Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Why Own Lehman Brothers?

CNBC Television personality Jim Cramer penned an article on Thursday, June 5th 2008 entitled Why Own Lehman? In that article he said that No, he did not think that Lehman Brothers was going under. "It's got a great franchise with a good cash position, reduced leverage, much better management than Bear [Stearns] and a buyback that's kicking in that wouldn't if things were as bad as the bears make it out to be." The questioner then apparently asked if Cramer would buy the Lehman Brothers stock. Cramer said, "Why the heck would I do that? To catch a 2- or 3-point rally? There is no earnings power at Lehman."

Toomre Capital Markets LLC ("TCM") normally approaches such pronouncements from television pundits with a healthy dose of skepticism. However in this case, Jim Cramer is right on. The article continues:

I explained that some stocks are neither longs nor shorts -- that, to me, is Lehman. There's no reason to short it, because I don't think it is going under but many are betting that way, and there is no reason to go long it, because the place is set up for a period of big fees from fixed-income products, from structured products, but clients have at last figured out that they will lose their jobs if they keep buying this nonsense.

And that's really the rub. These places have oodles of high-priced salespeople, tons of them, and they are all being paid fortunes to sell products that don't work. They sell broken vacuum cleaners with no warranties.

It is that stark.

I know that anyone in brokerage is always reluctant to admit that structured products really have no value or are too risky, that they're just a way to figure out how to take a little extra per million -- a fraction, but they do add up. But that's what happened to a lot of these great firms that got fixed-income-heavy. There isn't enough money to be made selling regular commodity fixed-income products, so you have to talk people into buying things they shouldn't that they don't understand.

That game is over. But the people are still there, as is the overhead. Without this stuff, I don't know how you make a lot of money at an investment firm, particularly when you have decided to shrink your balance sheet and make fewer loans. Some can get away with it: Bank of America BAC, for instance, because it has a deposit base (same reason Wachovia WB is worth something, but I don't want to own it, either), doesn't need to rely on structured products to make some money.

LEH? I just don't see how they can deliver $5-6 earnings power anymore. Worse, I can't even figure out what they could earn in this environment. The franchise isn't too dicey, just the earnings estimates.

Jim Cramer puts much more bluntly what Toomre Capital Markets LLC has been struggling with as illustrated by the post Value of the Investment Banking Franchises?? Just what can these investment banking franchises earn in the post credit-crunch environment where there is limited demand for structured finance, mortgage securities, and complex derivatives and where they must operate with sharply decreased leverage and more limited proprietary trading operations? The regulatory changes that are going to be forthcoming as a result of the credit crunch are as of yet unknown. However, surely there will be increased capital charges under Basel II for what are classified as "trading positions."

Traditional stock and bond trading do not require as many people as currently are employed in the investment bank businesses nor do they produce the profits that will get paid such extreme compensation as paid during the housing bubble years. If the Capital Markets operations go back to the former and lower risk model of "client flow trading", surely there will be more layoffs and a lower rate of return for this industry.

The key to getting back to that more stable state will be to clean up and continue to sharply deleverage the various investment banking balance sheets. There probably will be some additional losses that will need to be recognized as part of that deleveraging process. Various capital market participants seem to be concerned about Lehman Brother's transparency in its financial accounting and how accurate the assets on its highly leveraged balance sheet might be marked.

As a former employee of Lehman Brothers, Lars Toomre is sad to see this investment bank go through its current travails. However, he is a bit surprised that the lessons from when he ran the mortgage structured product trading area have not been passed on. Apparently, Dick Fuld, Joe Gregory and others have forgotten that the true price of what an illiquid security or derivative is worth is where you can sell it to an independent third-party. A trader or desk might think that it is worth X. However, if the only other buyer in the market is willing to pay Y, it really is only worth Y and the difference (Y-X) is a loss. Any price above Y is only worth it if one can find another independent buyer.

The faster that Lehman Brothers and the other investment banks liquefy their balance sheets, the quicker the recovery will be in their economic fundamentals. Another item will be to increase their financial transparency. For instance, one item that Toomre Capital Markets LLC would very much like to see is information on the aging of the trading inventory, particularly with regard to the FASB 157 Level 3 assets. Old "aged" inventory that has not been traded in several months is more likely to be further from its actual liquidation value and (absent severe mark-downs that used to occur at some trading firms) is more likely to produce realized losses vis-à-vis the marks. If those aged positions also are in the Level 3 bucket, one has real reason to question just how accurate the market values of those positions are determined.

Thoughts and comments are welcome.