The Lehman Situation: Brutally Logical, or Patently Illogical?

How can this be happening?

Every single market player in the world well knows that Lehman (LEH) has the ability to borrow as much money as it needs from the U.S. Federal Reserve, which means that it can convert vast amounts of its US$639 billion of assets (as at the May quarter) into good collateral. Unlike the situation that brought Bear Stearns to its knees (see prior post “U.S. Fed action comes too late to save Bear Stearns” March 14), brokers and banks around the world need not worry about “keeping lines open” since there is no practical chance that Lehman will go bankrupt and leave a counterparty hanging.

At the same time, any business needs clients, customers and revenue to stay relevant. In a bear market environment, Wall Street is finding it very difficult to keep the coffers filled. M&A volumes are down, equity offerings are being delayed, IPOs are being pulled, CDOs and their brethern are no longer generating a penny of profit.

Which brings us back to Lehman. As every public company CFO knows, it is no fun to raise equity under the spotlight. With all of the rumours about a potential equity investment from South Korea-based banks, the market clearly expected that a deal would happen. Once it went off the rails, assuming it was ever even on them, Lehman shares began to weaken further.

But it wasn’t until the U.S. government stepped in to corral Fannie Mae (FNM) and Freddie Mac (FRE) that the market seemed to focus on where Lehman was headed. With the benefit of hindsight, traders figured that Lehman’s efforts to sell assets or find minority investors for its money management division were no longer sufficient to keep it independent.

But, in reality, what has changed to drive the stock down this low? Lehman has assets in excess of US$600 million, and let’s assume for a moment that the firm’s auditors have done a good job ensuring that those assets are worth the value they are being carried on the balance sheet for. With the Federal Reserve standing behind Lehman’s balance sheet, why the need to sell the business at single digits, 93% below the price of just one year ago?

That’s what happened to Bear Stearns, since they didn’t have the luxury of the Fed window available to them. But here? At Lehman?

What the market is really telling us, at $3.73/share, is that either:

1) it doesn’t believe that Lehman has correctly priced the value of its assets (current book value is US$37.86/share as at May 2008),

2) that Lehman doesn’t have enough liquidity to finance continued losses from writedowns, or

3) that the current Lehman 2009 EPS forecast of $2.34 (the current average of 19 different equity research analysts) is wildly offbase, and that 2009 may well be a year of negative earnings.

And possibly a combination of all three. That’s where the brutal logic of the recent Lehman trading comes into play.

Whatever the outcome, you have to hand it to Warren Buffett; he sure avoided some sleepless nights (see prior post “From the desk of Dick Fuld, Lehman Brothers CEO” July 17-08). For my money, I just don’t see the need for a sale at Lehman. But, one always has to remember that the folks inside a company generally know a lot more than you do about what is going on in the engine room.

There’s a market rule about not “fighting the tape”. Perhaps that’s what Dick Fuld concluded.

Comments

[pelican:]

Your article is one of only a few I've read that actually looks at LEH's situation rationally. Absolutely, with the Fed backstopping the investment banks there is no counterparty risk. My only guess is that investors, caught up in the hysteria, forget that.

As to your points why LEH is trading below $4, I think its true many do not believe Lehman has correctly priced the value of its assets. But at the same time, they probably cannot tell you what the true value is, so it seems more of a nervous reaction along with the assumption that current book value is much lower. Hard to believe though that with all of LEH's writedowns, many quite aggressive, that the true value is that much askew from reality. In addition, even the rating agencies are not concerned about liquidity; rather, they see this as a problem of confidence, which sort of annoys me because they are basically making things worse. Finally, I think Lehman's 2009 EPS forecast is too high but as little to do with what's going on here. Most of the housing companies will lose money next year, for example, but most aren't selling below $4 a share (although their balance sheets are probably in worse shape).

If more people looked at this logically like your article did, we would not be seeing the level of panic that we are, in my opinion. One article today reported the Koreans were willling to pay $26/share for 25% of the company just last month. But hysteria trumps reason in the short term and so LEH is in a pickle. I think Fuld has handled this situation horribly but its possible that he thought it would be patently illogical for the market to react the way that it has, so he didn't react quickly enough.

And possibly a combination of all three. That’s where the brutal logic of the recent Lehman trading comes into play.

2008 Sep 12 05:42 PM

[Just The Facts:]

The way I see it, one of two things is going on.

1 - Either there's a concerted effort to create mass hysteria and drive LEH stock (and a few others) down hard for a short-term gain by market participants (or so the company(s) can be stolen for a few pennies on the dollar), or

2 - The whole house of cards has started falling and all the smart money knows it and is now running for cover.


Option # 2 would be supported with FNM and FRE, as well as recent action with WaMu and AIG. And starting a day or two ago, also with MER. And all the talk of Citi and others to soon follow, which has been going on for a while now. And I saw Goldman and JPM mentioned for the first time today as prime candidates for a huge drop. So far, they've managed to stay largely above the fray. If they start losing 20 to 30 percent of their value every day or two, then there can be no doubt that Option # 2 it is.

2008 Sep 12 10:24 PM

[Big Al45:]

Just, my money is on Option #1. The hedge funds are ganging up on the financial institutions. The billions they made in commodities are being used to finance their puts and short positions in the financials. Each financial they drive to zero generates more profits and enables them to short even more companies.

It will not end unless the SEC decides to do its job.

2008 Sep 12 10:39 PM

[PeteK:]

To Fuld, maybe he thought that this Korean guy can be kicked around and bullied a little. Big Ego, you know.

2008 Sep 12 11:12 PM

[E Nuff Sed:]

I also think the naked shorting and puts have created a massive negative feedback loop. If LEH can hang on, for a couple of weeks there could be a massive short squeeze. Same for Wamu and AIG.

2008 Sep 13 12:22 AM

[venividivici:]

Just the Facts my money is on 2: the whole house of cards has started falling and all the smart money knows it and is now running for cover. As for the hedge funds, they are perhaps the ugliest part of this Sodom and Gomorra financial system. They don't give a damn what damage their actions cause, just so long as they can make a buck.

2008 Sep 13 01:46 AM

[einstein p ...:]

It wasn't just the naked shorting that brought LEH down, it was greed and stupidity. They are one of many poster companies for this age.

The government bailed out Bear, Freddie, and Fannie. Let enough be enough If the company cannot find a private sector buyer, please let it die and rest in peace.

We supposedly believe in free market capitalism. So, let it work. We've seen the other side of the equation already.

Survival of the fittest with leave us with the best and the strongest when the dust clears. Anything less is at best life support and at worst socialism.

2008 Sep 13 02:29 AM

[williambanzai7:]

Another form of irrational exuberance deflated. Banks are boring.

2008 Sep 13 07:38 AM

[cyclone:]

I think Pelican hit the nail on the head! I think the hedge funds have driven down the financials as there is no uptick rule anymore and apparently naked shorting has become legal even though they say it is not. All a short seller needs is a counter party saying we will deliver stock and have it available at that time even though they may not be able to deliver the stock when the short actually covers. This allows free rein and the building of naked positions in a selffullfilling process. The more you short the lower the stock goes, the more you short and on and on.

The stock is trading around 10% of stated book value as of Aug. 31. Logically, even in a fire sale and discounting assets after current writedowns the company is worth more. How much, if any or less, will be based on Fuld and his skills along with the benefit to other companies and the need to ensure that the house of cards contagion does not spread to the likes of AIG, MER and others.

2008 Sep 13 08:27 AM

[Gerry Sullivan:]

With 30 to 1 leverage even a small mispricing of assets means the difference between survival or not. Does anyone think that the assets on Lehman's balance sheet are accurately priced? With time the company might be able to work out of its problems, but Lehman has very little time.

As the week began there was talk of dividing Lehman into a good bank and a bad bank. Now, the whole company is the bad bank.

Hubris, arrogance, greed. The end of a 150 year old company.

2008 Sep 13 08:55 AM

[andyn:]

What it means is there is a utter LACK of leadership.
Both within the company (read Mr. "folded" Fuld) and outside (in a sane market, this would be viewed as a MASSIVE opportunity).
Mr. Fuld threw the poor Ms. Callan under the bus, instead of taking decisive action either taking it private or selling the firm to a money center bank to remove the jitters. Whoever does the deal, I think they will come out the better in the next 2 years a-la Jamie Dimon who did the deal of the century with Bear Stearns. LEH is worth more than the $4 stock indicates.

2008 Sep 13 10:23 AM

[PeteK:]

Let me know which financial institution is not run by bunch of old guys who will never listen nor let go of the Chair. Some of them had to be Kicked-Out or Thrown-Out by the Board when water is up to their noses.

2008 Sep 13 01:08 PM