Next Up: Lehman Brothers?

Investors began dumping their shares in Lehman Brothers (LEH) before the opening bell. By 7 am ET, the stock was down about 18% in premarket trading, to $32.25, and the loss grew to 28% before 8am, to $28.20. It's now down 20% in early trading.

There’s one thing you need to understand about many of the complex risk models at the various banks across North America: one of the key inputs is public company share price performance. Within the RAROC model [Risk Adjusted Return On Capital], for example, an important driver of the risk rating of a business is the action of its stock. The theory is that the stock market is a better predictor of default risk than credit agency ratings. JPMorgan (JPM) (see prior post “JPMorgan inks the deal of the year,” March 16, 2008) is one of the key disciples of RAROC.

When credit officers turn on their computers this morning, the risk rating on Lehman Brothers will have jumped sky-high, given the performance of the stock on Friday and earlier this morning. Nothing will have changed at Lehman, but it doesn’t matter. Institutions will have no choice but to pull back their funding relationships.

South Asia’s largest bank, DBS Group Holdings (DBSDY.PK), pulled its relationship with Lehman earlier this morning according to the Wall Street Journal, although once word got out an internal communication was issued, reversing the prior direction.

Moodys has stepped in to support Lehman, affirming its A1 credit rating.

We’ll see if equity investors found that to be sufficient to end the rout on Lehman.

Related: Bear's Gone - Is Lehman Next?

Comments

[wcuk]

"an important driver of the risk rating of a business is the action of its stock"

This is what we engineers call a positive feedback loop. Risk rises as a result of poor stock action. As a result, institutions are forced to minimize exposure to the risk, thus creating more poor stock action. Positive feedback is almost always the enemy of stability.

[just.a.guy]

This is probably a pretty accurate way to measure risk for financial firms in particular. After all, the biggest piles of money moving against Lehman on the short side, buying puts, and so on, are going to be those of their Wall Street bretheren -- those most in the know about what's really going on at Lehman... who's trading with them and who's not, etc.

In fact, using public equity share price as a risk indicator is pretty much an admission that investment bank stocks move due to asymmetries of material non-public information -- that is to say, insider trading.

[dieuwer]

Rating agencies to investment banks are as Arthur Anderson to Enron...

[jcrash]

Salem Witch Trials. I think 6 months at the Fed Trough will fix them up.

[DanielJacome]

Barclays is already in talks with them according to someone inside

[DanielJacome]

Good day to trade MF -- catching a bounce here; also hearing Fed will cut @ 3pm today, still checking

[Vikram]

LEH can park their MBS with Uncle Ben for six months now. There will be no liquidity crisis in LEH. The spreads on MBS are also narrowing so the chance of a margin run on LEH are low. Plus unlike BSC they have been working on getting other sources of funding.

It took BSC's fall for Uncle Ben to act though.

[I shouldknow]

Lehman has stying power; yes, they made some BIg MBS mistakes but have written down the value by almost 100%. They'll continue to get slapped around but will survive this and be stronger for it in '09 and going forward.