Toomre Capital Markets LLC

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Lehman Brothers Weighs Raising Equity Capital

On Monday June 2nd 2008, Toomre Capital Markets LLC ("TCM") questioned just where is value with the global investment banking franchises in the post Value of the Investment Banking Franchsises?? The intent was to follow that post up with some of the details that is leading TCM to think that the Capital Markets are likely to be buffeted by further credit crunch turbulence.

However, on Tuesday June 3rd 2008, market participants woke to the news from The Wall Street Journal that Losses Push Lehman To Weigh Raising New Capital. As the article explains, the investment banking franchise known as Lehman Brothers apparently is "considering raising billions of dollars in fresh capital to help shore up its balance sheet, according to people familiar with the matter." This would be the first issuance of common stock by Lehman Brothers since it went public from American Express back in 1994. The cause of the stock issuance is what appears to be Lehman Brothers' first quarterly loss since it went public. The formal earnings announcement for Lehman Brothers is expected during the week of June 16th along with those from Goldman Sachs and Morgan Stanley.

This capital raise will be coming on top of six billion in capital Lehman Brothers raised during the past year including $4 billion in preferred stock raised after the forced sale of Bear Stearns to JPMorgan. The forthcoming earning report is expected to "show some fresh difficulties. The firm is saddled with billions of dollars in hard-to-sell commercial real-estate assets and leveraged loans and is expected to face further write-downs on these portfolios. That has led the firm to consider raising additional capital. Wall Street firms including Merrill Lynch and Morgan Stanley have also raised billions of dollars as losses from the mortgage meltdown have mounted."

The article concludes with information that Lehman Brothers was hurt by ineffective hedges. Specifically,

During the second quarter, Lehman was stung by hedges used to offset losses in real estate and other securities, according to people familiar with the matter. The firm bet that indexes tracking markets such as real-estate securities and leveraged loans would fall. If that happened, it would book profits that would make up some of its losses from holding these securities and loans.

However, in an unexpected twist, some of the indexes rose, even as the assets they were supposed to hedge against continued to lose value or stayed relatively flat. Lehman's losses from both write-downs on assets and ineffective hedges will likely top $2 billion, people familiar with the matter said. Lehman will also realize additional losses related to its decision to reduce its work force, according to a person familiar with the matter.

The S&P downgrades came after the ratings agency completed a review of the entire securities industry. S&P said it believes Lehman and other securities dealers' revenues may decline more than anticipated based on the firms' still large exposures to illiquid and hard-to-value assets.

S&P analyst Scott Sprinzen said the Federal Reserve's decision to allow brokers to borrow money directly from the Fed, "gave us the comfort not to go further with some of the downgrades that we did," he says. "But we can't count on that indefinitely."

S&P cut Lehman's rating to A from A+, and also cut the ratings of Morgan Stanley to A+ from AA- and Merrill Lynch to A from A+. Despite the downgrades, the firms are still considered high-quality investment-grade credits. S&P affirmed Goldman Sachs's ratings at AA-, but revised its outlook of the firm to negative.

In recent weeks, David Einhorn of the hedge fund Greenlight Capital has been highly critical of what some refer to as the Lehman Brothers black box and the firm's lack of transparency in reporting what risks it takes to make its reported profits. Perhaps his criticism is biased by his admitted short position in Lehman Brothers' common stock. The key point of his short thesis on Lehman Brothers concerns FASB 159 (The Fair Value Option for Financial Assets and Financial Liabilities), a new accounting standard, which he called "Profiting from your own demise." This new standard allows companies to update the fair value of both their assets and liabilities. Previously, if interest rates moved, only the assets were revalued, so companies would report a gain or a loss based on that move. If your assets are properly funded by matching liabilities, however, both should move in lockstep and offset each other, so this new accounting standard seems to make sense.

Mr. Einhorn goes on to suggest that suppose a company's debt is being severely downgraded. Suppose further that the market hasn't changed, so the value of the assets remain the same. Now the company will record a gain and increase its apparent book value, or equity, when in fact it is in recognizably worse financial shape due to the downgrade. It is an entirely absurd outcome. According to Mr. Einhorn, the investment banks have been early adopters of this standard and this has had the absurd effect that the worse their credit, the more money they're making (because of the gain in book value that goes through the income statement). The logical extreme of this is that the most lucrative day in the history of your company will be the day you go bankrupt.

Mr. Einhorn suggests that the FASB 159 gains from marking down the value of Lehman's debt and gains from private equity marked up (but not sold) were the primary reasons that Lehman Brothers reported a first quarter profit. He further points to a portfolio of more than $6 billion in CDOs that were marked down only approximately $200 million during the first quarter. Given that a large percentage of the portfolio was below investment grade and how other below investment grade bonds widened substantially during the first quarter, he reasonably questions whether those assets were being correctly marked even in such a highly illiquid market environment.

Toomre Capital Markets LLC joins Mr. Einhorn is questioning the transparency of Lehman Brothers' financial disclosures. Perhaps the forthcoming second quarter earnings report will be particularly bad as Lehman Brothers corrects various biases that allowed the firm to report profits in past quarters? Maybe with a "kitchen sink" quarter, this investment bank will be able to go forward in the new environment of decreased activity, sharply lowered leverage and increased regulation? The interesting question is what the franchise value will be going forward. Yesterday, Lehman Brothers closed at $33.83 down $2.98 (or 8.10%) on the day. The 52-week low was $20.25 was hit around the time of the Bear Stearns crisis when the market participants were wondering if Lehman Brothers might be the next investment bank to succumb to the credit crisis.

One has to wonder with the forthcoming equity issue whether the Lehman Brothers common stock will trade down again to those lows. However, the real question is where is value with this investment banking franchise? Does anyone really know? Reader comments and thoughts are welcome.