Is Lehman Liquid Enough?

The firm's heavy subprime exposure and minimal writedowns to this point have investors nervous. But defenders say it's no Bear Stearns

In the wake of the sale of Bear Stearns (BSC) to JPMorgan Chase (JPM) for the investment-banking equivalent of pocket change, the worry now on Wall Street is that the high-stakes game of dice the big firms were playing with asset-backed securities of dubious quality may force more players to exit the table.

Fear that the crisis of confidence that hit Bear Stearns last week, causing the fifth-largest U.S. investment bank to be sold for 2% of its former value on Mar. 16, could quickly spread to other big firms was only partly relieved by expansion of the Federal Reserve's discount window to other kinds of players, broader collateral, and longer lending terms.

Treasury Secretary Henry Paulson's assurances Mar. 17 that the Fed and the Treasury could be counted on as lenders of last resort if any other banks face liquidity shortages rekindled investor confidence in the broader equities market but offered scant comfort to investors in financial stocks.

And that has market players asking: Who may be next?

More Subprime Fallout

Some figure Lehman Brothers (LEH) may be vulnerable to a liquidity seize-up. Shares of Lehman took a beating Mar. 17 because of the similarity of its business model to that of Bear Stearns. Lehman shares lost as much as 48.4% of their value before bouncing back to finish 19% lower, at $31.75.

Other big names got caught up in the selling as well. Morgan Stanley (MS) shares fell 8%, to close at $36.38. Citigroup (C) shed 5.9%, to end at $18.62, and Merrill Lynch (MER) lost 5.4%, to trade at $41.18.

The pounding Lehman shares took was understandable given concerns that its relatively heavy exposure to the subprime mortgage market puts its capital balance at risk.

But investors became more optimistic after seeing Lehman’s first-quarter earnings release on the morning of Mar. 18. The company reported fiscal first quarter earnings of 81 cents per share, beating the Street’s consensus forecast by nine cents. What’s less encouraging is that the latest results were down 59% from $1.96 per share in the first quarter of fiscal 2007 on a 31% drop in net revenue to $3.5 billion.

Not surprisingly, revenue from the firm’s fixed income capital markets business plunged 88% to $262 million from $2.2 billion in the year-ago period due to continued deterioration in the broader credit markets, especially residential and commercial mortgages and acquisition finance. Lehman reported $1.8 billion in mark-to-market writedowns.

Even more than the earnings, Lehman investors may be breathing more easily after hearing the company report that it had a liquidity pool of $34 billion, unencumbered assets of $64 billion and an additional $99 billion at its regulated entities at the end of February.

“At Lehman, fixed income is very big. They were leaders in securitization of mortgages. Bear was No. 2," Christopher Whalen, managing director at Torrance (Calif.)-based Institutional Risk Analytics, said before the earnings release. "That's why everybody is looking at Lehman now." (His firm builds customized risk-management tools for audit firms and others.)

And though Lehman has a stronger investment banking business than Bear did, its merger-and-acquisition advisory services are effectively worthless in view of the credit freeze, making Lehman next on the target list for a liquidity crisis, Whalen said.

On Mar. 18, Lehman reported $867 million in revenue from investment banking, a 2% gain from a year ago, driven by a 34% increase in merger and acquisition advisory revenues to $330 million from $247 million in the first quarter of fiscal 2007.

In response to the earnings, Standard & Poor’s Equity Research cut its fiscal 2008 earnings outlook by 52 cents to $4.30 per share.

Although S&P believes Lehman has sufficient liquidity, it reaffirmed its sell rating but raised its target price by $10 to $30.

Lehman shares were 20% higher at 38.01 in morning trading Mar. 18.

Goldman Sachs also posted better-than-expected earnings on Mar. 18, posting $3.23 per share, vs. analysts’ consensus estimate of $2.58. But the results were more than 50% lower than the $6.67 it earned a year ago, on a 16% revenue decline.

The "Pro" Lehman Position

Deutsche Bank Securities upheld its buy rating on the stock on Mar. 17, declaring in a research note that Lehman is not Bear. As that note got some play in the financial media on Mar. 17, it may have helped prompt investors to rethink their gloomy outlook for Lehman, leading to the bounce in its share price as the market closed.

Deutsche Bank (DB) analyst Michael Mayo cited Lehman's $2 billion working capital line with 40 banks as proof that counterparties haven't lost confidence in the broker-dealer and pointed to the fact that nearly half of Lehman's franchise is outside the U.S. and that its asset-management business is more than twice as large relative to its size as evidence of its diversified business model.

Mayo predicted that Lehman will weather the credit storm and reaffirmed his estimate of a price-to-adjusted-book-value ratio of 83%, citing Lehman’s excess liquidity position at the end of 2007.

While it also has $180 billion of repurchase financing lines, "we take comfort that 40 banks extended credit on Friday and believe that some of the repos [reverse repurchase agreements] are likely to be termed at least to some degree," he said. (Deutsche Bank does business with and seeks to do business with companies covered in its research reports.)

Results Under a Magnifying Glass

Jeff Harte, an analyst at Sandler O'Neill & Partners, says it's doubtful Lehman had as much overnight repo financing as Bear had, but its heavy reliance on even longer-term repo financing is still cause for concern. Like the rest of Wall Street, Harte is looking for answers in the earnings releases for Lehman and other investment banks this week.

"What would be nice to hear from Lehman and Goldman Sachs and others is, how big is [their] repo book, what's the rollover, and what's [their] term?" Harte said before the earnings release. "That is not disclosed anywhere." (Sandler O'Neill has received compensation from Lehman for noninvestment banking services in the past 12 months.)

In a research note he published Mar. 18 after seeing Lehman’s results, Harte published a table showing that Lehman’s excess liquidity and other unencumbered collateral was 107% of its repos -- vs. the broker peer average of 79% and Bear’s 33% -- and the highest among the top five investment banks.

A high ratio shows a healthy cash position, says Greg Larkin, senior analyst at Innovest Strategic Value Advisors, which specializes in analyzing companies for their environmental, social, and governance performance. “It shows a very conservative tier-one capital ratio, that they keep a lot of cash on hand in case the risks they have taken actually materialize,” he says.

Larkin is concerned, however, that since the credit crisis began, Lehman's disclosures about its exposure to subprime mortgages has been paltry compared with those of other big Wall Street players.

More Information, Please

"One reason I'm so skeptical is that Lehman is so heavily into the subprime mortgage sector, yet their writedowns so far have been so small," he says.

It's fair for the market to assume the comparative dearth of writedowns has less to do with Lehman's adeptness as risk managers and more to do with the fact that the firm hasn't calculated the full extent of its losses yet or hasn't figured out how to market the securities profitably, Larkin says.

A major part of Innovest's analysis of the banks it covers involves evaluating the quality of the mortgage loans they securitize in terms of the potential impact on borrowers, as well as studying the delinquency and foreclosure rates of those mortgages, Larkin says. "Of the subprime loans Lehman is exposed to, it's impossible for me to say that 95% of those are fixed-rate, fully amortized mortgages [which hardly ever run the risk of going into foreclosure]. It's a black box," he says.

Relying on the Fed

Despite the liquidity update, Lehman’s portfolio of asset-backed securities remains murky, says Larkin. To fully dispel the market's doubts about Lehman's liquidity, it's critical that Fuld disclose what's on the firm's books, he says. "If he were to have a no-holds-barred, fully candid disclosure of what they're sitting on, that is the only way for people not to assume the worst at this point." Anything less and Lehman risks a mass withdrawal of capital similar to what hit Bear Stearns last week, he adds.

In contrast, Merrill Lynch, Goldman Sachs, and Morgan Stanley historically have been forthcoming about the quality and volume of the mortgages they have securitized, Larkin says. Not only have their asset writedowns been considerable, but their efforts to clean house, such as the ouster last fall of Merrill CEO Stan O'Neal, served to reassure the market that these firms are displaying their dirty laundry and that excessive asset valuations are a thing of the past, he adds.

Heated Debate

On Mar. 17, UBS (UBS) analyst Glenn Shorr downgraded all the financial names he had buy ratings on to neutral, saying he believes the crisis of confidence in the capital markets will combine with lower earnings and lower valuation multiples and cause the stocks to stay under pressure for the near term. (UBS, its affiliates, or subsidiaries have received compensation for investment banking services from Lehman Brothers within the past 12 months.)

Marino Marin, managing director at Gruppo Levey, a specialty investment bank in New York, who once worked in Lehman's M&A advisory division and still owns some stock, thinks Lehman doesn't deserve to be lumped with Bear Stearns because of differences between the two firms' liquidity positions and levels of commitment by top management.

"I can tell you no one [at Lehman] was playing bridge or golf over the weekend," he says. (Bear Stearns Chairman James Cayne was playing in a bridge tournament in Detroit over the weekend, according to sources cited in a Wall Street Journal report, and was also away from New York last summer when two of Bear's hedge funds failed.) "The level of commitment makes all the difference."

Lehman's sealing a deal with 40 banks on Friday for a three-year unsecured credit line of $2 billion should also go a long way toward bolstering the market's confidence in the firm's access to capital, Marin says. While he doesn't profess to know the condition of his former employer's balance sheet, he says "knowing there's $2 billion in place on top of what they had in place before should be a comfort" to counterparties.

Will the Fed Take a Loss?

Some people believe the Fed discount-window opening to independent broker-dealers as well as commercial banks puts Lehman in a much better liquidity position than Bear.

Whalen at Institutional Risk Analytics dismisses that, however, as a Band-Aid and only a temporary solution to Lehman's deeper liquidity issues.

"At the end of 28 days, if their collateral has been downgraded by Moody's [Ratings Services], the Fed will ask for more collateral," he says. "The Fed could actually take a loss on some of these loans. They can't afford to hold them if the value of the collateral is effectively zero."

At best, the Fed's moves are a stopgap designed to buy time until investor sentiment rebounds to the point where broker-dealers can fund their own investments, Whalen says. Lehman's proactive stance in securing more long-term loans is admirable, he says, but ultimately, without being able to raise capital apart from debt, the firm will be forced to shrink and sell assets at very low prices to raise cash. "They work on leverage, just like hedge funds. Their leverage is 30 to 1, and probably more when you take everything else into account."

As more hedge funds are forced to liquidate in the course of this year, Whalen predicts, broker-dealers such as Lehman will get hit again because hedge funds won't be able to make good on the credit-default swaps they have with broker-dealers. And that could make an already difficult year for Lehman even more unpleasant.

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