For Lehman, a Sigh of Relief

The investment bank's quarterly results offered hope that the credit crunch won't do too much damage to Wall Street firms' profitability

Wall Street and the rest of the financial world breathed a little bit easier Tuesday when one of it largest players gave a better-than-expected damage report from the recent credit crisis.

"Looking forward, our stance is cautiously optimistic," Lehman Brothers (LEH) chief financial officer told analysts. "Barring any unforeseen circumstances, we feel that the worst of this credit crisis is behind us," he said later.

The first of four big Wall Street firms announcing profits this week, Lehman reported earnings of $1.54 per share, less than the $1.57 it reported a year ago but more than the $1.47 analysts were expecting, according to Reuters Estimates. Revenues were $4.3 billion in the third quarter, about as expected.

The results, along with O'Meara's comments later in the morning, reassured investors and beat some very low expectations. But analysts warned that Lehman and the rest of the financial industry still face some big threats.

Investment banks' results were being closely watched for clues to how much the financial sector and the economy have been hurt by the recent credit crisis, which started in defaulting subprime loans in the U.S. but has spread far and wide.

For the economy, the worries are that credit market disruptions, problems with the housing and mortgage markets, and a falling stock market could help send the U.S. economy into recession. But for investment banks like Lehman, the most immediate concerns were losses from two forms of debt hit hard this summer: Mortgage-backed debt decimated by the rise in defaults on residential mortgages, and the debt associated with corporate mergers-and-acquisitions. The M&A climate has changed quickly as investors run away from riskier debt used to fund buyout deals, and that has left investment bankers who arrange those deals on the hook.

Lehman said Tuesday that its losses associated with mortgage debt and buyout deals amounted to $700 million. Actually, O'Meara said, losses from buyout deals alone exceeded $1 billion, but the company used a variety of hedges -- other investments used to minimize or cancel out risk -- to cut its losses substantially.

One of the big concerns for those watching investment banks is how closely their reported loss numbers match reality. With the recent credit crisis, figuring out the market value of losses can be tough. Big Wall Street banks often give out as little information as possible about their holdings. Can the numbers be trusted?

Morningstar (MORN) analyst Ryan Lentell says Lehman's O'Meara countered those concerns by providing more information than usual to analysts. "That was pretty reassuring," Lentell says. As long as credit issues don't get worse, Lentell believes Lehman's assertion that it shouldn't need to take more losses.

Many investors seemed to take heart from O'Meara's comments, too. Before the morning conference call began, Lehman's stock was up almost 1% based solely on its earnings report. By late morning, after the call, the stock surged. In the early afternoon, Lehman shares were up 3.77% to $60.83 per share before the Federal Reserve announced its half-point rate cut Sept. 18, and surged 8.6% to $63.67 in the aftermath of the Fed decision.

Still, there is plenty to worry about, both for Lehman and for big financial players generally.

E*Trade Financial (ETFC) plunged 6% by midday Sept. 18 after warning this quarter's profits could fall short by 31%. (The stock recovered after the Fed announcement to trade down 1.2%.) E*Trade could lose up to $345 million in its mortgage business, the firm said.

Scott Armiger, portfolio manager at Christiana Bank & Trust Company, compares E*Trade to Lehman and finds benefit in Lehman's diverse stream of revenues. His portfolio includes Goldman Sachs (GS) and Morgan Stanley (MS), which should benefit from "multiple sources of income," Armiger says. Analysts have assumed Bear Stearns (BSC), the fourth bank reporting this week, will be hit harder because of its high exposure to credit markets and especially mortgage debt.

Lehman was able to offset a 47% drop from a year ago in its fixed income business with surprising strength elsewhere. It has been expanding internationally, which helped it avoid a full hit from the U.S.-centered credit crunch. In total, 53% of revenues came from overseas, a record for Lehman. Growth is coming for unexpected places like the Middle East and Eastern Europe, the firm says. International growth also helped Lehman lower its tax rate.

"The global diversity of the company clearly helped," said Standard & Poor's equity analyst Matthew Albrecht. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

Also, the firm is relying less on fixed income, its traditional strength, and more on investment banking and investment management revenues. Both were unexpected bright spots last quarter.

But Albrecht points out that Lehman's diversity of may not help as much in future quarters. The firm benefited somewhat from the market's volatility as trading volume increased. In a prolonged downturn, that would stop. Lehman could be hurt by both investment losses like those reported Tuesday and a drop-off in other activity. "If we're going to see a slowdown in the U.S. economy, we're going to see that reflected in their results," Albrecht says.

Also, it's important to remember how low expectations were before Tuesday's earnings report. Lehman and other financial stocks have plunged in value in a short amount of time. Lehman and other big banks, buoyed by record M&A activity and rising markets, had a huge amount of momentum earlier in 2007. Now trading at about $60 per share, Lehman was above $80 in June and also earlier this year.

Though Tuesday's results, for the quarter ended Aug. 31, look OK compared to a year ago, they look terrible compared to Lehman's second quarter, which ended May 31. Total revenues are down 22% from last quarter. Earnings per share are off 2% from a year ago but 30% from last quarter.

The hope for Lehman and others on Wall Street is that conditions begin to improve on credit markets. The Federal Reserve's moves to cut the federal funds rate by half a percentage point on Tuesday may help. More news like the disaster at Northern Rock (NRK.L), a British mortgage lender, could make matters worse.

O'Meara told analysts Tuesday that the typical credit market dislocations last three months. "Higher yields eventually attract buyers to the markets," he said.

Bill Larkin, portfolio manager of fixed income at Cabot Money Management, cautions that credit market issues will be a long-term problem as an unknown of homeowners continue to default on subprime and other mortgages.

However, Larkin says there are recent signs of hope on the credit markets, as rates on riskier debt is starting to fall. "The credit markets now are starting to heal themselves," he says.

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