What is the market telling us about the outlook for Lehman Brothers (LEH)? 

On the credit markets, the company’s CDS spreads for its senior debt was trading last week at around 400 bps, very close to the peak reached during the Bear Stearns (BSC) crisis and trending higher.  This is indicative of “stress,” although not yet of extreme distress (i.e., elevated likelihood of default).  Clearly, if it were not for Lehman’s access to the Fed’s discount window, these spreads would have been much wider, or, quite possibly, LEH could have failed by now.

The equity market is sending a different message: The stock, at about $12.4, results in a P/B of  0.36, which probably indicates that the firm is beyond the point of no return.  The equity market is telling us that LEH will likely not be able to continue as a going concern. 

In Roger Lowenstein’s excellent book When Genius Failed, he recounts an incident when John Meriwether disclosed to a friend that LTCM was down 50%, and his friend told him, “You’re finished,” the friend’s argument being that, if a fund has gone down that much, people believe it can go down all the way; trust is gone, margins will be called, redemptions will come in, and it becomes a self-fulfilling prophecy.  The same principle holds true for a financial institution, and that is the predicament that Lehman Brothers is in today, even with access to the discount window. 

Joining the credit picture and the equity picture, it emerges that the market does not seem to be incorporating an imminent collapse, but that likely there is no medium-term viability for the firm as a going concern.  In other words, the expectations seem to anticipate that there will be an orderly, gradual unwinding of Lehman Brothers supported by the Fed promise (or actual supply) of liquidity, where shareholders likely get wiped out (or close to it), and senior lenders are likely to recover most of their money.      

Fundamental analysis 

I certainly believe more in what the market is saying about LEH than what Dick Fuld, Bernanke, or Paulson are saying.  In Lehman’s case, I am, however, more pessimistic than the market.   

I think there is a good chance that the unwind might be less orderly and end up with a classic run on the bank and bankruptcy for the institution (with a 60% likelihood). 

In my view, the lack of viability is clear from these factors: 

• the very low price-to-book value of 0.36

• the 83% fall in price since October

• the fact that it is the smallest of the bulge-bracket investment banks

• the fact that they have the most relative exposure to domestic fixed-income markets of the bulge market firms in general and residential mortgages in particular (with about $60 billion of commercial and residential real estate, as of May 30, 2008, including about $12 billion of Alt-A toxic garbage—a business they got into in the late nineties with the acquisition of BNC), and the most absolute dollar exposure to commercial real estate

• recklessly high levels of leverage (even after finally reducing leverage in the last quarter to about 25 to 1, which is still way too much), as all other such firms have, and a lot of assets in Level III, valued at over 1.7 times equity

More importantly, there is the embarrassing loss of face from management mistakes and the revelation of lack of candor and questionable accounting practices from the firm’s management.  This is really what has wounded the institution mortally. There is no recovery from this.   

Consider the following: 

• Until the Bear Stearns crisis in March, the firm seemed to be weathering the crisis well, like Goldman Sachs. This was surprising, considering their high domestic fixed-income and mortgage exposure.  This could be driven by (1) excellent risk management or (2) being less than forthcoming in writing down assets. It would have been easier for Lehman’s management to pull off the latter than at Citi, UBS, Merrill, or Morgan Stanley, because its CEO has been on the job for over 20 years and had much more leverage over the board and any internal checks and balances than the CEO’s in the other institutions.  In the other institutions, particularly the ones where the CEO was eventually replaced, the new CEO has all the incentives, for obvious reasons, to write down bad assets as soon as possible and seek to move on.   The suspicion increased with the tremendous lack of quality of Lehman’s Q1 2008 earnings, where substantial gains resulted from marking to market its liabilities (a bizarre result of a rule that allows a firm to recognize accounting gains resulting from a deterioration in its credit profile), and (so it seems); where they have not appropriately written down sub-investment-grade structured securities; and where they, inappropriately it seems, wrote up Level III assets.  Only under extreme scrutiny of their statements by a short seller with a strong reputation, David Einhorn, the company admitted that it needed to raise more capital and recorded its first-ever loss since its IPO over 20 years ago.

• The company was increasing its leverage all the way up until the Bear Stearns collapse. For example, in the first quarter Lehman added over $80 billion in assets, and, amid falling mortgage markets, it increased by about $2 billion its holdings of Alt-A loans (mortgages made to borrowers who are less than prime and cannot provide evidence of their income). “We saw a great opportunity,” Lehman’s then-CFO Erin Callan said on March 18.  This is a clear sign that they completely misread the markets and thought that doubling down and window dressing would get them through this crisis.

• The firm increased its dividend when it needed to bolster its capital position at the beginning of the year.  By this time, they must have known better; was this was an attempt to show defiance and mislead the market?  Again, a serious misread of the severity of the crisis: They did not seem to realize that this was the real McCoy.

• Lehman was aggressive in tapping the Fed's “lender of last resort” facility for broker dealers. In fact, Lehman was so “creative,” that in March they created a $2.8 billion “Freedom CLO” out of leveraged loans that couldn't be readily sold to investors (such as for the buyouts of payment processor First Data Corp. and power producer TXU Corp.) for the express purpose of meeting the Fed rating requirements for collateral. That the Fed went along and accepted this junk as high investment-grade collateral is shocking.

• Last month, at the same time it admitted that it will likely need to raise new capital, Lehman decided to use precious capital to (in my opinion) manipulate its stock price by buying its own shares.  Some analysts in the market saw this as a positive sign.  This is unbelievable. It is very easy to show “confidence” in the future of the firm with other people’s money.  If Dick Fuld were to step up and put a substantial portion of his net worth in the stock of the company, then I would agree that that would be a positive indication; however, he has not done so.

• At a time when it needed to conserve capital, Lehman very recently invested $1 billion in R3, a hedge fund started by employees who departed the firm to form it, which is based at Lehman Brothers’ facilities, and which has bought $4 billion of assets from Lehman.  This is eerily reminiscent of Enron.  If all of these are arms-length transactions, how can Lehman justify investing $1 billion in a hedge fund under its current conditions?

• It seems that the firm may have employed deplorable tactics last month, doing what appeared to be selective disclosure of material information through the leaking of an “internal memo” about its reduction of leverage.  Such practice would be against SEC regulations.

What could tip Lehman over? 

At this point, Lehman has no option but to continue to deleverage itself, although this raises doubts about the assets that were not sold.  Is this an approach of selling what they can and keep what they cannot sell?  

Lehman has no real trade-sale alternatives: BoA (BAC) and JPMorgan (JPM) have already done large and potentially disastrous acquisitions. Goldman (GS) is too smart to fall for it.  

It is also very doubtful that Lehman would be able now to tap into the equity markets, with investors having poured over $300 billion into financials and licking their wounds.  The New Jersey investments division, which was one of the key investors in Lehman’s most recent, $6 billion, equity injection, closed last month, has lost well over 50% of its investment (they came in at $28). 

I have great intellectual respect for Bill Gross of PIMCO, so I was surprised last week when he apparently indicated that there were no concerns about Lehman’s solvency as long as the Fed window is made available.  The problem is that the Fed window is not unconditional and may be withdrawn.  The company does have substantial liquidity, but solvency is a different question; the fact that the Fed has opened the discount window does nothing for Lehman’s solvency, which only exists if the market value of assets exceeds the market value of liabilities.   

The collapse of IndyMac (IMB), which was a federally insured savings bank, and therefore had access to the discount window, proves that even with this access, a collapse is possible.  The Fed, in theory, should only provide liquidity to solvent entities. If it becomes obvious that the company is insolvent (for example, because of a bank run, as was the case with IndyMac), the Fed may stop throwing money at a black hole.  Nouriel Roubini recently, brilliantly, explained how such a collapse could happen (read his 6/27 piece, “the delusional complacency that the “worst is behind us” is rapidly melting away…and the risk of another run against systemically important broker dealers”).  If LEH counterparties believe that the company is insolvent, then they should fear that the Fed could stop providing the “last resort” loans.

Ironically, as the authorities work on rules to handle the liquidation of large or systemic broker dealers and work to bring the credit derivative market under a clearing house mechanism, this could increase the likelihood of a Lehman failure as the financial system will be better ready to withstand it.  

The Fed and particularly the Treasury have been indicating concern with moral hazards and may soon be ready to have a sacrificial lamb to establish their hawkish credentials.

Disclosure: Short LEH

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