Lehman Brothers: New Plan but Same Problems

Lehman decided to have their conference call today. The massive selloff of the stock over the past two days plus the negative credit implication by S&P forced management’s hand.

You can find their conference call HERE and their press release HERE.

Highlights from the release and call:

1. Estimated net loss of ($3.9) billion or ($5.92) per common diluted share.

2. Decreased residential mortgages from $24.9 billion in 2Q08 to $13.2 billion which includes a deal with Blackrock to unload $4 billion in UK assets.

3. Decreased commercial mortgages from last quarter’s $39.8 billion to $32.6 billion.

4. Intends to spinoff the commercial assets into a new entity named REI Global. Current Lehman shareholders will receive shares in REI. The spinoff should be completed in 1Q09.

5. Spinoff will require Lehman to inject capital of 25% into new entity and then debt finance the remaining portion.

6. REI will take custody of SunCal and Archstone investments.

7. REI will be able to show assets as on a “hold-to-maturity” basis thus allowing for more prudent selling.

8. Lehman also intends to sell off 55% of their Investment Management Division (“IMD”). IMD will include Neuberger, private equity and their wealth management arm. If, and when, the sale takes place, the firm will see a positive impact of at least $3 billion towards their capital base from the goodwill associated from the NB acquisition in 2003.

9. Firm also intends to cut their dividend to $0.05 per share which will allow them to retain $450 million annually

It is apparent that Lehman is in full survival mode. And even with these actions going into effect, there are still some serious hurdles that Lehman must face. Time is not on the firm's side and deals must be done swiftly but with a great deal of prudence.

My initial thoughts of Lehman moving forward:

1. Not enough time to shore up balance sheet before S&P downgrades their credit worthiness. Of course, a downgrade would have a significant impact across various business lines – violation of debt covenants, counterparty sentiments, etc.

2. For the REI deal to work, management is counting on a good price for IMD and I am afraid that Lehman is selling from a position of weakness. Will they get their asking price? I am not so sure. To further complicate matters, they intend to use funds supplied from that sale to inject capital into REI.

3. It is possible that even after an injection of capital into the REI spinoff, approximately 75-80% of REI will be debt financed by Lehman. Again, the firm still maintains some form of credit risk even after transferring the assets.

4. I still think there will be further writedowns on the commercial assets before they are transferred over to REI (assuming the deal gets done).

5. The sale of the $4 billion in UK assets to Blackstone are requiring Lehman to seller finance.

6. The firm enjoyed much success from their ability to leverage. Unfortunately, that leverage will no longer be deployed as liberally as it once was. Thus, the earnings power that was based on higher leverage inputs will be negatively impacted.

I will continue to review conference call and the press release. At this point, the firm is still in a very dire position. I will have more later. Please stay tuned.

Lehman Brothers: Time is Up!

It appears at this point that the Lehman situation is going to hit a climax next week. There are so many questions that surround this entity and I believe the management team is in full gear to get the firm sold (or infused with fresh capital) before next week's conference call.

UPDATE: The conference call took place about 6 hours after this post. I will spend some time reviewing the call and examining the data in their release.

If you are interested in doing some homework before the call and the earnings release next week then I would recommend you review the following:

Lehman Brothers May 2008 10-Q
Be sure to pay attention to their discussion of the Level 3 assets on Page 29.

Lehman Brothers June 2008 Conference Call Transcript
Review the questions asked by Mike Mayo from Deutsche Bank - he really pressed them last time

Lehman Brother Financial Supplement from Last Quarter
You will want to reference Attachment II

Also, if you have a Merrill Lynch account be sure to spend a few minutes reading Guy Moszkowski's comments about the Lehman. Guy is a very good analyst but I would be willing to be that Lehman's results will be far worse than what he is currently predicting. (I will discuss this topic later this week)

In preparation for the Lehman call, I have put together a number of questions that I think would give us a clear view of Lehman's financial condition. The questions are as follows:

1. How much of their commercial related positions did they end up writing off for this quarter? They had roughly $30 billion on the books according to Attachment II of the financial supplement they provided investors last quarter.

2. What is the status of the undeveloped SunCal investment? How much more of a writedown did they take on that asset? I believe they had only taken about a $700M gross writedown last quarter.

3. Where do the Level 3 assets sit at this point? Their last 10-Q had it sitting at $38 billion. Let's hope for the sake of shareholders they were able to trim this down.

4. Are they still investigating the "Good Bank/Bad Bank" Model? Note: of course, this strategy could allow the firm to shed toxic assets however there are two real problems with this setup: (1) it will be tough to find a good manager to run it knowing that its a train wreck and (2) they will need to find financing for the new entity - which I would think might be very tough at the moment.

5. Will they give us more disclosure on the whole loans? The mezzanine side of the whole loans could give us clarity on more issues awaiting to surface.

6. Did they make any transfers/sales/negotiations with R3 Capital Partners? If so, please elaborate.

7. Where are they at with Neuberger? If they sell Neuberger, is there any expectation that they might compromise their credit rating which could also trigger another host of credit-related issues.

8. What are their thoughts on the S&P CreditWatch "negative" implication slapped on the firm this week?

I intend to add more questions to my list plus make a few predictions. Please stay tuned.

Thanks for reading.

Breaking News: Bloomberg reports that Lehman to form a new company to buy mortgage assets

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.

In case your not sure what FAS 157 is, here’s a quick primer:

The US Financial Accounting Standards Board Rule 157, which became effective for fiscal years that began after November 15, 2007, makes it harder for companies that must assign pricing to those securities considered the hardest to value – Level 3 assets. Essentially, firms are now forced to “mark-to-market” and determine a current fair value rather than use historical cost figures to value assets on the their books.

In the fair value hierarchy, Level 1 assets are simply “mark-to-market” whereby an asset’s value is determined with quoted prices for identical instruments in an active market (ie., an equity security traded on the NYSE).

Level 2 assets, known as “marked-to-model” instruments, are based on an estimate of observable inputs. In estimating value, firms can use pricing models based on net present value of future cash flows and directly observed prices from exchange traded or OTC derivatives. While Level 2 assets are a bit more complex than Level 1, measurement can be rendered with a fairly high degree of confidence. However, Level 3 assets are not so simple.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability. Ultimately, Level 3 inputs, which assist at deriving the underlying asset’s current value, must include information based on extrapolation or interpolation of observable market data.

In the case of Lehman, this sits at the very core of their recent writedown and massive losses. In the last quarter, the firm sold $3.5 billion of Level 3 assets which consisted mostly of mortgage-backed securities. And despite these sales, the firm still has approximately $38 billion in Level 3 assets sitting on the books as of their most recent 10-Q filing. Selling into a weak and uncertain market environment have made matters even worse. And while the firm works to decrease their exposure in Level 3 assets, Lehman makes these sales even more interesting by acknowledging that some of their transactions have taken place with an entity known as R3 Capital Partners.

R3 Capital Partners, launched this past May, is a hedge fund run by an ex-Lehman executive named Rick Rieder. Sounds fishy doesn’t it? I would say so.

Oh and did I mention that Lehman is an investor in this hedge fund. In fact, it currently maintains a "non-voting, minority ownership stake" in the fund.

With that said, I think a few good questions would be:

1. How much did R3 pay for Lehman’s Level 3 assets?

2. Were there any assumptions/conditions built into these deals that actually make these transactions simply a temporary transfer of risk?

3. Could you discuss in further detail the $4.5 billion in assets sold and/or transferred to R3 during Q2?

4. Do any of these executives that run R3 hold Lehman stock? And if so, doesn’t this present a conflict of interest? (The hedge fund’s disclosure documents states that it is possible that R3’s executives “could” be holding restricted stock in Lehman.)

Unfortunately, we probably won’t get the answer to any of those questions. The truth is: they don’t have to.

And so we come back to that darn FAS 157 – it’s forced firms to report market values and not assumed values. Shame on you FAS 157. Look at what you have done to this market.

Tom Brown refutes Meredith's analysis with an Excel chart while his firm blows up 50% in 2007

Meredith Whitney is on fire at the moment. Her calls have been very good and she's not afraid to go out on a limb.

And then you have this quote from Tom Brown (for those of you all who don't know Tom Brown you can read his bio HERE):

"Every cycle there's one analyst who races to be the most bearish, and this time it's her. Honestly, I think we'll look back and see that Meredith Whitney's credibility peaked on July 15"

And I would counter this statement by saying, "every time someone actually makes a good call you always have someone who is jealous or goes against the grain just to get more attention - in this case its Tom Brown."

Brown goes on to accuse Whitney of being "incredibly arrogant" on the basis of her recent opinions. He then takes a personal shot at her: "The only explanation I can see is, she has no idea how to evaluate the possible downside risks."

I sense jealousy on the part of Tom Brown.

If you are interested, HERE is Tom Brown's case for a bottoming of the financial services stocks.

In my opinion, a quick glance at the metrics (bank net charge-offs and loan loss provisions of the past 20 years) he uses to refute Meredith's case are overly-simplistic. There are many more dynamics in place today that did not exist in the 80's and 90's. Using an simple excel chart of charge offs versus loan provisions just won't do it. Reminds me of a concept I remember from my engineering classes in college: curve-fitting. Nice try Tom.

Ironically, Tom Brown's investment firm lost nearly 50% of its value in 2007 due to bets in financial stocks.

In fact, the "oracle" himself made the following bold statement last November: "I think we're really close, if not at the bottom, for the financial services industry," Brown told hundreds of investors at the Value Investing Congress in New York. "There are many opportunities in the most battered sectors."

Wow Tom...a lot has happened since last November. Maybe someone should question your analysis.

Firm tries to restore client confidence

Bloomberg is reporting that UBS, Switzerland's biggest bank, plans to separate its investment banking and wealth management units after the recent subprime meltdowns. All being done to stop the bleeding - an attempt to stop their rich clients from taking their money out of the firm and running for the exits.

More precisely, the firm will separate the firm into three different pieces: wealth management, asset management, and investment banking. This move has prompted critics to speculate that the firm is preparing to facilitate a sale.

The firm saw over $15 billion withdrawn from its wealth management unit during the second quarter.

I wouldn't be surprised to see Merrill Lynch do the same thing.

After $43 billion in write-downs, UBS to split main businesses [NY Times]

UBS to split investment bank from wealth management [Bloomberg]

This shouldn't come as a surprise to anyone but maybe a form of validation:

Oppenheimer analyst Meredith Whitney seeing problems in consumer-based credit to continue over next 12 to 18 months. This comes on the heels of American Express noting a significant credit deterioration among its most affluent clients.

"The wide-ranging effects of the housing downturn are highlighted by the worsening of U.S. cards' credit quality in AXP's affluent cardmember base," Whitney wrote in a note to clients last week.

"Typically, the affluent segment holds up well during downturns, but home price declines have resulted in significant losses in consumer net worth (lower home values)," she added.

American Express said that even its best clients were spending less and taking longer to pay bills. With consumers weaker the company said it was no longer on track to boost earnings per share by 4 to 6% this year.

Whitney slashed her $76 price target on the stock and cut her 2008 earnings estimate to $2.60 from $3.45.

Analyst Whitney gloomy on U.S. spending as top AmEx clients hurt [Reuters]

Gilt-edged AmEx cards tarnishing [Barrons]

American Express cut to perform at Oppenheimer on deteriorating credit quality [Thomson]

When Meredith speaks people listen. She is a sharp analyst that has made some bold calls the past couple of years. Her biggest call: Citi's failures. This interview took place earlier this week on the CNBC set. Among her points in this interview:

1. Expect to see further weakness in housing prices



2. Banks are recapitalizing but very little of that is being used for loans



3. Systemic risk still pretty high for most investment banks



4. In this kind of market, money goes from "weaker" hands to "stronger" hands



5. Credit card industry will have repricing problems with their loan portfolios due to higher regulation

Her calls have been pretty spot-on recently. This interview is probably a bit extreme to the extent that she might be "overselling" the current market conditions. But at any rate, I would recommend that you keep her word in mind. And if you have a problem with her then maybe you should take it up with her husband.

Current Fortune article on Meredith Whitney [Fortune.com]

With a current market value of about $11 billion and Lehman's Neuberger piece valued somewhere in the neighborhood of $8 billion, then an asset sale would then leave the rest of the firm's pieces (investment banking, fixed income, and equity) sitting somewhere around $3 billion. And thats pocket change for a larger bank. In my opinion, a sale, in effect, would be the beginning of an end of the Lehman franchise.

Lehman to sell Neuberger? [Dealbreaker.com]

Lehman mulls sale of Neuberger [CNBC]

I suspect we should know within the next couple of weeks. This is a huge decision for LEH and playing the Neuberger card is like going "all-in" in a high stakes poker tournament. Let's just hope that they don't overplay their hand.

KKR LOOKING TO BUY NEUBERGER

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.

SUBPRIME WRITEDOWNS: BLAME IT ON FAS 157!

In case your not sure what FAS 157 is, here’s a quick primer:

The US Financial Accounting Standards Board Rule 157, which became effective for fiscal years that began after November 15, 2007, makes it harder for companies that must assign pricing to those securities considered the hardest to value – Level 3 assets. Essentially, firms are now forced to “mark-to-market” and determine a current fair value rather than use historical cost figures to value assets on the their books.

In the fair value hierarchy, Level 1 assets are simply “mark-to-market” whereby an asset’s value is determined with quoted prices for identical instruments in an active market (ie., an equity security traded on the NYSE).

Level 2 assets, known as “marked-to-model” instruments, are based on an estimate of observable inputs. In estimating value, firms can use pricing models based on net present value of future cash flows and directly observed prices from exchange traded or OTC derivatives. While Level 2 assets are a bit more complex than Level 1, measurement can be rendered with a fairly high degree of confidence. However, Level 3 assets are not so simple.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability. Ultimately, Level 3 inputs, which assist at deriving the underlying asset’s current value, must include information based on extrapolation or interpolation of observable market data.

In the case of Lehman, this sits at the very core of their recent writedown and massive losses. In the last quarter, the firm sold $3.5 billion of Level 3 assets which consisted mostly of mortgage-backed securities. And despite these sales, the firm still has approximately $38 billion in Level 3 assets sitting on the books as of their most recent 10-Q filing. Selling into a weak and uncertain market environment have made matters even worse. And while the firm works to decrease their exposure in Level 3 assets, Lehman makes these sales even more interesting by acknowledging that some of their transactions have taken place with an entity known as R3 Capital Partners.

R3 Capital Partners, launched this past May, is a hedge fund run by an ex-Lehman executive named Rick Rieder. Sounds fishy doesn’t it? I would say so.

Oh and did I mention that Lehman is an investor in this hedge fund. In fact, it currently maintains a "non-voting, minority ownership stake" in the fund.

With that said, I think a few good questions would be:

1. How much did R3 pay for Lehman’s Level 3 assets?

2. Were there any assumptions/conditions built into these deals that actually make these transactions simply a temporary transfer of risk?

3. Could you discuss in further detail the $4.5 billion in assets sold and/or transferred to R3 during Q2?

4. Do any of these executives that run R3 hold Lehman stock? And if so, doesn’t this present a conflict of interest? (The hedge fund’s disclosure documents states that it is possible that R3’s executives “could” be holding restricted stock in Lehman.)

Unfortunately, we probably won’t get the answer to any of those questions. The truth is: they don’t have to.

And so we come back to that darn FAS 157 – it’s forced firms to report market values and not assumed values. Shame on you FAS 157. Look at what you have done to this market.

Meredith Whitney is an easy target for Tom Brown

Tom Brown refutes Meredith's analysis with an Excel chart while his firm blows up 50% in 2007

Meredith Whitney is on fire at the moment. Her calls have been very good and she's not afraid to go out on a limb.

And then you have this quote from Tom Brown (for those of you all who don't know Tom Brown you can read his bio HERE):

"Every cycle there's one analyst who races to be the most bearish, and this time it's her. Honestly, I think we'll look back and see that Meredith Whitney's credibility peaked on July 15"

And I would counter this statement by saying, "every time someone actually makes a good call you always have someone who is jealous or goes against the grain just to get more attention - in this case its Tom Brown."

Brown goes on to accuse Whitney of being "incredibly arrogant" on the basis of her recent opinions. He then takes a personal shot at her: "The only explanation I can see is, she has no idea how to evaluate the possible downside risks."

I sense jealousy on the part of Tom Brown.

If you are interested, HERE is Tom Brown's case for a bottoming of the financial services stocks.

In my opinion, a quick glance at the metrics (bank net charge-offs and loan loss provisions of the past 20 years) he uses to refute Meredith's case are overly-simplistic. There are many more dynamics in place today that did not exist in the 80's and 90's. Using an simple excel chart of charge offs versus loan provisions just won't do it. Reminds me of a concept I remember from my engineering classes in college: curve-fitting. Nice try Tom.

Ironically, Tom Brown's investment firm lost nearly 50% of its value in 2007 due to bets in financial stocks.

In fact, the "oracle" himself made the following bold statement last November: "I think we're really close, if not at the bottom, for the financial services industry," Brown told hundreds of investors at the Value Investing Congress in New York. "There are many opportunities in the most battered sectors."

Wow Tom...a lot has happened since last November. Maybe someone should question your analysis.

UBS to split Investment Bankers and Brokers

Firm tries to restore client confidence

Bloomberg is reporting that UBS, Switzerland's biggest bank, plans to separate its investment banking and wealth management units after the recent subprime meltdowns. All being done to stop the bleeding - an attempt to stop their rich clients from taking their money out of the firm and running for the exits.

More precisely, the firm will separate the firm into three different pieces: wealth management, asset management, and investment banking. This move has prompted critics to speculate that the firm is preparing to facilitate a sale.

The firm saw over $15 billion withdrawn from its wealth management unit during the second quarter.

I wouldn't be surprised to see Merrill Lynch do the same thing.

After $43 billion in write-downs, UBS to split main businesses [NY Times]

UBS to split investment bank from wealth management [Bloomberg]

Meredith Whitney sees AmEx consumer credit situation a major problem over 12 months

This shouldn't come as a surprise to anyone but maybe a form of validation:

Oppenheimer analyst Meredith Whitney seeing problems in consumer-based credit to continue over next 12 to 18 months. This comes on the heels of American Express noting a significant credit deterioration among its most affluent clients.

"The wide-ranging effects of the housing downturn are highlighted by the worsening of U.S. cards' credit quality in AXP's affluent cardmember base," Whitney wrote in a note to clients last week.

"Typically, the affluent segment holds up well during downturns, but home price declines have resulted in significant losses in consumer net worth (lower home values)," she added.

American Express said that even its best clients were spending less and taking longer to pay bills. With consumers weaker the company said it was no longer on track to boost earnings per share by 4 to 6% this year.

Whitney slashed her $76 price target on the stock and cut her 2008 earnings estimate to $2.60 from $3.45.

Analyst Whitney gloomy on U.S. spending as top AmEx clients hurt [Reuters]

Gilt-edged AmEx cards tarnishing [Barrons]

American Express cut to perform at Oppenheimer on deteriorating credit quality [Thomson]

Meredith Whitney: More Weakness Ahead?

When Meredith speaks people listen. She is a sharp analyst that has made some bold calls the past couple of years. Her biggest call: Citi's failures. This interview took place earlier this week on the CNBC set. Among her points in this interview:

1. Expect to see further weakness in housing prices



2. Banks are recapitalizing but very little of that is being used for loans



3. Systemic risk still pretty high for most investment banks



4. In this kind of market, money goes from "weaker" hands to "stronger" hands



5. Credit card industry will have repricing problems with their loan portfolios due to higher regulation

Her calls have been pretty spot-on recently. This interview is probably a bit extreme to the extent that she might be "overselling" the current market conditions. But at any rate, I would recommend that you keep her word in mind. And if you have a problem with her then maybe you should take it up with her husband.

Current Fortune article on Meredith Whitney [Fortune.com]

If Lehman sells Neuberger, then LEH will be bought out

With a current market value of about $11 billion and Lehman's Neuberger piece valued somewhere in the neighborhood of $8 billion, then an asset sale would then leave the rest of the firm's pieces (investment banking, fixed income, and equity) sitting somewhere around $3 billion. And thats pocket change for a larger bank. In my opinion, a sale, in effect, would be the beginning of an end of the Lehman franchise.

Lehman to sell Neuberger? [Dealbreaker.com]

Lehman mulls sale of Neuberger [CNBC]

I suspect we should know within the next couple of weeks. This is a huge decision for LEH and playing the Neuberger card is like going "all-in" in a high stakes poker tournament. Let's just hope that they don't overplay their hand.