Is Lehman Liquid Enough?

The firm's heavy subprime exposure and minimal writedowns to this point have investors nervous. But defenders say it's no Bear Stearns

by David Bogoslaw

In the wake of the sale of Bear Stearns (BSC) to JPMorgan Chase (JPM) for the investment-banking equivalent of pocket change, the worry now on Wall Street is that the high-stakes game of dice the big firms were playing with asset-backed securities of dubious quality may force more players to exit the table.

Fear that the crisis of confidence that hit Bear Stearns last week, causing the fifth-largest U.S. investment bank to be sold for 2% of its former value on Mar. 16, could quickly spread to other big firms was only partly relieved by expansion of the Federal Reserve's discount window to other kinds of players, broader collateral, and longer lending terms.

Treasury Secretary Henry Paulson's assurances Mar. 17 that the Fed and the Treasury could be counted on as lenders of last resort if any other banks face liquidity shortages rekindled investor confidence in the broader equities market but offered scant comfort to investors in financial stocks.

And that has market players asking: Who may be next?

More Subprime Fallout

Some figure Lehman Brothers (LEH) may be vulnerable to a liquidity seize-up. Shares of Lehman took a beating Mar. 17 because of the similarity of its business model to that of Bear Stearns. Lehman shares lost as much as 48.4% of their value before bouncing back to finish 19% lower, at $31.75.

Other big names got caught up in the selling as well. Morgan Stanley (MS) shares fell 8%, to close at $36.38. Citigroup (C) shed 5.9%, to end at $18.62, and Merrill Lynch (MER) lost 5.4%, to trade at $41.18.

The pounding Lehman shares took was understandable given concerns that its relatively heavy exposure to the subprime mortgage market puts its capital balance at risk.

But investors became more optimistic after seeing Lehman’s first-quarter earnings release on the morning of Mar. 18. The company reported fiscal first quarter earnings of 81 cents per share, beating the Street’s consensus forecast by nine cents. What’s less encouraging is that the latest results were down 59% from $1.96 per share in the first quarter of fiscal 2007 on a 31% drop in net revenue to $3.5 billion.

Not surprisingly, revenue from the firm’s fixed income capital markets business plunged 88% to $262 million from $2.2 billion in the year-ago period due to continued deterioration in the broader credit markets, especially residential and commercial mortgages and acquisition finance. Lehman reported $1.8 billion in mark-to-market writedowns.

Even more than the earnings, Lehman investors may be breathing more easily after hearing the company report that it had a liquidity pool of $34 billion, unencumbered assets of $64 billion and an additional $99 billion at its regulated entities at the end of February.

“At Lehman, fixed income is very big. They were leaders in securitization of mortgages. Bear was No. 2," Christopher Whalen, managing director at Torrance (Calif.)-based Institutional Risk Analytics, said before the earnings release. "That's why everybody is looking at Lehman now." (His firm builds customized risk-management tools for audit firms and others.)

And though Lehman has a stronger investment banking business than Bear did, its merger-and-acquisition advisory services are effectively worthless in view of the credit freeze, making Lehman next on the target list for a liquidity crisis, Whalen said.

On Mar. 18, Lehman reported $867 million in revenue from investment banking, a 2% gain from a year ago, driven by a 34% increase in merger and acquisition advisory revenues to $330 million from $247 million in the first quarter of fiscal 2007.

In response to the earnings, Standard & Poor’s Equity Research cut its fiscal 2008 earnings outlook by 52 cents to $4.30 per share.