Making Sense of David Einhorn vs. Lehman Brothers

Lehman’s stock plummeted earlier this week in the wake of a Wall Street Journal story saying the firm is “considering” a common stock offering that would be dilutive to shareholders. The precipitous decline was no doubt welcomed by David Einhorn, a hedge fund manager who is short Lehman’s stock and has been quite vocal in his attacks questioning the transparency of the brokerage firm’s financials. Mr. Einhorn’s repeated public slamming of Lehman Brothers reportedly has contributed to the decline in Lehman’s stock price.

Mr. Einhorn has made some extremely damning allegations about Lehman’s accounting practices. He questions some large, unrealized gains Lehman booked in the first quarter that helped goose up the firm’s earnings. The gains were on illiquid securities for which there are no public markets, which means Lehman’s management can assign values at its own discretion. As if that alone isn’t enough of a red flag, Mr. Einhorn also charges that Lehman has given him conflicting explanations of its valuation process. To boot, Mr. Einhorn says Lehman has not properly disclosed or written down various complex debt securities, including $6.5 billion of CDOs. Lehman vehemently denies Mr. Einhorn’s allegations, saying they have “no basis in fact.”

I’m in no position to evaluate Lehman’s earnings statements, and I have no reason to question them. But I also am not quick to accept that Mr. Einhorn’s allegations have no basis in fact. The short seller’s claim that Lehman has placed an artificially high valuation on illiquid securities is eerily familiar. There were similar allegations that Bear Stearns priced artificially high the illiquid assets in its subprime hedge funds before those investment vehicles collapsed. A recent comment by Sy Jacobs, a hedge-fund manager who correctly predicted the subprime mortgage crisis, also cannot be ignored. “Just because we got saved from what would have happened that Monday if Bear went down doesn’t mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place,” Mr. Jacobs told Barrons.

I also note a comment by star banking analyst Meredith Whitney about Lehman CFO Erin Callan in the May 17th issue of the Journal: “(Callan) is going out on a limb to provide more transparency in Lehman’s earnings, business and strategy.” On Monday, Ms. Whitney predicted Lehman would report a second quarter loss after earlier predicting a profit. The sudden about face possibly suggests that Lehman’s transparency wasn’t quite as clear as Ms. Whitney originally believed.

The reality is there is so much market turmoil and uncertainty today that it is no longer possible to accurately value many of the assets the major brokerage firms have on their books. As Standard & Poor’s analyst Diane Hinton has noted, “We’re in a market environment where sometimes perception becomes reality.” At the moment, it appears that a short seller on Lehman’s stock appears to have the upper hand in shaping the company’s market perception.