naked capitalism

The markets responded positively today to Lehman’s announcement of its second quarter results, its provision of a financial supplement that gave more detail on its balance sheet exposures and how they had changed over time, and its investor conference call, The stock was up over 5% of the day, although its closing price of $27.20 is still below the offering price last week of $28.00.

One of the problems with the conference call format is that the balance sheet is not available until the 10-Q is filed. For most companies, the balance sheet is not where the action is, but financial firms are an exception, particularly in trying times. So the analysts miss the opportunity to grill management on the really meaty stuff. Admittedly, there was a page in the Lehman press release that contained leverage computations, and the supplement did provide a good deal of detail on certain types of exposures. But as Michael Mayo of Deutshce Bank pointed out during the Q&A, it’s hard to know what to make of those figures without having the carrying values (as in average markdown). And even with the detail, several analysts asked for more breakdowns which Lehman said it would provide to them.

First, we’ll deal with a few anomalies, then we’ll get to what is admittedly a rumor, but one if true with pretty serious implications.

The preliminary announcement indicated that Lehman’s reduction in gross assets was $130 billion and net was $70 billion; today, the gross figure was $147 billion. Figures can move around while statements are being finalized, and the gross number is probably less important than the net.

The marks on the now-somewhat-notorious SunCal deal (largely raw land) is 70 cents on the dollar. Land, which in a negative carry item (you have to keep paying taxes) is very much a “beauty is in the eye of the beholder” asset unless you have developed properties nearby to give a benchmark. I’m not clear what stage this project is in (the plan was to subdivide, develop, and sell lots, so the “development” consists of getting roads and utilities in). However, the Wall Street Journal indicated that land values in the area have fallen by as much as 60%. Lehman’s exposure is senior debt, and a mark in the mid-70s seems a tad aggressive (um, where is the cashflow to service debt? Mid-70s seems high for an asset that by its demographics is probably non-performing). This is not a large exposure ($1.6 billion gross), but it is one David Einhorn discussed, and taking what appears to be a generous valuation on a high-profile position raises unnecessary questions.

Another oddity is compensation expenses. They rose $418 million ($130 of that was severance) when headcount fell by 1,900.

A further question mark is Level Three assets. They fell on a gross level from $40 billion to $38 billion, but when you decompose that, Lehman sold $3 billion of assets in the Level 3 bucket, wrote down $2 billion, and then added another $3.5 billion. That might not seem so bad were it not for this statement from Dick Fuld in the conference call:

We had the benefit of much greater price visibility due to the number of assets that were sold especially in the commercial and residential mortgage area that were the result of our deleveraging and the strong trading volumes in the cash, and then certain derivative markets that gave us important additional valuation information.

If they had a much better sense of market values, particularly in the sometimes thorny derivatives arena, one would have expected some assets to be moved out of Level 3 via having market reference points, as opposed to by offloading them or reducing their values. But that appeared not to have happened.

The last, looming mystery is how Lehman delevered in a crappy credit market. Their quarter ended in May, and March, thanks to the Bear meltdown and the worries about Lehman, would not have been a good time to sell assets. Similarly, one would have expected sales to be concentrated in certain sectors of the market where pricing was more favorable. Lehman went to great pains to show that the sales were spread across product and said they were not concentrated in the highest credit qualty assets either. They also said sales were spread over the quarter (given March, I find that to be quite a statement).

This seems to be too good to be true, and begs the question I raised when Lehman first began talking up its delevering via CNBC: were these really arm’s length sales, or, as has happened with a lot of leveraged loans and some Alt-A portfolios, were they financed? Note no analyst raised this issue in the conference call.

I received an e-mail from a former Lehman MD yesterday. I am not able to independently verify it, so be warned that this falls in the category of a rumor. Nevertheless, it is sufficiently specific that it sounds credible to me, and it explains the mystery of how Lehman was able to distribute its sales so well across its various types of holdings and not take any apparent big hits to tidy up its balance sheet (even if you have marked an asset at a defensible price, the offer for, say, $5 million in assets is gong to be higher than if you are trying to unload $500 million, and thus you could take a loss on a supposedly conservative mark if you get serious about reducing exposures in a wobbly market).

The message:

Curious whether, to your knowledge, they’ve given much detail around the reduction in gross & net leverage they achieved in the May qtr. My understanding is that the vast majority of the reduction came from spinning out two large businesses into independent entities: the mortgage trading business (now called “One William St Capital”) and the principal investing business (now called “R3 Capital”). R3 Capital is starting life with assets of around $55 billion.

From friends both inside & outside LEH, I understand that LEH is keeping a 45% stake in each business. They are continuing to vest stock for former LEH employees who join the new ventures (so LEH is effectively paying much of their compensation…this may be why LEH’s compensation expense spiked in the May qtr). LEH’s continued economic interest in the two entities has been described to be as “complex” (ie, it’s not as simple as 45% carried interest in profits or losses). The main driver, unsurprisingly, was to allow LEH to maintain as much econ interest as possible, consistent with meeting accounting standards to get the biz’s off LEH’s balance sheet.

I haven’t spoken to anyone who has had much to say either way about whether (& to what extent) LEH would face contingent liabilities in the event the new entities were counterparties to losses…but it’s not that hard to imagine a situation where either of these two entities faced losses from derivatives contracts that exceeded (by a wide margin) the capitalization of the newco’s. Will the counterparties, in those cases, look to LEH as a backstop? How could they not?

Anyway, perhaps LEH has given adequate disclosure on this today, and if so my concerns are moot.

I read the conference call transcript and the filings today and saw no reference of asset sales to new entities.

Now if this is indeed accurate, and comes out at some future point, I’d be pretty unhappy if I were an analyst. Given the recent history with Bear Stearn’s failed hedge funds and SIVs, financial firms have had a pretty hard time not supporting off-balance sheet businesses and sponsored entities when they run aground. And if Lehman managed to maintain a 45% economic interest while getting an off balance sheet treatment (their accountant must be some sort of evil genius), it would be even harder for them not to step up in the event of mishap.

If true, and I stress if true, this stinks to high heaven. But given that Lehman played fast and loose with SEC Rule FD, this would be another instance of questionable business practices.

Anyone who can corroborate or deny is very much encouraged to speak up.