A Bear-Stearns-like Story Unfolding at Lehman Brothers

Lehman Brothers (LEH), one of the top investment banks in the world, seems to be entering some scary, swampy, land than Bear Stearns fell victim to a few months ago. Fortunately for Lehman Brothers, it is larger, has better assets, and can learn from the mistakes of Bear Stearns.

The stock is down sharply down (-9.5%) on rumours of a liquidity crisis. It seems that superbearish bets are being placed on the options market. Coincidentally, or perhaps by design, we have short-sellers like David Einhorn of Greenlight Capital making a strong argument just when the line between fact and fiction is blurred.

In response to the market perceptions regarding its weak balance sheet, it looks like Lehman is selling some of the risky mortgage assets and shutting down a portion of its proprietary trading business. Traders may disagree but proprietary trading in my eyes is akin to gambling with the house's money--and that's the last thing Lehman needs to be doing right now. I am sure that some of the thrust for shutting down some of the proprietary trading probably came from the losses taken on the supposed hedges. If your hedges aren't working, it does beg the question if anyone trading Lehman Brothers' money knows how risky any of their activities are.

It also seems like Lehman Brothers was buying back stock recently. Although many will disagree with me, I think buying back stock isn't a bad idea if Lehman actually has $40 billion in liquidity (as they claim). The buyback here isn't done because the stock is undervalued; instead, it is done to restore confidence from customers, lenders, bondholders, and others, who are using the stock price to evaluate the health of the company. Having said that, buying back shares probably won't do much in this case because (i) you need to buy back a lot of shares (not happening here), and (ii) market can interpret its confidence from other prices such as CDS spreads, option prices, and so forth (it's hard to influence all of those).

Without knowing much about Lehman, my opinion is that Lehman probably isn't in as bad a shape as the short-sellers claim. But the problem is that a decent balance sheet can evaporate quickly if there is a run on the bank. In particular, it is a difficult problem for highly leveraged entities such as Lehman Brothers (Lehman's leverage according to David Einhorn is 40x). Debt is a double-edged sword. As equityholders, we profit off the bondholders when times are good. But when things fall apart, the debt that was boosting returns ends up being a big problem. Raising a few billion may not do anything and that's one reason Lehman is hesistant to do so (although I think they will raise some money just to placate the rumours). The problem is that, going with David Einhorn's numbers, the 40x leverage means a small movement in the price of assets can mean massive losses. That's why I'm skeptical that raising capital does much other than increase some confidence.

Wall Street is going to change radically after the current credit crisis is done with. People say that things will revert to the same in a few years (partly because Wall Street has high turnover and average employee age is quite low). But I'm not so sure. Many storied firms destroyed their franchises and tarnished their names literally overnight. It's quite amazing for an outsider like me to see a name like Bear Stearns go down in flames. Or for Lehman Brothers to be on the brink. Morgan Stanley's name has also been tarnished. It's not limited to Wall Street either. For a working class person like me, who will never have access to high net-worth financial management, a Swiss company like UBS was an elite institution. After the current crisis, it has been thrown into the dustbin.

Jean-Marie Eveillard has said that he doesn't invest in many financial institutions because they are all black boxes. Well, after following them, it is blatantly obvious. I used to think that certain high technology, biotech, or fashion industries were black boxes, but these Wall Street banks are even worse. Even my local Canadian banks, who are quite conservative, are posting losses that one wouldn't expect.