Lehman Brothers Leverage 32:1 Capital $24.8 Billion

What if the Worst is Not Over?
By Dan Amoss

Since the rescue of Bear Stearns on March 17, the Amex Securities Broker/Dealer Index has rallied 20%. The shares of Lehman Brothers have rocketed more than 30%. These dramatic rallies support the popular thesis that "the worst is over" for the financial sector. But these dramatic rallies also provide attractive short-selling opportunities for every investor who believes that the "worst is yet to come."

Most of Wall Street's money-making machines have shut down. Mortgage-securitization activity has gone kaput, while IPO and M&A activities are sputtering. Even worse, Billions of dollars of future write-downs and losses are still buried inside Wall Street's balance sheets.

Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks. The stock has rallied hard since the Bear Stearns rescue. Because its business model closely resembles that of Bear Stearns, Wall Street thought Lehman was next. And it might have been, if not for the Fed.

The Fed instituted a lending facility allowing the investment banks to temporarily swap the ugliest "alphabet soup" assets for Treasuries. These alphabet soup assets - mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized loan obligations (CLO), and others - had been smothering the brokers to the point that Bear Stearns was hours from declaring bankruptcy.

In the hopeful words of Lehman Brothers CEO, Dick Fuld, the Federal Reserve's lending facility "takes the liquidity issue for the entire industry off the table." Sure, the Fed's actions may have forestalled a modern-day "bank run" on Wall Street. But the Fed has not solved the bigger, longer-term crisis.

The Fed's new facility allows Lehman to temporarily swap its garbage assets for Treasuries. What it doesn't do is protect Lehman shareholders from losses on these securities. Lehman shareholders will be the first to absorb these losses. Shareholders are in the most junior position in every company's capital structure. So the more leverage - or debt - a company employs, the quicker shareholders get wiped out when assets sour.

As the chart below shows, Lehman's equity (in red) supports just a tiny sliver of Lehman's towering liabilities. Lehman's gross leverage ratio amounts to about 32 times equity. This means Lehman's assets can fall only about 3% in value before equity is wiped out.



Lehman is scrambling to reduce leverage and raise capital by selling illiquid assets into a weak secondary market. Unfortunately, illiquid mortgage-backed securities aren't a particularly hot item these days. There are few buyers for such assets - even at steep discounts.

According to Bernstein Research, Lehman's "troubled" residential and commercial mortgage assets amount to nearly three times its tangible equity. That's danger level for Lehman shareholders. And the danger is growing…



Last year, the investment banks, including Lehman, adopted a new Financial Accounting Standards Board rule called "FAS 157." This new accounting rule segregates balance sheet assets according to their liquidity and marketability. "Level I Assets" have readily available market prices. "Level II Assets" can be valued by comparing them to prices of similar assets. But "Level III Assets" lack any observable market price or price inputs. They are "marked to model" - not "marked to market."

So how many Lehman assets are Level II and III? According to its latest 10-Q, Lehman categorized $60.5 billion and $23.8 billion of its mortgage securities as Level II and III assets, respectively. This adds up to $84.3 billion – or more than four times tangible equity per share! Therefore, if just 12% of Lehman's $153 per share in Level II and III mortgage assets were written off - a reasonable assumption - such losses would eat through half of Lehman's tangible equity.

The odd thing about Level III assets, also know as "mark-to-model" assets, is that the owner of them gets to decide how much they're worth. I'm not kidding. Lehman management determines for itself the value of the Level III it owns. Therefore, no one can really know what the true value might be. There's no way to know, for example, what models management uses to value its Level III assets. Hopefully, they are not using the same badly flawed models that predicted smooth sailing for subprime mortgage-backed securities.

This lack of pricing transparency (or pricing reality) can be management's strongest ally…for a while. But eventually, the truth will out. Eventually, the Level III assets will make their way from the dark recesses of Lehman's balance sheet into the unforgiving light of real-world pricing. Eventually, living and breathing buyers will determine the value of these assets, not some mainframe computer in the Lehman back office. And as these real-world transactions occur, Lehman might face billions of dollars of additional write-downs and losses.

Lehman management has not been terribly forthcoming about reporting quarterly losses and write-downs. Brad Hintz from Bernstein Research hinted that fuzzy math produced Lehman's "strong" March earnings report: "We believe the quality of these earnings was weak, as the firm benefited from a lower tax rate and enjoyed a $600 million mark-to-market gain on its liabilities." That's a polite understatement. Believe it or not, accounting rules allow investment banks to book a profit when the value of the bonds they have issued FALL. Follow along with this crazy logic if you can: Because the holders of Lehman's bonds became fearful that Lehman would declare bankruptcy, the bondholders dumped the bonds at very low prices. Therefore, because Lehman's bond prices tumbled, Lehman could, theoretically, buy back the bonds at prices much lower than the stated value of those bonds on Lehman's balance sheet. As a result, this bizarre accounting rule concludes, Lehman can book a "profit" on the difference between the issue price of its bonds and the depressed market prices. Taken to an extreme, Lehman could probably post one if its most profitable quarters ever, just by declaring bankruptcy!

Obviously, falling bond prices indicate financial stress, and certainly do not produce sustainable, high-quality earnings. Such "earnings" do not generate cash or create any value of shareholders whatsoever.

Net-net, Lehman is still facing the likelihood of losing tens of billions of dollars over the course of the next few years. As losses pile up, Lehman will have to raise capital. That means flooding the market with LEH shares. Lehman may have to issue hundreds of millions of new shares at a discount to rebuild its capital shortfall, severely diluting the existing shareholders.

David Einhorn, an accomplished hedge fund manager, recently explained why he's still selling short Lehman shares. In a speech at the April 8 Grant's conference, he said that Lehman may have to boost its capital by as much as $30 to $70 billion. If Einhorn's guesstimate is anywhere close to the mark, Lehman's shareholders are in for a very rough ride.

The worst might be over for the financial sector, just like so many investors seem to believe. But a lot of bad stuff is still rolling our way. For the rest of 2008, therefore, investors might want to take their cue from Credit Suisse CEO Brady Dougan when he said, "The number of times people have seen the light at the end of the tunnel, it turned out to be a train coming down the tracks."