locking ourselves into decades more of petroleum dependence.
So let's remember the old saying: When in a hole, stop digging. If every new car sold in the United States were a flex-fuel vehicle and if millions of Americans could plug in their electric cars, gasoline would be facing fierce competition at the pump and the socket. Moreover, our money would have migrated from Exxon to Pepco, from the Middle East to the Midwest -- as well as to scores of poor, biomass-producing countries in Africa, Latin America and South Asia, including the few countries that don't yet hate our guts. This, and no other, is the road to independence.
How Lehman lost its way
The venerable Wall Street firm once looked like it would escape the worst of the credit crisis. Now there's talk of a Bear Stearns-like collapse - or a sale.
By Allan Sloan and Roddy Boyd
July 3, 2008
NEW YORK (Fortune) -- To understand what went wrong at Lehman Brothers, leave the canyons of Wall Street and head to the flatlands of Bakersfield, 120 miles northeast of Los Angeles.
That's where you'll find McAllister Ranch, envisioned as a 6,000-home, multibillion-dollar recreational community built around a Greg Norman-designed golf course, boating and fishing waters and a beach club. Now McAllister is three-square miles of fenced-off, almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.
So far Lehman's bets on McAllister and other real estate plays in Southern California's Inland Empire have cost Lehman at least $350 million.
None of Lehman's investment bank peers have this kind of exposure to the burst real estate bubble. Then there's the exposure all of them have: problems with collateralized loan obligations, leveraged buyouts, and mortgage-related securities. But Lehman insisted it was only minimally exposed to this kind of stuff.
Turns out, it wasn't. As a result, the bank and its shareholders have endured big losses; messy public demotions of the chief operating officer and chief financial officer; battles with short-sellers, who are betting that Lehman's share price, down about 70% on the year, will decline further; rumblings that the firm will be sold; and rumors (which we consider unfounded) that it will pull a financial El Foldo the way the late Bear Stearns did.
How has Lehman come to this? Read on, and we'll tell you Lehman's true history - and how management miscues, combined with historical forces outside Lehman's control, have put the firm in a world of hurt. We'll also tell you how we think the drama will play out.
Deals gone bad
McAllister Ranch is an apt symbol for Lehman's problems on several counts.
First, Lehman's commercial paper unit is on the hook for a $235 million loan it made to the development. Good luck trying to collect that debt. Worse, in 2006 - the height of the housing bubble - Lehman invested a total of $2 billion in deals with McAllister's developer, SunCal Cos., a Southern California firm severely spattered by the bursting of the real estate bubble. The $350 million McAllister loss looks increasingly like only a down payment.
Because it prided itself on real estate expertise - it helped popularize real estate-backed securities in the early 1970s - and investment prowess, Lehman risked far bigger proportions of its own capital doing deals than its major competitors did. Brad Hintz, a former Lehman chief financial officer who now follows the firm as an analyst at Alliance Bernstein, wrote recently that Lehman has more than 2.5 times its entire net worth tied up in complex, hard-to-value securitized products.
Only Merrill Lynch, among Lehman's peers, has a higher ratio, Hintz said - and Merrill is vastly larger than Lehman. What's more, Merrill has multibillion-dollar assets, such as stakes in Bloomberg LP and BlackRock, that it can sell quickly without interfering with its core businesses. Lehman has nothing similar.
Lehman's high-risk, high-reward strategy produced cash gushers during the good days - the firm reported almost $16 billion of profits from 2003 through 2007 - but those days are gone. Lehman recently reported a $2.8 billion second-quarter loss, which probably won't be its last unprofitable quarter. Two years ago Fortune lauded Lehman and its chief executive, Dick Fuld, because the firm was the best-performing investment-banking stock in the country. That was then.
Now Lehman finds itself stuck with all sorts of hard-to-sell assets and securities worth far less than what it has invested in them. For example, last October - with the credit crunch and real estate meltdown well underway - Lehman (in partnership with the Tishman Speyer real estate firm) paid $22.2 billion to do a leveraged buyout of Archstone, a big apartment developer. Lehman decided to go through with the deal rather than walk and risk paying a $1 billion breakup fee (which could presumably have been negotiated down, as happened in subsequent busted LBOs).
Lehman's Archstone losses could ultimately exceed what a breakup fee would have cost. The firm disclosed a $350 million Archstone charge to earnings last month, and that could be only the start.
"Archstone is the preeminent apartment developer, but the timing was off," says Craig Leupold, president of Green Street Advisors, a real estate consulting firm. "I'm looking at a decline of 10% to 15% in value for apartment complex values, which amounts to $2 billion to $3 billion off the purchase price."
That would be a staggering hit for Lehman, whose capital is only around $27 billion (including recent preferred-stock issues).
Founded in 1850 as a cotton trading firm in Montgomery, Ala., Lehman Bros. had a storied reputation for prudence and sound management.
So how did it end up in this pickle?
What went wrong
In part because, irony of ironies, CEO Fuld, who prevailed in a decades-long battle for Lehman's soul, adopted the policies of the people that he and his trading floor allies fought so bitterly in Wall Street's most famous civil war of the 1980s.
The trading faction, which included Fuld and was led by his then-boss, Lew Glucksman, wanted the firm to stick to its traditional knitting of trading and underwriting securities. The banking faction, led by Steve Schwarzman and Pete Peterson, wanted to use the firm's capital aggressively to do risky deals.
The traders prevailed then - but Fuld ultimately adopted large elements of the bankers' proposed strategy. It's as if Jack Welch had decided during his GE days that the touchy-feely school of management was right after all and began walking the halls to ensure that people were happy. Lehman eventually sold itself to American Express in 1984. Schwarzman and Peterson left to start Blackstone Group and become multibillionaires. Fuld stayed at Lehman.
After ten mediocre-to-awful years as part of American Express's failed financial supermarket strategy, an undercapitalized, independent company called Lehman Brothers emerged in 1994 with Fuld as CEO.
Neither Fuld, a passionate Lehman lifer, Schwarzman or Peterson would speak with Fortune. A Lehman spokesman said the firm wouldn't cooperate either, because our questions were "unfair and biased."
It's tempting to blame Fuld for everything that's gone wrong at Lehman. After all, the man took credit for the firm's successes (while throwing the occasional victim under the bus when there were problems) and got a corporate rock star compensation package.
By Fortune's math, Fuld has realized almost half-a-billion dollars in cash - $489.7 million, to be precise - by cashing in stock options and restricted stock that he was granted. (That's a pretax number.) He's also knocked down wads and wads of regular old money.
Done in by a financial arms race
But a significant part of Lehman's problem doesn't stem from Fuld's management - it's because the firm suffered collateral damage from Washington's decision a decade ago to repeal the Glass-Steagall Act, adopted during the Great Depression to separate investment banking from commercial banking.
Until Glass-Steagall disappeared, one of the attractions of owning a piece of an investment bank was that it was asset-lite. The major asset - the firm's people - went home at night. The financial assets were generally liquid (which means easily sellable at the market price). And because they weren't burdened with multibillion-dollar investments in real estate or corporations, investment banks had staying power and could wait for bad markets to recover.
The repeal of Glass-Steagall would change that. Ask Chris Andersen, chief executive of investment boutique Andersen Partners and, at 70, one of Wall Street's grand old men. When Glass-Steagall was adopted in 1999 to let Citi and Travelers (which have since split apart) combine, Andersen notes, commercial banks promised not to use their balance sheet to compete with investment banks, which traditionally had far smaller capitalizations.
"Of course, the minute Glass-Steagall was repealed, the commercial banks began using their balance sheets to compete, offering loans if they also got to do equity offerings as well as arranging public debt financials for transactions," says Andersen.
So investment banks like Lehman bulked up to compete with the Citis and J.P. Morgan Chases of the world, setting off a financial arms race to compete on size and scope.
The arms race - and the associated risk for Lehman - has grown exponentially more intense since 2004, when the world began to find itself awash in cheap short-term money, and globalization and dealmaking increased the call on Lehman's capital for things such as leveraged buyouts-and real estate.
At the end of 2003, Lehman had $11.9 billion of tangible equity and $308.5 billion of tangible assets on its balance sheet. The ratio: just under 26 to 1. As of the first quarter of this year, it showed $782 billion of tangible assets and $20 billion of equity. Ratio: around 39 to 1, leaving relatively little cushion to absorb losses, and forcing the company to shed assets and raise capital in the second quarter.
Lehman also has self-inflicted wounds.
Lehman's paper profits
When firms like Citi and Merrill and Morgan Stanley began fessing up to big problems related to the real estate bubble popping and the ensuing worldwide credit squeeze, Lehman insisted all was well. It even managed to show a $489 million profit for its first quarter, but only with accounting so aggressive and bizarre (albeit legal) that it undercut faith in Lehman's numbers.
Lehman took a $722 million paper profit in the value of its so-called Level 3 equity holdings - stocks that don't trade publicly and for which there aren't liquid markets. This means that Lehman claimed a 9% profit on its private-market stocks during the same period the Standard & Poor's 500 index of publicly traded stocks fell by 10%. Hmmmm.
David Einhorn, a short-seller whose questions about Lehman's balance sheet have confounded its management, says the firm's since-deposed chief financial officer, Erin Callan, told him $400 million to $600 million came from writing up the value of electric generating plants in India - Einhorn feels that only about $65 million was justified. (Lehman, as we've said, declined comment.)
Lehman also showed a $600 million profit because of the decline in the market value of its own debt obligations, whose price was falling because of perceptions that the company was in trouble. That's permissible accounting - but these are ugly, low-grade earnings, not unlike the "profit" you make when your house is foreclosed at a value lower than your mortgage.
And finally, we found that Lehman created another $176 million by almost doubling (to $365 million) the value it ascribed to certain mortgage servicing rights. Servicers get paid by mortgage holders for collecting payments and handling paperwork, and valuing servicing rights is notoriously tricky.
Until recently Lehman managed to raise capital without getting its stock price killed. The neatest move came on April 1, when Lehman sold $4 billion of preferred stock convertible into common stock. For arcane reasons we won't bore you with, when a company sells a big convert issue, convertible arbitragers - who make money exploiting differences between the prices of convertible issues and their underlying common stock - short the common like mad, driving down its price.
But Lehman kept the arbs at bay by placing the vast majority of the issue with large, long-term holders of its common. This helped precipitate a short squeeze, and Lehman's stock rose 18% (to $44.17 from $37.50) the day of the issue, rather than declining as the market expected.
But in a second sale last month Lehman seemed to have lost its touch - or gotten desperate. It sold $4 billion of common stock and $2 billion of convertible preferred, but seems to have placed much of the preferred with hedge funds and arbs that shorted the common, which promptly plummeted. That bummed out investors who bought the common, and the declining price increased the talk about Lehman's problems.
While we won't get bogged down in the minutiae of collateralized debt obligation exposures - which Lehman has done a better job of avoiding than Merrill, Citi or UBS (UBS) - the exposure it does have poses serious potential problems.
Lehman's filings indicate it has about $6 billion of CDO exposure. About a quarter of them are rated BB+ or below. These low-rated arcane, illiquid bonds-made-from-other-bonds are worth maybe 10 cents on the dollar. That indicates a loss of at least $1 billion. There are likely additional losses looming in the other three quarters of the portfolio.
What's next for Lehman
We're not predicting that Lehman will fail - it won't because of the Federal Reserve Board, which has let it be known that it will lend Lehman (and any other investment bank it deems worthy) enough money to avoid collapsing, the way Bear Stearns did.
Lehman has been in trouble before - the collapse of the Long Term Capital Management hedge fund in 1998 started rumors it was insolvent, the 9/11 terrorist attacks traumatized employees and made its headquarters near Ground Zero unusable - and it somehow managed to escape and prosper and stay independent.
But this time we suspect that because of pressures we foresee both from the capital markets and regulators, Lehman will ultimately end up owned, once again, by a much larger institution.
So let's close by going back to where we started: McAllister Ranch. An official with SunCal, the project's developer, says the company "remains committed to seeing that this community becomes a reality." When we tried to get a tour of the property, a man in a Hawaiian shirt and shorts, who clearly isn't an investment banker, emerged from deep inside the development's darkened sales office.
His final words as he shooed us off: "This is not a public business." Which may be said of Lehman soon.
The Boiled Frog
They say that if you put a frog into a pot of boiling water, it will leap out right away to escape the danger.
But, if you put a frog in a kettle that is filled with water that is cool and pleasant, and then you gradually heat the kettle until it starts boiling, the frog will not become aware of the threat until it is too late. The frog's survival instincts are geared towards detecting sudden changes.
This is a story that is used to illustrate how people might get themselves into terrible trouble.
This parable is often used to illustrate how humans have to be careful to watch slowly changing trends in the environment, not just the sudden changes. Its a warning to keep us paying attention not just to obvious threats but to more slowly developing ones.
An example:
Let's say that every year, the local well had an inch less of water in it. A person might realize there's a problem if there's suddenly NO water, but a slowly dropping level might not be an obvious crisis until it's too late!
Can you think of other examples?
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