Questions linger over NomuraÆs acquisition of Lehman

A bland press conference by Nomura CEO Kenichi Watanabe fails to allay doubts.
At the end of a 90-minute press conference at the Tokyo Foreign CorrespondentsÆ Club on Wednesday, it was still not clear how Nomura plans to squeeze synergies and profits out of its acquisition of former powerhouse brokerage Lehman Brothers. Lehman was taken over by Nomura in late September in a deal which Nomura CEO and president Kenichi Watanabe described as ôthe opportunity of a lifetimeö.

However, journalists were left scratching their heads as Watanabe persistently evaded the questions lobbed at him by reporters. These questions referred to the morale-sapping fact that Japanese bankers will be getting paid less than foreign bankers; that a core Lehman client base, namely hedge funds, is under enormous stress; that Nomura is under financial pressure; and many others. But whether it was the Nomura interpreter fluffing his lines, or the chairman refusing to answer directly, the upshot to all the questions was the same: a lack of quality information.

One member of the club, a distinguished writer and long-term observer of Japan, said that any Western investment banker present would not have been motivated to work for an organisation which insisted on being so vague and non-communicative. ôIt is the first time a Nomura president has spoken to the Foreign Correspondents Club in Japan in over 10 years, but it was like a flashback to the way Japanese companies interacted with the press 30 years ago,ö he said. ôIt should have been the showcase of a transparent and articulate strategy, but it was the opposite.ö

This hits the nail on the head, because the problem is that the takeover of Lehman does not make sense in some fundamental ways. How can Nomura buy an investment bank and expect that model to be profitable, when the model appears broken? The bones of Merrill Lynch, Lehman Brothers and Bear Stearns litter the financial desert. Morgan Stanley and Goldman Sachs are facing tremendous share price pressure even after converting to bank holding companies. That would seem to indicate that the model has been discredited.

It was a model that thrived on cheap debt and rising asset prices. But it was destroyed by a characteristic common to investors in rising markets: the temptation to hold on to assets to make capital gains. So despite all the fancy tricks for moving risk off the balance sheet, such as securitisations, many investment banks moved further and further away from their agency role and piled risk on to their books. They combined the underwriting and arranging of financial instruments with investments in the same instruments, including collateralised debt obligations (CDOs) and commercial mortgage-backed securities (CMBSs).

Clearly, cheap debt and rising asset prices are no longer with us, at least for the time being. Liquidity has been created by the numerous interventions of the Federal Reserve Board, but investor sentiment has turned risk averse, and stockmarkets around the world are down, often more than 50% from their peaks. Many banks that were players in the game of æraising debt and pushing up asset pricesÆ have become nationalised. ItÆs unlikely their new owners will allow them to be as blasT with risking other peopleÆs money as they were in the past.

The idea that Nomura will use Lehman to continue to invest directly into assets, and juice the returns through leverage, therefore seems highly unlikely. But if thatÆs not likely to happen, why pay guaranteed bonuses to the top 500 Lehman staff in Asia for two years? Other staff have also been promised one-year bonuses. What are these employees supposed to do? In Japan, for example, Lehman has amassed a considerable real estate portfolio and was an active player in the CMBS market. Now the CMBS market is dead and real estate prices are beginning to go down.

The fact that bonuses have been guaranteed at the level of 2007 also sends out the wrong messages. The bonus culture was one of the problems which undermined investment banking, for reasons we are familiar with by now. It encouraged bankers to take high risk without considering the long-term consequences. With the CEO at Goldman Sachs setting a welcome precedent by not taking a bonus this year, Nomura should have taken the opportunity to revamp the incentive structure, instead of sending the message that itÆs æbusiness as usualÆ.

Nomura has traditionally combined the roles of retail broker and advisor to Japanese blue-chips. In other words, the firm has had a clear agency bias, rather than a principal bias. It was the principal bias of many US investment firms which created the losses, since they were sitting on dud real investments worth billions of dollars when the markets started falling. A traditional agency broker would have been immune, since such a firm would be satisfied with the straight commission business. Yet, just as the rest of the industry is turning risk averse, Nomura is getting into the high-risk business.

In addition, Nomura appears to have made its move at a time when both the agency business and the principal business are in trouble. The problems of the principal business have been discussed above, but the agency business is also in a bad state. According to data firm Dealogic, equity issuance in Japan halved in 2007 from the record levels of 2006, and have halved again year-to-date. The issuance of Samurai bonds, which prospered before the current crisis because of the huge pools of liquidity in Japan, shut down after the bankruptcy of Lehman Brothers, a frequent issuer, and difficulties faced by other global banks, including a clutch of Icelandic issuers (such as Kaupthing Bank) and several US commercial and investment banks. Samurai bond investors, notorious for preferring the æbrandedÆ blue-chips like Goldman and Citi, have received an unpleasant shock.

There was one æjewelÆ in LehmanÆs operations, but Nomura has failed to get it. This was the electronics trading team, which has decamped to Mizuho. Electronic trading is growing faster in Japan than any other country in Asia, accelerated by the growth of exchanges set up by the investment banks. This permits them to trade with each other and with their clients, while avoiding the high fees and old technology of the Tokyo Stock Exchange.

Nomura has an additional weakness. It is the last independent investment bank without links to a commercial bank. Nomura maintains the top position in Japanese M&A despite that. But domestic firms which are interested in acquiring foreign assets in a downturn may eventually want their investment bank to provide the financing as well. This has become increasingly common in markets outside Japan.

The final issue is how much longer Nomura can bleed as it beds down its takeover of Lehman. NomuraÆs finances are in a weakened state. A Credit Suisse report dated October 28 states that ôif conditions continue as they are, we believe the companyÆs full-year losses could balloon to Ñ500 billion ($5.1 billion) or moreö. The report states that NomuraÆs pre-tax second quarter losses were ôgreater than anticipated at Ñ69.3 billionö. Contributing to full-year losses are NomuraÆs $425 million position in Icelandic banks and the unrealised valuation loss of $460 million in Fortress Investment Group.

Although positive about the takeover of Lehman in the long term, Credit Suisse states that it expects ôsuccession costs at Lehman Brothers of around $2 billionàin the current environment we believe it will be very difficult to turn Lehman into the blackö. The bank concluded with an interesting observation, namely that Nomura ôdid not provide sufficient detail about actual expense levels and measures being taken to turn the company into the black in futureö. The journalists at the Foreign CorrespondentsÆ Club would certainly agree with that.
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