July 22 (Bloomberg) -- ``Everything is over!''

So wrote Emanuel Lehman, one of three brothers who founded the cotton-trading company that bore his name. The year was 1862. The cause of alarm: the Civil War, which had cut off communications between Montgomery, Alabama, where Lehman Brothers was founded a dozen years earlier, and New York, where much of its business was transacted.

Lehman's despair, contained in a letter to in-laws in the U.K., was premature, it turned out. He and brother Mayer moved the firm to New York after the war, underwrote their first stock offering two decades later for a manufacturer of steam pumps and went on to become one of Wall Street's most powerful investment banks.

The panic kept coming back though. It reappeared in 1929, when the stock market crashed; in 1973, when the firm lost $6.7 million betting the wrong way on interest rates; and in 1984, when internal dissension led to a takeover by American Express Co. It surfaced again in 1994, when Lehman Brothers Holdings Inc., newly independent, faced a capital shortage -- losses had depleted shareholder equity to less than 2 percent of assets -- and in 1998, when Russia defaulted on its debt.

So when the bank confronted doubts about its survival this spring, it was deja vu for Chief Executive Officer Richard Fuld, 62, who has spent his entire 39-year career at Lehman, the past 15 in the top job.

``To put your head under the covers and hide is a useless exercise,'' Fuld told friends in June, as he scrambled to regain the confidence of investors. ``When you get dealt a hand, react to it. Don't pretend it's going to go away. Create a plan, execute it and get back to work.''

Longest-Serving CEO

That was the lesson that Fuld, the longest-serving CEO on Wall Street, says he learned in 1998, when the company's shares fell 63 percent in four months on speculation the bank was about to fold. This time around, when the shares fell 70 percent in six months, Fuld didn't duck. Nor did he absent himself at bridge tournaments, like his counterpart at Bear Stearns Cos., James ``Jimmy'' Cayne.

Instead, he raised $14 billion of capital, sold $147 billion of assets, increased cash holdings and reduced the fourth-largest U.S. securities firm's reliance on short-term funding to create a buffer against a possible bank run. When none of those measures worked, he replaced Lehman's No. 2, Joseph Gregory, his trusted lieutenant of 30 years, with a younger man known for his cautious approach to risk taking. And he moved aside Lehman's high-profile Chief Financial Officer Erin Callan, who had a spat with hedge fund manager David Einhorn, a short seller of Lehman stock. (Callan was hired by Credit Suisse Group AG in July to head a unit at the rival firm that advises hedge funds.)

Fuld's Blunders

Yet Fuld, who declined to be interviewed for this article, also made a series of blunders that threaten to take the firm down or end its independence, and to taint his legacy, says Richard Bove, an analyst at Ladenburg Thalmann & Co.

``What he inherited and what he created out of it is amazing,'' Bove says. ``He's one of the best out there. Yet he messed up this time around.''

What Fuld messed up was mortgages. He expanded rapidly into subprime lending in 2004, buying BNC Mortgage LLC so he could have a steady flow of debt to package into bonds. In the first quarter of 2006, BNC was lending more than $1 billion a month.

He also bought Aurora Loan Services LLC, a mortgage lender that makes so-called Alt-A loans, a notch above subprime, to more-creditworthy borrowers who don't provide full documentation for their assets. Aurora was originating more than $3 billion a month of such loans in the first half of 2007.

Mortgage-Market Trouble

Last year, as the market collapsed, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, 44 percent more than Morgan Stanley's and almost four times the $22.5 billion of shareholder equity Lehman had as a buffer against losses. Lehman saw trouble in the mortgage market in late 2006 and still didn't move fast enough to reverse course, according to people familiar with the firm's internal workings.

``Lehman's problem is mortgages,'' says Brad Hintz, an analyst at Sanford C. Bernstein & Co. ``They grew the balance sheet too fast. While diversification has been pretty good in recent years, Lehman still doesn't have the investment banking or asset management businesses at the same level as rivals.''

Lehman's troubles reflect the challenges faced by all Wall Street firms. The implosion of the U.S. subprime mortgage market and the fire sale of Bear Stearns, once the fifth-largest U.S. investment bank, have exposed an inherent competitive disadvantage shared by all brokers: the lack of a stable funding base.

Glass-Steagall Repeal

The repeal of the Glass-Steagall Act in 1999 allowed commercial banks to compete with brokers on every level. To stay in the game, Lehman and its peers ratcheted up their leverage, using their balance sheets to borrow money from banks, hedge funds and other investors. They then lent the cash for buyouts and used it to purchase mortgages they packaged into securities.

When the music stopped, the banks found themselves holding billions of dollars in loans and bonds they couldn't sell. They've written down $422 billion in the value of those holdings since last year. The biggest casualty was Lehman's closest rival, Bear Stearns. It ran out of cash in March, when creditors refused to lend the company money in the overnight market amid speculation that the firm was facing bigger losses. On March 16, the U.S. Federal Reserve engineered the takeover of Bear Stearns by JPMorgan Chase & Co.

`Under Siege'

While commercial banks, including JPMorgan, lost as much or more than investment banks, they didn't have to worry about nervous lenders pulling back their loans; much of their funding comes from depositors whose savings are guaranteed by the government. Citigroup Inc., the largest U.S. bank by assets, had lost $43 billion from its mortgage investments as of the end of March. While that's five times more than Lehman has lost, Citigroup has $831 billion of deposits, which reduces investors' concern about the bank's running out of cash.

``The brokerage model is under siege, with many of the major business drivers facing uphill battles,'' says David Hendler, a credit analyst at CreditSights Inc. ``While everybody was taking risks during the mortgage boom, the brokers had the most at stake because they don't have the deposits to rely on. They blew it.''

Now investors are worried that No. 4 Lehman -- which trails investment bank rivals Goldman Sachs Group Inc., Morgan Stanley and Merrill Lynch & Co. -- might fail the way Bear Stearns did, even though the Fed now allows broker-dealers to borrow directly from the central bank.

Short Selling Lehman

Many investors have sold the stock short, borrowing shares to sell with the expectation that they can be repurchased at a lower price to pay back the loan. Some have bought put options, which give buyers the right, but not the obligation, to sell by a specific date, betting the price will go down by another 69 percent to $5.

Einhorn, the most vocal of the short sellers, challenged former CFO Callan's credibility in a May 21 speech, saying she changed her story about how the firm had valued a private equity investment during private conversations with him. Einhorn's allegations contributed to the stock's decline over the next few weeks amid speculation about the firm's financial health.

On one day, July 10, Lehman's shares fell 12 percent on rumors that Pacific Investment Management Co., manager of the world's biggest bond fund, had stopped trading with the firm, even though Pimco denied the rumor. The next day, the stock fell an additional 17 percent on concern that government-backed mortgage finance companies Fannie Mae and Freddie Mac would have to be bailed out. On July 15, the U.S. Securities and Exchange Commission imposed temporary restrictions on so-called naked short selling of brokerage stocks, requiring traders to hold or reserve the shares of the company before betting against them.

Diversification Plan

Fuld has spent the past decade diversifying Lehman, making sure it would have other businesses to depend on if one collapsed. Equity trading accounted for one-third of Lehman's revenue last year, and the firm was the largest trader of stocks on the London Stock Exchange and Euronext. It ranked as high as No. 5 among mergers and acquisitions advisers in 2007, when it had a role in one-fifth of all corporate takeovers, according to data compiled by Bloomberg. Its research teams in equities and fixed income have ranked at the top of surveys of money managers conducted by Greenwich Associates, an industry consulting firm. Non-U.S. revenue accounted for half of the total in 2007 for the first time.

Yet Lehman could lose it all. As the shares remain under pressure -- they were down 72 percent so far this year as of July 21 -- and talk about the firm's future continues, clients could desert one by one, says Bruce Foerster, a former Lehman executive who now runs investor advisory firm South Beach Capital Markets in Miami.

Burgers, Fries

``Lehman could bleed to death slowly,'' Foerster says. ``Will the firm outlive the speculation, or the speculation hurt business enough to actually bring it down? It's a tough call.''

Fuld, who has worked at Lehman since he was 23, is a trader by nature and nurture. He's highly competitive, keeps a straight face and has played on U.S. teams at international squash tournaments. Even when he's under stress and eats compulsively -- as he did one marathon weekend in June, when associates say he gorged on hamburgers, fries and turkey sandwiches every hour -- he doesn't appear to put on weight or break a sweat.

He learned the trade at the feet of a master: the late Lewis Glucksman, who battled Pete Peterson and the band of bankers that ran Lehman during much of the 1970s for control of the firm, only to lose the company to American Express in 1984.

Fuld Becomes First CEO

Glucksman and many others left soon after the sale. Fuld, who was in charge of trading at the time, stuck around. In 1993, he became CEO of what was then the Lehman Brothers unit of American Express. When American Express spun off Lehman as a public company in 1994, Fuld became its first chief executive.

``The battle within Lehman in the 1980s was one sign of the rising power of traders on Wall Street,'' says Peter Solomon, one of the banker partners who fought on Peterson's side. ``In the last 10 years, trading has dominated Wall Street.''

Traders have a bigger appetite for risk than bankers. They leverage their capital to magnify returns and hope their bets are right more often than wrong.

``Lehman, like the others, ended up playing big games with too little capital by taking on too much leverage,'' says Solomon, who turns 70 in September. Peterson, 82, declined to comment for this story.

South Beach's Foerster, a managing director at the firm at the time of the spin-off, credits Fuld with saving the new company, which was saddled with losses, inhibited by insufficient capital and handicapped by a 30 percent share decline. Four years later, amid rumors Lehman had been badly hurt by Russia's debt default and the collapse of hedge fund firm Long-Term Capital Management LP, Fuld went door to door to convince creditors that the bank had enough capital and cash to pay its debts.

Risk Management

Then he set his sights on Lehman's bigger rivals. While global and product diversification was part of the catch-up plan, it was the booming mortgage market that provided Fuld with the additional profits he needed to invest in other businesses. In 2005 and '06, only Bear Stearns underwrote more bonds backed by mortgages than Lehman.

Toward the end of 2006, people familiar with Lehman's risk management operations say, executives at the firm started seeing trouble in the mortgage market. The securitization division raised rates on its bonds to reflect higher risk, which meant higher interest on the loans Lehman's mortgage units made to home owners. When that didn't slow borrowing, lending standards were tightened, a decision that was met with resistance by BNC and Aurora executives, whose fees depended on volume, the people say.

Hedging Home Loans

By the end of 2006, Lehman started hedging against its mortgage exposure. Some traders were allowed to bet against the prices of home loans by shorting indexes tied to mortgage securities.

Still, Lehman President Gregory didn't move fast enough to reduce risk, the people say. And at least two executives who urged caution were pushed aside.

One was Madelyn Antoncic, 55, head of risk, who was moved to a government relations job in September 2007. Two months later, at a risk management conference in New York, she said that hedging mortgage positions had curtailed Lehman's profit, which was difficult for top management to accept.

The second was Michael Gelband, 49, who ran fixed income and was pushed out altogether in May 2007 after he balked at taking more risk, people familiar with the situation say.

``Lehman at one time had very good risk management in place,'' says Walter Gerasimowicz, who worked at Lehman from 1995 to 2003 and now heads Meditron Asset Management in New York. ``They strayed in search of incremental profit and market share.''

Leveraged-Loan Losses

Lehman's hedges helped offset losses in the second half of 2007 and the first quarter of 2008. While the firm wrote down the value of mortgage-related assets by more than $10 billion, the net reduction to profit was only $3.3 billion.

Some of Lehman's losses in that period were from leveraged loans, which are used by private equity firms and others for buyouts. The firm was stuck with the loans, which they had aimed to package and sell, when the leveraged buyout market froze in the second half of 2007.

Fuld used the temporary recovery of credit markets in the first quarter, which ended in February, to offload one-fifth of the firm's leveraged-loan portfolio. Yet he also tried to gain market share by borrowing against the firm's capital to trade other fixed-income products for Lehman's clients, people say. That increased Lehman's risk in the event of a renewed downturn, as did its growing inventory of Alt-A loans.

Wrong-Way Bet

Fuld had bet the wrong way: In March, markets tumbled as defaults by homeowners surged, housing prices fell further and the U.S. headed toward a recession. Reversing course, he ordered his associates to hunker down, people say. Traders were told to sell troubled assets or buy credit protection for further potential losses, which meant that if prices were to recover, Lehman couldn't benefit. In other words, things weren't going to turn around anytime soon.

``The current environment remains challenging,'' Fuld told the company's shareholders on April 15.

Selling $147 billion of assets in a jittery market, as Lehman did in the second quarter, meant taking significant losses. On top of that, people familiar with the transactions say, some of the hedges didn't work.

For example, Lehman bet against the CMBX index, a gauge of bonds backed by commercial mortgage bonds, to hedge its residential mortgage portfolio. In the second quarter, the index improved -- the cost of protecting against losses on commercial mortgage bonds narrowed to 100 basis points from 150 -- while the prices of residential mortgages continued to drop, resulting in losses on both sides of the trade. (A basis point is 0.01 percentage point.)

$2.8 Billion Loss

The firm was also too late slowing its commercial mortgage business, calculating that the rout in residential mortgages wouldn't spread to the commercial market, people familiar with the thinking at the time say. More than half of Lehman's mortgage exposure is to commercial mortgages and real estate, which have also declined in value this year.

On June 9, after Fuld's hamburger-fueled marathon weekend, Lehman preannounced second-quarter losses of $2.8 billion, four times more than the worst analyst estimate. It also arranged a $6 billion share sale. ``As painful as this quarterly loss has been, now is the time to look forward,'' Fuld wrote to employees. ``In past down cycles, the firm has always emerged stronger. We have done it before, and we will do it again.''

McDade's Mandate

Herbert ``Bart'' McDade, 49, who replaced Gregory as Lehman's president three days after the preannouncement, doesn't have much time these days to work in the garden behind his Rye, New York, home or watch his two teenage sons play soccer and basketball. Instead, he's busy fighting short sellers, hosing down rumors and trying to save Lehman.

A graduate of Duke University in Durham, North Carolina, who holds a Master of Business Administration from the University of Michigan in Ann Arbor, McDade started at Lehman as a corporate bond trader in 1983. He became head of fixed income in 2000 and, five years later, was named to run the equities division, with a mission to grow it. Under his watch, revenue tripled as the business expanded overseas and into new products.

McDade was the first to assign research analysts to the trading desk, where instead of publishing reports on companies, they were tasked with creating trading ideas for clients. The model was followed by competitors such as Merrill Lynch as hedge funds gained prominence on Wall Street and demanded more short- term trading ideas instead of in-depth analytic reports.

Duke, Michigan

McDade earned a reputation as a prudent risk manager, someone who hedges his bets. Kevin Cronin, head of investments at Putnam Investments, the 16th-largest holder of Lehman shares, who has known McDade professionally and personally for two decades, says his hedging skills apply even to the sports teams he roots for -- Duke basketball and Michigan football, both of which have high winning percentages. If one team has a bad year, Cronin says, the odds are that the other won't.

``Bart's been all about diversifying into other areas in the businesses he ran,'' Cronin says. ``He saw that as the best hedge.''

Although McDade long had ambitions to replace Gregory, say people familiar with internal politics at the firm, his style wasn't confrontational. Dissension didn't sit well with Fuld. Instead, McDade stayed on the sidelines, those people say, allowing Gelband, his handpicked successor in the fixed-income business, to fight some battles on his behalf. (Gelband, who lost his job last year, has since been rehired by McDade.)

Righting the Ship

When losses mounted and the stock tanked, McDade made his move with the backing of executives who had long seen him as the firm's future leader. McDade declined to comment on any aspect of the succession.

``If there's someone who can help right the ship, he's definitely the right candidate because he has a good track record,'' Douglas Sipkin, an analyst at Wachovia Corp., says of McDade. ``But he faces several challenges: keeping employees motivated, gaining back the credibility of investors and clients and continuing to work through some of the balance sheet exposures.''

Fuld is counting on McDade's help to convince investors that Lehman can go it alone and that further losses on its mortgage portfolio won't be at the level of the second quarter, says South Beach Capital's Foerster.

`Bear Case Scenario'

Morgan Stanley analyst Patrick Pinschmidt estimates Lehman will have as much as $2.5 billion of writedowns in the second half of the year compared with $4.9 billion in the second quarter alone. In what he calls a ``bear case scenario,'' the losses could be $5.4 billion in the last two quarters, which would mean Lehman would have to raise $1 billion more in capital, Pinschmidt wrote in a June 30 report.

Meanwhile, rumors continue to haunt Lehman. Speculation that London-based Barclays Plc would buy the firm for a 25 percent discount caused Lehman stock to fall 11 percent on June 30. Both firms said the speculation was groundless.

``Fuld would be out of character if he sought a buyer,'' says Michael Holland, who has worked on Wall Street for more than four decades and now heads Holland & Co., managing $4 billion of assets. ``He has consistently defied predictions of the firm's being sold.''

Takeover Candidate

Still, Fuld might not have a choice. A depressed share price -- the company's market value is about 40 percent of what its assets would fetch in the event of a sudden liquidation -- makes Lehman an obvious takeover candidate. It also increases the likelihood that its most prized employees will leave, since most of their pay is in the form of Lehman stock.

``Lehman wanted to be like the bigger guys, and for a while it looked like they were catching up,'' says CreditSights' Hendler. ``But they failed to see the risks and ended up in this situation. It will be tough to survive. They're the weakest of the big four investment banks.''

Hendler says a hookup with Minneapolis-based U.S. Bancorp, the sixth-largest U.S. bank by assets, could provide Lehman with the necessary stable funding base. U.S. Bancorp declined to comment.

Not everyone thinks Lehman needs to merge with another bank.

``They can survive thanks to the Fed's liquidity facilities and realign their businesses when things change,'' says Corne Biemans, a Boston-based senior portfolio manager at Fortis Investments, which oversees about $200 billion. ``In every downturn, people think Wall Street's model is completely broken and it can't go on. Each time, Wall Street firms reinvent themselves. They'll come up with something again. I don't know what, but they will.''

Apocalyptic Prediction

The recovery won't be easy. Taking lower risk with the balance sheet means reducing profitability. A smaller balance sheet, along with $65 billion of hard-to-sell assets tied to mortgages, gives the firm little wiggle room to expand into areas such as emerging markets, where it might be able to increase profits. It will be several years before Lehman can achieve the 15 percent return on equity it set as its goal in June, says Wachovia analyst Sipkin.

Fuld and McDade are now in the eye of what may be the fiercest storm to have hit Lehman. As the markets have done before, they will again determine whether the firm will survive, and in what form, or whether Emanuel Lehman's apocalyptic prediction will come to pass 146 years late.

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net.

Last Updated: July 22, 2008 00:01 EDT