Lehman Bros. is Losing More than Money

By STEVEN M. SEARS
barrons.com

The investment bank’s credibility is shot and its put options have gotten red-hot.

ON A DAY WHEN MOST stocks are rising simply because some 90% declined in the previous trading session on Friday, Lehman Brothers (LEH) is an exception.

The stock of the nation’s fourth-largest investment bank fell about 11% in midday trading Monday after the company warned investors that next Monday’s second-quarter financial report will reveal a big loss.

Ineffective hedges, and apparently a breakdown with the bank’s decision making, caused Lehman to unexpectedly announce that it thinks it lost $2.6 billion, and that it will now rebuild its finances by issuing $4 billion of common stock priced at $28 per share and $2 billion of mandatory convertible preferred stock.

Of course, this is just a pre-announcement, and the final results could be different when announced next Monday, said Lehman’s chief financial officer, Erin Callan, in a morning conference call with investors and analysts.

The options and debt markets had expected earnings troubles, though arguably not even the legion of traders aligned against Lehman anticipated a loss of this magnitude. Lehman’s expected second-quarter equals $5.41 per share, markedly higher than the analyst consensus of a loss of 20 cents.

Put options on Lehman, which increase in value when the stock price declines, were obscenely expensive last week in anticipation of Lehman’s weakened position. Today, they are still richly priced, and though they have declined somewhat from last week’s doomsday scenario level, anyone interested in hedging against further weakness in Lehman’s stock will pay a princely risk premium.

Lehman’s implied volatility is about 84%. To put that volatility level into perspective, the implied volatility of the financial sector proxy, the Select Sector Financial SPDR (XLF) is about 39%, and about 43% for Goldman Sachs. In essence, Lehman’s options are priced as if owning the stock is twice as risky as maintaining an investment in the financial sector and Goldman Sachs.

The options market is writhing with bearish activity. Investors are readjusting expectations for the stock. The picture is not pretty, nor is it unexpected. In recent weeks, many investors were posturing in the options market in case Lehman ran into Bear Stearns-like financial trouble and was forced to sell itself at a severe discount to its recent stock price.

The pre-announced quarterly report has provided enough clarity to merit readjusting bearish positions to take advantage of fluctuations in Lehman’s implied volatility levels, and range-bound shares.

Of course, if next Monday’s earnings report is materially worse than the pre-announced figures, or if the details management provides is at odds with investor interpretations of Callan’s comments during the pre-announcement call, Lehman’s stock will decline, and options implied volatility will increase to reflect the escalated risk of owning Lehman stock.

Of the many troubling revelations raised by the announcement, one of the most troublesome is the breakdown in what is glibly called risk management. The phrase is rather vague, so as to divorce the act of risk management from man to machine.

In fact, risk management is the responsibility of senior executives who are paid considerable sums of money to make decisions, and enter into transactions, to expose investors to maximized profits, and minimized losses. Lehman’s stock has lost more than half of its value in the past year.

To lose money in hedged positions, and lose money across the enterprise, is inexcusable, and damages the firm’s credibility. Lehman is a firm that is, or was, respected for attention to detail, and the executive teams focus on running the business.

We’ve admired how Lehman’s management has internationalized, and energized, this once plodding bond house, but today’s revelations cause us to question that premise.

One benefit to the day’s events it is that investors likely face a reprieve from the press posturing of Erin Callan, Lehman’s tres chic CFO whom everyone now knows has a personal shopper at Bergdorf Goodman on Manhattan’s Fifth Avenue, and hedge fund manager David Einhorn, whose boyish looks masks the lethal impact he has on stocks he dislikes.

Einhorn was convinced something was wrong at Lehman, and he was right.

The questions left lingering about Lehman defy the easy categorization of pop culture. The forward story line is nuanced, even though issues of trust and credibility are so simple that children understand them.

Much will be made in the future about Lehman’s capital raising efforts, and some pundits and investors will even cite transactions as evidence of investors renewing their faith in the House of Lehman. They will not be wrong, per se, but do not forget that financial terms are flexible and structured to make any deal appeal to anyone.

Isn’t that the moral of the sub-prime mortgage crisis where garbage assets received high-debt ratings?

It’s easy to raise capital; building trust is more elusive.