The Doom And Gloom Of Lehman

Over the past 5 trading days, shares of Lehman Brothers (LEH) have been beaten down over 51% due to capital raising issues. Shares are now down to their lowest point in the past 10 years, and had their biggest drop ever yesterday in the firm’s 158 year history. Many investors have become wary of Lehman over the past 3 months and their ability to successfully continue their operations. In order for them to operate smoothly, they will need to raise a lot of capital to offset the sharp decline in some of their commercial and real estate assets. Compared to other financial firms, Lehman has taken too long to raise capital to absorb these expected losses. Investors are now scared to invest more into Lehman after seeing the value of their other additional investments in Lehman and other banks fall dramatically in value. Spreads to raise debt in the capital markets have also become too expensive with some of their spreads over 800 bps to treasuries.

Lehman’s Previewed Earnings

Lehman is on track to report what will be the firm’s largest loss since their IPO in 1994. Internal projections are in the range of $4 billion, or $5.92 a share, for the quarter on just under $8 billion in write-downs. Contributing to the write-downs include gross write-downs of $5.3 billion on residential mortgages and $1.7 billion in their commercial real estate portfolio. The firm is also projecting negative net revenue of about $2.9 billion. According to Thomson Reuters, analysts were expecting a loss of $3.35 a share on revenue of $286 million.

Their investment management division, which they are trying to sell, is expected to post $600 million in net revenues. This will be a 25% decline from the past quarter’s results. Their capital markets division will post negative net revenues of over $4 billion and projections for investment banking revenues will be down 33% from the last quarter.

In Lehman’s conference call the CEO, Richard Fuld, said of Lehman’s plans, “The strategic initiatives we have announced today reflect our determination to fundamentally reposition Lehman Brothers by dramatically reducing balance sheet risk, reinforcing our focus on our client-facing businesses and returning the firm to profitability.” Returning the firm to profitability after delivering their businesses will be impossible. Lehman saw record earnings and saw their share price soar between 2004 and 2007 as they moved their business plan from a bond powerhouse to taking on more risk with commercial and real-estate assets. Lehman also announced that they will cut their dividend to 5 cents from 68 cents which is expected to save the firm about a half billion a year.

Lehman is also working on a plan in which it will spin off $25-30 billion of its commercial real estate operations into a new entity “SpinCo.” Finding funding for this business may be a problem, considering the complexity of the assets that would be included in this portfolio. The remaining portion of the company may be spun off into the name of Clean Co.

Capital Issues

Lehman’s Tier 1 ratio is currently at 10.7% and is expected to bounce up to 11% in their next reported results. Lehman’s liquidity pool is estimated in the range of $42 billion. The firm has also been working extremely hard over the past year to reduce their leverage ratio, and is expected to fall to 10.6 from 12.1 last quarter.

To shore up more capital, Lehman has been looking to sell a majority interest or all of its investment-management division to receive around $5 billion. Their investment-management unit includes their extremely profitable and marketable Neuberger Berman unit. Lehman was in talks with Korea Development Bank to raise capital by selling the Neurberger Berman unit.  Talks have since ceased amid concers from KDB that Lehman may default on its debt. Other rumors have been swarming around the sale as three private equity firms may place bids on this business as early as Friday. One private equity firm that may be extremely interested in the business may be KKR.  KKR is looking to revamp its businesses before their reverse-merger IPO takes place in the second half of the year.

After their shares were slammed in the past couple of days, Lehman’s management felt it was necessary to relieve investor concerns by offering a preview of its third quarter results. Analysts are also expecting management to announce “key strategic initiatives” such as selling parts of their business. I see this as a desperate move by stubborn management who are delaying what they need to do, which is to find buyers for all of their businesses. According to an article in the Wall Street Journal, Lehman’s “problem assets” outweigh their capital cushion by a ratio of about 2.2. This compares to Merrill Lynch (MER), Morgan Stanley (MS), and Goldman Sachs (GS) ratios of 1.9, 1.7, and 1.2 respectively.

Lehman is also in talks with BlackRock (BLK) to sell packages of residential real-estate assets. A deal is already being worked out to sell a package of British RMBS assets for about $4 billion, and should close in the next few weeks. This would still leave their residential mortgage portfolio exposure to over $13 billion, a figure that is still too high according to analysts. Lehman will also try to cut other real estate investments by about $10 billion to just under $40 billion.

One thing to watch is Lehman’s level 3 asset exposure and the flow from level 2 assets to level 3 assets.  According to their last reported figures, Lehman had $161.84 billion in level 2 assets and $48.73 billion in level 3 assets.  Their level 3 assets to total assets are on the higher side of the industry at 6.47%.  The most important ratio to watch is their level 3 assets to total equity.  On this metric, they are under-capitalized at a ratio of 157.4%.  This ratio is extremely high not only on a nominal basis but also relative to other financial sector companies.  This ratio alone shows the riskiness of their assets and how much capital they may have to raise with even a 10% writedown in their level 3 asset portfolio.  Many analysts say that Lehman is behind the curve in level 3 asset write-downs and refuses to mark them down close to what investors believe is the true value.  If regulators and auditors come in and force Lehman to write-down these assets further, bad things will happen.  S&P currently has a negative outlook on Lehman’s debt rating as they are concerned about their capital position and their ability to raise debt to cover their short term obligations.

The Future

All of these desperate moves in the past week have made Lehman appear weak. Richard Bove of Ladenenburg Thalmann & Co. said, “Clearly the company does not believe that it has a serious balance-sheet problem and it simply refuses to take what it believes are fire-sale prices for its key assets… Buyers seem to believe that Lehman is overvaluing its assets and refuse to hit the bid.” The future is definitely not looking good for Lehman. I believe that Lehman will not be a publicly operating company by the end of the year. My guess is that Lehman will be sold at a sum of the parts business to multiple firms. No one will take over Lehman as it is now, due to the risk that is associated with it. Watch for a move over the weekend to at least have an announcement for the sale of their investment-management business. My guess is that after all of these plans to sell their businesses, the remaining firm will still be too under-capitalized to continue operations. The government may then come in to expedite a sale of the firm, but expect them to remain on the side-lines. After everything that has happened with recent bank failures, Bear Stearns, and now Fannie and Freddie, the Treasury and Fed have too much on their plates to take any financial responsibility with Lehman.

Disclosure:  The mutual fund the author is associated with is long GS.

Subscribe by RSS Subscribe by Email