Conde Naste is writing about Lehman’s Debt Shuffle.
Investors were thrilled when Lehman topped earnings expectations on Tuesday—as the firm took pains to reassure the markets that it has plenty of cash to ride out the turbulence. Yet aside from a smattering of attention here and there, investors and the media mostly overlooked the balance sheet. In other words, they forgot what happened mere hours earlier with Bear Stearns. Wall Street’s short-term memory is notoriously lousy, but this must set a record.
What actually happened to Lehman’s balance sheet in the first quarter? Assets rose. Leverage rose. Write-downs were suspiciously minuscule. And the company fiddled with the way it defines a key measure of the firm’s net worth. Let’s look at the cautionary flags:
Lehman’s balance sheet isn’t shrinking.
Lehman finished the first quarter was total assets of $786 billion, up almost 14 percent from the previous quarter and 40 percent from a year earlier.
Lehman got more leveraged, not less.
The investment banks “gross” leverage hit 31.7 times equity, up from the fourth quarter and way up from last year’s 28.1. According to Brad Hintz, an analyst with Bernstein Research, Lehman’s leverage reached its highest point since 2000.
Lehman reaped substantial earnings gains because investors thought it is more likely to go bankrupt.
For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilities fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million.
Lehman’s write-downs seem tiny.
Lehman finished the quarter with $87.3 billion of real estate assets. These include residential mortgages and commercial real estate paper. The bank only wrote these assets down by 3 percent. And its Level III assets —the hardest to value portion of these instruments—were written down by only the same percentage.
Lehman remains exposed to lots of dodgy mortgages, including a group labeled: “Prime and Alt-A.” Prime mortgages represent loans to good quality borrowers; Alt-A loans go to borrowers a mere step up from subprime, and represent an area with almost as many problem loans as subprime. The total amount of such mortgages on Lehman’s balance sheet was $14.6 billion in the first quarter and it actually rose from $12.7 billion in the previous quarter. Is this the time to be increasing exposure to questionable mortgages? More ominously, only $1 billion of that figure is prime and the rest is Alt-A, according to Hintz’s estimate.
The picture emerging is that of an investment bank that is dancing as fast as it can.
Great Moments In Accounting
Back in September 2007 the Wall Street Journal wrote about Great Moments In Accounting.
Thanks to a relatively new accounting rule, firms like Morgan Stanley, Lehman Brothers and Goldman Sachs last quarter booked hundreds of millions of dollars in gains based on worsening perceptions of their own creditworthiness.
How does that work? If the market decides a company is a bigger credit risk and starts demanding fatter risk premiums to buy its debt, the value of its existing debt falls. Under a rule being phased in throughout corporate America known as Financial Accounting Statement No. 159, that same logic applies to a company’s own debt. Companies that mark their liabilities to a market price, as Wall Street usually does, thus record as revenue a drop in the value of their own debt obligations.
Accounting experts said the exercise is perfectly legitimate, particularly if firms that mark liabilities to market do the same with their assets. At the same time, it highlights one of the ironies of so-called fair value accounting. “If you have a liability that declines in value because your credit worsens, you have a gain,” said Stephen Ryan, associate professor of accounting at New York University’s Stern School of Business.
FAS 159, which brokers are adopting earlier than most companies, couldn’t have come at a better time for Wall Street. The firms are taking writedowns of billions of dollars to reflect the lower value of leveraged buyout loans and securities backed by mortgages and other assets that are stuck on their books.
The Balance Sheet Is The Future
Let’s now review Minyan Peter’s post on Bank Earnings 102 also from September 2007.
[Here is] one simple rule for financial services firms: The income statement is the past. The balance sheet is the future.
Let me repeat it again. The income statement is the past and the balance sheet is the future, especially now.
At the top of a credit cycle, the income statement for a financial institution shows “the best of times”, but buried in the balance sheet is “the worst of times” to come.
Judging from what’s happening to its balance sheet, Lehman’s future looks bleak.
Mike “Mish” Shedlock
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