Lehman Brothers Seen As Cheap Recovery Bet

Voltron says: despite the title, the author warns against Lehman.
By PETER EAVIS and DAVID REILLY

Shares in Lehman Brothers Holdings Inc. have rallied from lows seen during the Bears Stearns Cos. crisis, and some investors see the investment house as a cheap way to bet on any eventual markets recovery.

Lehman's stock rallied Thursday on the New York Stock Exchange, rising about 6% to close at $46.38.

But a deeper look at Lehman's most-recent results shows that the broker's reliance on one-time, noncash gains could make any earnings recovery more difficult than some investors think. Lehman racked up about $1.6 billion in pretax gains thanks to changes in hard-to-value equity assets, mortgage-servicing rights and the value of its own debt, which may be tough to repeat.

So, investors should be cautious when it comes to Lehman's stock, which is trading at a price that is 1.18 times book value -- or a firm's net worth -- the lowest valuation among the four big brokers: Goldman Sachs Group tops out the list with price-to-book ratio of 1.95 times; Merrill is at 1.75 times; and Morgan Stanley is at 1.65.

While no broker reported stellar first-quarter numbers, Lehman's greater reliance on some noncash gains that appear hard to repeat may explain part of this valuation discount. It could also suggest that the firm's future earnings power is depleted.

Chief Financial Officer Erin Callan, in a statement, said, "Our earnings were below our prior periods given the challenging markets; however, the diversified revenue generation capability of the underlying franchise was evidenced by our second best-ever revenue run rate."

The biggest one-off item in Lehman's fiscal first quarter that ended in February was a pretax, unrealized gain of $695 million related to an increase in hard-to-value equity positions.

Lehman also booked a $364 million pretax gain on changes in the value of mortgage-servicing rights, which are treated as an asset because they represent the future cash flows from fees borrowers pay to the companies that collect mortgage payments.

The value of these rights changes depending on expectations of things like the future direction of interest rates, risk associated with mortgages and, most importantly, the likelihood that investors will prepay their loans.

When expected prepayments decline, holders of servicing rights see gains. Prepayment rates have been dropping since last year because fewer people can refinance mortgages.

Lehman also posted $600 million from declines in the value of its own debt. The firm wasn't unique in this regard: Merrill booked $2.1 billion this way. But, with worries about the big brokerage houses receding, and the price of their debt stabilizing or improving, such gains are unlikely in coming quarters and could reverse.