Lehman’s Losses

The numbers are in, and they are worse than the $2.2 bn loss expected, a deeper $3.9 bn loss at Lehman Brothers, the biggest in the history of the fourth largest investment firm, founded in 1850.

Make no mistake, Lehman is in serious trouble and is fighting for its life. But Lehman is making restructuring and accounting moves to avoid withering writedowns in the future, historic writedowns which have slammed its earnings and sent its shares to record lows.

There are also bright spots in Lehman Brothers' third quarter earnings that should help the firm going forward, including the sale of a majority 55% stake in its investment management division which houses Neuberger Berman, a deal which the firm may have to partly finance and which may take by October, a person familiar with the matter tells Reuters.

Separately, Lehman (LEH) said "it is committed to examining all strategic alternatives," raising the prospect it might sell itself to another company.

Results Out Early

Lehman reported its third quarter results earlier than scheduled before the market opened this morning in a bid to calm investors, as the fourth largest investment firm has lost 88% of its stock market value in the past year, down to $6 bn from $37.2 bn at the start of the year.

Talks with Korea Development Bank about a potential $6 bn investment stake fell through, rocking Lehman's shares in trading. Lehman has also in recent days named new heads of its global fixed income division, the second executive change here in less than a year, spooking the market further.

Lehman posted a net loss of $3.9 bn, or $5.92 per share on negative net revenue of $2.9 bn, due to mark-to-market writedowns on its commercial and residential mortgage and real estate assets. Thomson-Reuters estimates had it that Lehman would lose $3.35 a share on revenue of just $286 mn.

The losses come on the heels of Lehman's $2.8 bn loss, or $5.14 a share, in the second quarter. Lehman has taken a total of at least $15 bn in writedowns and losses since the credit crisis began in August of 2007, wiping out its profits in prior years. Lehman has also eliminated about 1,500 jobs in the third quarter, (2,800 since August of 2007) saving it $300 mn in compensation expenses.

The third quarter $3.9 bn loss stems from a gross mark-to-market writedown of $7.8 bn, or net $5.6 bn. The mark to market losses broke down as $5.3 bn on residential mortgages and $1.7 bn on its commercial real estate assets.

Lehman also slashed its dividend to a nickel a share from 68 cents a share, raising questions as to why pay a dividend when Lehman needs all the capital it can get.

How Lehman Avoids Future Writedowns

"Future writedowns are unlikely," Lehman executives said on the conference call this morning. An overstatement? Maybe, but maybe not, given an accounting move Lehman is making now which could mitigate future profit hits.

In the biggest element of its dramatic restructuring, Lehman is making a Hail Mary pass to try to avoid drastic writedowns in the future from painful mark-to-market accounting that have shriveled its earnings and created losses never before seen in the history of of the 158-year-old firm.

Specifically, Lehman is trying to wipe clean its balance sheet of its most hard-to-sell commercial real estate securities, amounting to $25 bn to $20 bn, by spinning them off into a separate unit, called Real Estate Investments Global, in the first quarter of 2009. These securities have plunged in value in the collapse of the housing and credit market.

But the moves do not erase the chances that Lehman may still face serious writedowns from these assets. If Lehman has to finance the deal--it may have to sink $7.5 bn in the unit to float it--the firm may have to record writedowns from this new unit, depending on how it structures the deal.

The new company can account for the assets on a "hold-to-maturity" basis, meaning, it doesn't have to book quarterly writedowns after comparing the assets to what it could get if Lehman sold them in the market each quarter.

The question is: If investors shun this new outfit, and if Lehman can't raise the $7 bn to $8 bn in capital analysts says the new company needs, will Lehman be forced to spend desperately needed capital on an equity stake in the new company?

On the conference call, Lehman disclosed it may capitalize 20% to 25% of the asset value (or $5 bn to $7 bn) of the unit, and provide debt financing of 75% to 80% of the total assets. After the spinoff, Lehman will have an estimated $5 bn in commercial real estate on its books.

The question is, if Lehman;s investment in the unit turns into a stake above 50%, then it hits the the threshold which triggers losses from the unit to bleed back onto Lehman's balance sheet, according to accounting rules.

Also, if Lehman does transact debt financing to launch this new off-balance sheet unit, the new debt jeopardize its already precarious credit rating.

New Pricetags on Lehman's Assets

Specifically, Lehman marked down its Alt-A mortgage assets, backed by mortgages in which borrowers provided little documentation of personal income or assets, to 39 cents on the dollar.

Its subprime mortgage assets were marked down to 34 cents on the dollar from 55 cents in the second quarter, and its asset-backed collateralized debt obligations were marked down to 29 cents on the dollar versus 35 cents in the second quarter.

The 29 cent valuation on its CDOs compares to Merrill Lynch's (MER) recent fire sale of its asset-backed securities of 22 cents on the dollar to Lone Star Capital, a Dallas vulture fund (really 6 cents when you factor in Merrill's 75% financing of this deal). And it compares to E*Trade's sale of its CDO portfolio to hedge fund Citadel for 27 cents on the dollar.

The Bright Spots

The firm did improve its net worth, or shareholders equity, to $28.4 bn, up from $26.3 bn. It says it has a liquidity pool of $42 bn.

The improvement in net worth came about as Lehman has been racing to deleverage its balance sheet, some $130 bn as of the second quarter.

However, even with the improvement of its net worth to $28.4bn, the company could still be swamped by its illiquid assets, which it can't sell because nobody wants them. As of the end of its second quarter, those assets stood at $37.9bn--in its third-quarter release Lehman didn't disclose the current value of its so called "level-3" assets.

Slashing Its Commercial and Residential Portfolio

Lehman's bad commercial real estate bets have been well-ventilated.

For example, last year, Lehman joined Tishman Speyer Properties in a $22 bn purchase in which the two overpaid for one of the largest apartment building deals ever from Archstone-Smith, a real estate investment trust.

In another deal belying poor judgement, Lehman also hooked up with SunCal Cos., an Irvine, Calif. land developer to develop and sell thousands of housing lots to builders across southern California.

Lehman cut its commercial real estate exposure by 18% to $32.6 bn from $39.8 bn.

And in the third quarter, Lehman slashed its residential mortgage portfolio by nearly half, 47%, to $13.2 bn, a pro forma number that includes a pending $4 bn mortgage transaction in the UK. It says it has "formally engaged with BlackRock Financial Management" to sell $4bn of its UK residential mortgage portfolio. Pending that sale, Lehman for now cut its exposure here by 31% to $17.2 bn.

It also cut its leveraged loans by 38% to $7.1 bn from $11.5 bn.

Sale of Stake in Investment Division

Lehman also plans to sell a majority interest, 55%, in its investment management division, which houses Neuberger Berman. Lehman is reportedly in talks with private-equity firms, including Kohlberg Kravis Roberts & Co. and the Carlyle Group, about the sale, which Lehman says will take the form of an auction. Lehman says the sale could add $3 bn to Lehman’s tangible book value.

Specifically, Lehman plans to sell its asset management, private equity and wealth management business, but not its middle market institutional business or its minority stakes in hedge fund managers.

Business Lines Show Dismal Results

However, Lehman also reported losses in all of its business lines, capital markets, fixed income and equities. Investment banking and management eked out net revenues in positive territory, $600 mn each, but both of these businesses' earnings are down from the prior quarter.

Different From Bear Stearns

There are distinctions here between Lehman and the Bear Stearns fiasco. What should calm the stock market is that, unlike Bear Stearns, which nearly collapsed last March before it merged with JPMorgan Chase in a shotgun wedding orchestrated by the Federal Reserve, Lehman has access to the Fed's discount window for funding. Bear Stearns did not have access to the funding window, and it collapsed after its trading partners stopped doing business with it, triggering a run on the bank. Goldman Sachs (GS) and Citigroup (C) say it is still doing business with Lehman.

Also, Lehman is a bond shop, whereas Bear Stearns ran one of the country's largest securities clearing houses, raising the specter of cascading losses throughout the financial system from counterparty risk if Bear went bankrupt.

Chairman and chief executive officer Richard Fuld said in a statement: “This is an extraordinary time for our industry and one of the toughest periods in the firm’s history. The strategic initiatives we have announced today reflect our determination to fundamentally reposition Lehman Brothers by dramatically reducing balance sheet risk, reinforcing our focus on our client-facing businesses and returning the firm to profitability.”