Monday, June 9, 2008

Lehman Talks a Rosy Talk

The Wall Street Journal


Walking the Walk
May Prove Thornier
Than Bank Predicts

After raising $6 billion in fresh capital, Lehman Brothers Holdings Inc. quickly declared dead any questions about its ability to survive.

"The discussions at this point aren't about our viability or the fact that we will be here or the fact that we have sufficient liquidity," Chief Financial Officer Erin Callan said on a conference call with investors Monday. "I think we put that to bed on a number of different levels through our own actions."

Not so fast. Any firm that is forced to sell equity at a 20% discount to book value while diluting existing holders by 30% is far from out of the woods. And the recent track record of both Lehman and Ms. Callan means it will be some time before investors regain confidence in the firm.


Consider that earlier this year Lehman, amid falling mortgage markets, increased by about $2 billion its holdings of so-called Alt-A loans, or mortgages made to borrowers who aren't exactly prime. "We saw a great opportunity," Ms. Callan said March 18.

Now, less than three months later, that move doesn't look so smart. Lehman said Monday that it had gross write-downs of about $2 billion on residential-mortgage holdings, which are mostly Alt-A loans, during the fiscal second quarter that ended in May. That helped fuel what Lehman expects to be a $2.8 billion net loss for the quarter.

While Lehman may eventually see some of those holdings rebound, the episode underlines the big worry surrounding the firm: that it has been slower than peers in adequately marking down holdings and shedding deadweight assets.

Lehman may still face further losses on its still-big books of residential- and commercial-mortgage holdings. Those could cause the firm's reliance on borrowed money to again increase, even as they eat into its now-replenished capital base. Also, while Lehman in the past quarter trimmed its balance sheet by $130 billion, the firm had expanded the balance sheet by $95 billion in the previous quarter.

Lehman's defiant tone in the face of woeful performance also has jarred investors. Indeed, rather than sounding contrite about the firm's losses, Ms. Callan was quick to say it is ready to again play offense in markets.

True, the capital raising, along with the sale by Lehman during the quarter of about $130 billion in assets, is a step in the right direction. But the balance sheet is still wobbly.

And Lehman's most-vocal critic, David Einhorn, manager of hedge fund Greenlight Capital, who has been short the stock, betting it will decline, remains dissatisfied. "They just raised $6 billion of capital that they said they didn't need, to replace losses they said they didn't have."

Banks' Tries at Hedging Likely Will Show Losses

One criticism of Wall Street firms is that they are like hedge funds since their results are at the mercy of their trading strategies.

That viewpoint is likely to gain ground only as the brokerages report second-quarter earnings. The results at several investment banks are likely to contain big losses on trades made to protect their balance sheets against write-downs on risky assets.

Lehman Brothers, which gave investors an advance snapshot of its fiscal second-quarter earnings Monday, said these losses totaled $400 million on financial instruments that were bought to protect the bank against declines in the value of its commercial-mortgage assets.

The "hedging" losses increased the overall quarterly write-down on Lehman's commercial mortgages to $1.1 billion from $700 million. Analysts also expect hedging losses at Goldman Sachs Group Inc. and Morgan Stanley.

Since investment banks are supposed to have razor-sharp risk managers, how is it that they have been tripped up by their own hedges? In short, it appears they were all betting the same way.

Whenever a trade becomes popular, it becomes vulnerable to an adverse move because so many people try to exit it at the first sign of losses.

One of the most common trades on Wall Street has been to place a bearish bet on the CMBX index, which tracks the performance of credit-default swaps on bonds backed by commercial mortgages. In the second quarter, the CMBX moved against bearish trades. Making matters worse: Often the assets being hedged didn't post gains when the hedge lost value.

But it isn't all bad news. One investor thinks the bearish bets on the CMBX will work out. Carlos Mendez, managing director at asset manager ICP Capital, says the deterioration in the performance of bonds underlying the CMBX will move the index in a bearish direction -- and benefit the investment banks. But that assumes the banks haven't locked in the losses by then.

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