What to Watch Out for at Lehman Brothers

The possibility that Lehman Brothers Holdings may report its first quarterly loss since going public 14 years ago, when it reports its quarterly results the week of June 16, has dropped its stock to a new 52-week low, down to $20.25 from its high of $82.05.

To figure out what's at stake and where the potential future writedowns could come from at Lehman and five other major firms, watch the rotten assets the companies have had to disclose beginning this past January 1 due to new accounting rules. The estimates are at bottom.

The Lehman (LEH) news comes on top of Standard & Poor's downgrading its credit ratings yesterday as well as ratings for Morgan Stanley (MS) and Merrill Lynch (MER), as it expects these securities firms to book more writedowns for plummeting asset values. S&P slashed both Merrill's and Lehman's credit rating to A from A+. It also cut the ratings of Morgan Stanley to A+ from AA-.

Lehman in particular has been under the gun, as it has had to respond forcefully to mounting rumors in recent weeks about its financial status in the aftermath of Bear Stearns' near collapse. Wall Street analysts now anticipate a second quarter loss of as much as 75 cents a share at the country's fourth biggest, though Wall Street's smallest, independent investment house. The problem: Lehman's outsized, frozen solid assets on its balance sheet, as the blackout in the credit markets remain in effect.

Wall Street expects further shareholder dilution at Lehman of as much as 20% as Lehman is estimated to need to raise anywhere from $3b to $4b in a new common equity offering to plug its balance sheet holes. That comes on top of the $6b it's already raised due to record asset writedowns and losses.

The capital raising has helped Lehman's gross leverage ratio, which gauges its borrowing relative to assets, fall to 27.3 from 31.7 at the end of its first quarter in February. The figure is expected to be down to 25 as of the end of the second quarter.

The news of fresh losses and possible writedowns at Lehman comes on top of the estimated $345b already taken at 100 banks around the world, due to the housing and credit squeeze.

Lehman, like other U.S. investment houses, can now borrow directly from the Federal Reserve by putting up an assortment of collateral.  The possibility though of yet another bank relying too heavily on the Fed has seen Henry Paulson, US Treasury Secretary, traveling to the Middle East to reportedly let it be known in this region that the US has kept its door open to more unlevered, cold hard petrodollars coming into companies here. For examples, Citigroup has raised $30.4b in capital infusions as well as public offerings.

But capital raisings can't stop the turnstile now turning fast in executive suites. Some $7b in capital raisings at Wachovia did not stop the departure of its chief executive, G. Kennedy Thompson. Washington Mutual also raised some $7b this year, but CEO Kerry Killinger could not hold onto his as chairman though he remains CEO of the Seattle bank, despite the fact it's warned of another $19b in potential losses from the housing crisis over the next three years.  

Here's what you should keep an eye on in coming days.

Lehman is now in a top-speed horse race with other Wall Street banks and brokerages--including Citigroup and Merrill Lynch--to dramatically cut the size of its balance sheet. It is stuck with billions of dollars in frozen solid commercial and residential real-estate assets as well as leveraged loans.

To figure out where the potential future writedowns could come from and what's at stake, watch the level 3 assets the companies have had to disclose beginning this past January 1 due to new accounting rules.

Level 3 assets show values of illiquid, rotten securities, values that are based on management's best guess of what they think they are worth, using their own idiosyncratic, internal models, a "mark to market" valuation approach that has been jokingly redubbed "mark to  myth" or "mark to make-believe. Management gets to value level three assets, essentially by, get this, using "no observable inputs." 

The new accounting rules have flushed out this little-known ticking time-bomb of a profit figure that tracks bad assets now overwhelming the net worth of Wall Street firms (a company's assets minus its liabilities, similar to your own net worth) and stings their book values per share, one of the most important valuation measures for banks and brokerages.

Level 3 assets provide one of the truest gauges of the speculative bender Wall Street was on during the housing bubble. 

This profit figure helps show you the rotten securities that have helped blow the economic circuits at places like Citigroup and Merrill Lynch (see my prior blogs  "The Answer to Who's Next on Wall Street," "What's Really Rocking the Stock Market," and "The Bear Trap"), bad asset plays that have caused CEOs to be frog-marched out the door and has sent our highest corporate and government officials to go sheepishly gone hat in hand to sovereign wealth funds in the Middle East and Asia.

These zombie securities are typically backed by the sub prime and other credit deals now defaulting left and right, dead loan walking. Companies must deduct on a quarterly basis the changes in the value of these Frankenstein securities from their profits, causing steam pipes to burst.

But it's a number Wall Street has been submarining out of sight in footnotes using typeface that are the font size of pharmaceutical disclosures, hoping you'll cruise right by it. Goldman didn't disclose an updated figure for it in its recent profit release or on its earnings call today, waiting to do so weeks later when it has to file its latest quarterly with the Securities & Exchange Commission.

Lehman also didn't print the figure in its earnings release, but disclosed the number on its earnings conference call.

Now this isn't to say that all of these assets will drop into a ditch. No one knows, it depends on the credit markets. All could be worthless-all could have value.

Some analysts now say to figure out what future hits to earnings could be at each firm, multiply the level 3 assets by 15% to 20% to get a rough idea, those percentages equivalent to what the best guesses are about how much mortgage- and other credit-backed assets have further to drop (if you're really bearish, raise those percentages). The resulting writedowns get carved out of both company profits and book value.

The level 3 bucket can hold other items, to be sure. For instance, Morgan Stanley and other firms generally classify private-equity investments as level 3, because private equity deals, being private, aren't traded on any market.

Lehman Bros. says its level 3 assets have dropped by $3b to $38.7b, after having more than doubled to $42b in the last six months of last year. Lehman in its last quarterly report took just a $1.8b "mark to market" haircut against earnings due to the downturn in these holdings.

But $38.7b is still a big number, outstripping Lehman's $24.8 billion in shareholder equity, or what's generally understood as net worth. The number was of such concern that it was partly why Lehman hastened in recent days to point out that it has not just a $2b credit line--a sign of the good faith and confidence its lenders have in its operations--but also that it has a "robust liquidity pool" of $34b plus other "unencumbered" assets of $64b to plug this black hole.

Six Wall Street houses now have more level 3 assets than shareholder equity. In order they are (as a % of total shareholder equity):

Note: Latest figures available. Source: Company filings; Lehman's numbers were reported in the company's conference call

Footnote: David Einhorn, a hedge fund manager who runs Greenlight Capital LLC, has been criticizing Lehman's accounting in recent months. Einhorn, who is short Lehman Brothers, claims the bank didn't properly disclosed its holdings of collateralized debt obligations before the first quarter and wasn't valuing its commercial mortgage-related assets based on market prices.

Lehman heatedly took exception to Einhorn's characterization. ``Mr. Einhorn cherry-picks certain specific items from our 10-Q and takes them out of context and distorts them to relay a false impression of the firm's financial condition, which suits him because of his short position in our stock,'' Lehman has said in a statement. ``He also makes allegations that have no basis in fact with the same hope of achieving personal gain.''

According to Bloomberg, Einhorn has claimed that Lehman failed to disclose $6.5b of CDOS on its balance sheet until a regulatory filing at the end of the first quarter. Lehman spokeswoman Kerrie Cohen referred to the company's 10-Q filing, which says the $6.5b is ``Other Asset-Backed Securities.'' She said CDOs represent a small proportion of the total, Bloomberg says.

The filing said that those securities are mostly tied to consumer and business lending. The portfolio of CDOs backed by mortgage-related assets, which have declined during the subprime crisis, was smaller than $1b, according to the firm. That part of the portfolio has been disclosed in recent quarters.

But Einhorn argues that all CDOs had declined in value and that the $200m (yes million) in gross writedowns Lehman took on the portfolio didn't reflect market prices, regardless of the combination of assets.