(FORTUNE Magazine) – CHRISTOPHER PETTIT, a West Pointer who served as a captain in Vietnam, is engaged these days in another uphill conflict as president of Lehman Brothers: keeping the old-line brokerage independent.

He has a lot to fight for. As a reminder of the firm's distinguished and sometimes bumpy past, Pettit fills his office bookshelves with Lehman baseball caps and other paraphernalia that commemorate almost 19 years of banquets and ball games, public offerings and leveraged buyouts. He's still exulting in Lehman's most recent triumph--shedding the yoke of American Express, which owned Lehman until last year. Of the future he brags: "We're building a great institution!"

Pettit and Richard Fuld, the firm's top strategist and CEO, see an investment bank reaching into the global big time by serving the full financial needs of giant corporations and wealthy individuals. Pettit, Lehman's chief operating officer, also has a more personal objective: to wind Lehman back closer to how he found it in 1977 when he signed on as a young salesman fresh out of teaching math in junior high school--a proud institution run by loyal partners. It's not a job, he seems to believe, it's his destiny. "Many, many years from now," he says, "I want my name etched in granite in the corridors of Lehman."

Huh? Hearing of that vision, one might reasonably wonder whether Pettit dreams too much. This is, after all, the Nineties, the decade of the great financial consolidation, where banks, brokers, and financial wannabes are folding into one. The rules of this era are simple: the strong acquire and the weak work out severance packages. Under those rules, Pettit's dream doesn't square with the numbers: Lehman's stock sells at less than book value, offering a low-cost move into Wall Street for some acquisition-hungry European bank or even a domestic financial services company. It is a fate Pettit dreads. "We have scars on our back from working for a travel company," he says disparagingly of the ten-year period when American Express called the shots.

But whether Lehman's future leads to glory or servitude will depend on whether Pettit can quickly get it up to speed with the Morgan Stanleys and Goldman Sachses and achieve the same profitability.

So far, it is lagging behind in that race, hobbled in part by the heavy financial burden that it carries--a legacy of its bondage to American Express. When Amex CEO Harvey Golub dumped first Shearson and then Lehman as he sought to extricate his company from the volatile brokerage business, he saddled Lehman with enough financial claims to make Lehman's future a struggle. At the time of the roughly $2 billion spinoff in 1994, Golub forced the firm to shoulder potentially damaging liabilities for a bunch of failed limited partnerships, to agree to hand over a big chunk of Lehman's future profits, and, some contend, to take a chunk of Amex's expensive office space. To Golub, it was probably a fair assessment designed to fetch Amex a decent return on its multibillion-dollar investment in Shearson/Lehman. Even so, dead weight is just that.

Lehman's problems aren't all the result of Golub's harsh terms. The hard fact is that the firm today suffers from a poor mix of businesses. It flourishes as No. 2 in the enormous yet low-margin fixed-income trade but trails in far more profitable areas like equities, where rivals like Merrill Lynch make real killings. It has also crimped its own stock market performance with a compensation plan that heaps enormous quantities of restricted shares on employees, diluting the stake of current investors. The restricted stock is lavished only on highly valued staff, but it vests so quickly--after just one year--that it will hold them only if the shares perform well, a prospect made dimmer by the ongoing dilution.

Like all of Wall Street, Lehman already faces mountainous people costs. Roughly half the firm's revenues--they reached $2.7 billion in the 11 months ended November 1994--are spoken for in the form of salaries and benefits. That averages more than $150,000 a year per person, pretty pricey considering that the work force includes a humble flock of secretaries and computer operators.

Lehman's pay scale is de rigueur for the gilded indus- try, but its profits are not. Excluding extraordinary gains, Lehman is expected to post around a 7% return on equity for the fiscal year ended November 1995, according to Sanford C. Bernstein & Co., a figure way below the industry average (see chart). Worse, a big piece of its profits flows not from its staple businesses but from gains on merchant-banking investments made in 1989 and the early 1990s. Lehman sharply curtailed the funding of merchant-banking activities in 1994, and since then it has mostly been pulling out money. At some point that well is bound to run dry. But the bonuses keep flowing.

Lehman pegs its survival as an independent outfit on the laudable goal of achieving a 15% return on equity within two or three years, a target it will try to reach by taming expenses and increasing revenues. It has already chopped its bloated work force from 9,400 in early 1994 to some 8,000, partly by trimming its army of brokers for private clients. By early next year it will have pared total costs by roughly $300 million, or about 11%.

While impressive, these strides leave Lehman far short of its goal. To reach a 15% ROE, it will have to lift net earnings from about $200 million this year to well over $500 million. Building high-margin revenues in equities--one of Lehman's targeted areas for growth--will take time and money, and the pressure on costs will make it harder to hire marquee names and open new offices. Those who question whether Lehman can hit its target include Jack Byrne, CEO of asset management firm Fund American and a Lehman director until early 1995. Says he: "I applaud their progress. But I really don't know if they can achieve 15%." Pettit hasn't crunched the numbers either. When asked how much Lehman has to earn to achieve that lofty number, he demurs, "I'm not comfortable with those statistics."

The biggest roadblock to a double-digit ROE may be that the firm no longer enjoys the great leverage of a vast retail network. That was lost in the wrenching sale of Shearson, its retail arm, in 1993. Golub's predecessor, James Robinson III, had bought Lehman from its partners in 1984 to meld its investment-banking prowess with Shearson's vast network of brokers. The new siblings squabbled through the rest of the decade. But by 1990 the businesses, and the personalities, finally started to mesh.

Heading Lehman at that time, and helping run Shearson as well, were investment banker J. Tomilson Hill and Fuld, a former bond trader. The pair formed an unlikely twosome. Elegantly attired and smoothly articulate, Hill was Mr. Outside, a whiz at collecting new clients in investment banking. Fuld, a protege of Lew Glucksman, the cigar-chomping Lehman legend, is a trader's Heathcliff, a brooding, taciturn type who dislikes traveling or glad-handing and usually lunches alone in his office. So formidable is his temper that even Fuld's legion of admirers dub him the "gorilla." Fuld has intense loyalty--patience, even--for the band who followed his rise through the fixed-income business, Pettit among them.

The vision that Hill and Fuld tried to instill in the place was for Shearson/Lehman to become a one-stop financial supermarket rivaling Merrill Lynch. Their drive to integrate Shearson's galaxy of over 8,000 brokers with Lehman's institutional sales team gave the combined Shearson/Lehman firm an immense network for selling stocks. Touting its mini-Merrill clout in distribution, Lehman's investment bankers brought in a slew of new underwriting business. From 1990 to 1992 its share of IPO underwritings jumped from 3.2% to 9.7%, second only to Merrill Lynch.

But as much as Lehman's chiefs saw advantages to the Shearson link, they chafed under the tie to American Express. Fuld, Hill, and Pettit had always wanted to free all of Shearson/Lehman from Amex. They deeply resented what they saw as meddling in everything from strategy to pay practices. At the same time, Lehman was getting Amex's goat, especially that of its new president, Harvey Golub, a former McKinsey partner. Golub found Wall Street's spendthrift pay structure particularly bothersome. On several occasions he summoned Lehman's top managers from their offices to his--the firms operate out of different towers in the World Financial Center, though Golub is 43 floors higher, on the 51st--and denounced the lavish bonuses they paid their senior people and themselves. Fuld, a weightlifter, sat steaming through such meetings, a source says, his neck swelling with rage.

Despite the promise of a financial powerhouse, Golub could not forget that Shearson/Lehman losses finally helped sink his predecessor at Amex, Robinson. And in addition to those irksome compensation plans, Lehman's profits were volatile--it made $159 million in 1991, but lost $171 million in 1992--and constantly subject to big write-offs. Golub wanted change. In February 1993 he summoned Fuld and Hill and dropped a bomb. As the story goes, Golub wasted no time on niceties. "I'm selling Shearson," he told the pair. "The deal is done. I just want you to execute it."

At Lehman, Shearson haters cheered the news. But Fuld and Hill were stunned; they were helping run Shearson, yet hadn't even been consulted. According to a version that leaked back to Lehman's top managers, Golub tacked on a brutal postscript: "If you stand in my way, I'll roll over you." Through a spokeswoman, Golub denies ever saying such a thing, though she does acknowledge that the deal to sell Shearson to Smith Barney was negotiated between Smith Barney's parent (Travelers) and Amex management without consulting Shearson/Lehman's chiefs. What they got was a briefing before the deal was signed.

Lehman has yet to climb out of the equities rubble that the sale of Shearson left behind. Hill quit the firm later that year and is now a partner in the Blackstone Group, which includes other Lehman alums. The damage to Lehman's research operation is particularly devastating. Between early 1994 and mid-1995, some 30 analysts left the firm, either pulled by higher bonuses or pushed by Lehman. Among those who walked: superstar software analyst Dave Readerman. The mass exodus was reflected in the Institutional Investor's annual survey of analysts. From 1990 through 1992, Lehman had ranked first. But it fell to ninth in 1994 and is now tied for 13th.

The loss of Shearson's retail force hit Lehman's underwriting business hard. The firm now ranks No. 13 in IPO underwritings. "One week we'd be pitching Shearson's sales network," recalls Mel Shaftel, who heads investment banking. "The next week it's gone." Lehman's equity business can no longer grow organically, fed through Shearson's huge retail network. Now it has to regain market share by hiring pricey bankers and rebuilding research. By some estimates it will have to spend an extra $10 million to $20 million a year to restore its ranking on the analyst surveys.

As a solo player, Lehman is once again primarily a bond house. Pettit has been moving to reassert fixed-income's control of the firm. He has gone too far by some counts. Pettit commands great loyalty from his friends in fixed income, guys he worked with in the commercialpaper unit during the 1970s and car-pooled with from his home in Huntington, New York. But Pettit's affection for the fixed-income crowd dismays many observers because he is using these people to fill key slots in equities, a vital business if Lehman is to make it and yet not one in which many of them have appropriate backgrounds or, former employees say, the right skills. This schism evokes the time when Shearson and Lehman first got together. Many bankers and traders at Lehman brand the bond crew as the "Moonies" for what is perceived as their blind devotion to the boss.

One Pettit appointment is especially controversial. Paul Williams, the former head of fixed-income trading, now runs equities. Critics contend that Pettit moved him there despite the fact that Williams had little experience with equities. They add that Williams is still uncomfortable with stocks and that he maintains a chilly distance from analysts and traders. On one occasion, Williams reportedly emerged from his office, peered at a gaggle of traders, and then ducked back into isolation. Joked one of the traders: "Now we know it's six weeks till spring." Pettit defends his appointment of Williams, claiming that the bond people are the best managers in the firm.

Friction on the staff will make it all the more difficult to overcome the burdens imposed by Amex. And they are substantial burdens. "Amex added trunks of baggage that are not obvious," says Byrne, the former director. "Lehman's capital structure is encumbered." According to the prospectus for the spinoff, a number of conditions were included in the price Golub set for Lehman's freedom. First, Amex loaded Lehman with $200 million in preferred stock that pays Amex an annual dividend of 8.44%. That grabs $17 million in net income that would otherwise flow to common shareholders. Under the spinoff agreement, Amex is also entitled to about half of Lehman profits that exceed $400 million, up to a maximum of about $50 million a year through 2002.

But the profits tax is a "minor valise," according to Byrne, compared with the profusion of less visible weights. Potentially the most damaging is the slew of limited partnerships in everything from oil and gas to cattle ranches that Shearson sold, as well as others that it inherited when it bought E.F. Hutton. Stung by stiff losses and huge commissions, small investors have begun to sue. When he sold Shearson, Golub stuck Lehman, which had sold none of the partnerships, with most of Shearson's risk. The eventual cost of these suits is an unknown but could become a big problem. Liability for limited partnerships also hovers over other firms, notably Prudential Securities.

All of which means that despite the recent progress in Lehman's stock--it is up 53% so far this year, to $22.50, roughly in line with its peers--the forward progress in earnings and stock price may be elusive. And in this climate, a cheap financial stock is like blood in the water--sharks respond. It could be a foreign bank or, if Glass-Steagall falls, a U.S. institution. Or maybe it will be a big brokerage like Smith Barney. That, at least, would re-unite Lehman and Shearson.

Don't expect Pettit, Fuld, and their top people to stick around--or get rich--in any such takeover. Most were obliged to buy into Lehman at the time of the spinoff, paying $25 a share. Given the problems Lehman faces, a buyer is unlikely to pay much of a premium. Lehman's independence would die, and the long battle to preserve it would be lost. For Pettit, shades of Vietnam.