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Bringing Lehman's Fuzzy 3Q Into Focus


Lehman either did a really good job of trading around its levered loan and mortgage book or it is masking losses, which might explain the bump up in dividend and interest income.


On the face of it, it was a decent quarter for Lehman Brothers (LEH). It beat on revenues and just missed on EPS, which had been downgraded several times by analysts leading into the quarter.

There is not a lot of clarity to the quarter, however. The beat was despite much lower revenues from principal transactions (prop trading) and contains a huge bump-up in interest and dividends (which is not broken out in the release). Investment banking (both advising and origination) had a good quarter.

All in all, the release was too cryptic to really draw any conclusions. The call was at 10 AM and here are the issues that investors will be focusing on from it:

Asset valuation: In the release it says that the firm:

"...recorded very substantial valuation reductions, most significantly on leveraged loan commitments and residential mortgage related positions. These losses were partially offset by large valuation gains on economic hedges and other liabilities. The result of these valuation items was a net reduction in revenues of $700 mln."

Essentially, it means that Lehman either did a really good job of trading around its levered loan and mortgage book (shorting the ABX and the LDX) or it is masking losses, which might explain the bump up in dividend and interest income.

Assets are grouped into three levels:

  • Level One: quotable prices.

  • Level Two: significant observable inputs (this is where you have some discretion over marks, but if you recently extended a bridge loan and you are marking it at 100 cents and similar bridges are trading at 92 cents, you should probably mark it down).

  • Level Three: mark to model (most open to interpretation, includes CDOs, CLOs and the like).

Securitizations: Retained interests, particularly in non-investment grade securitizations (subprime mortgage, for example), have been the focus since the first meltdown in February. Lehman has $11.4 bln in retained interests of which $1.7 bln is non-investment grade.

Loan Commitments: These are commitments so they are not on the balance sheet as of yet. Lehman has $81.2 bln in commercial lending commitments with about $27 bln in investment grade and $55 bln in non-investment grade. It is also important to remember that not all commitments are necessarily associated with LBOs. In Lehman's case, almost $51 bln is contingent (on the closing of a deal), $44 bln of that is non-investment grade, and Lehman has $14 bln in disclosed hedges against those commitments. We'll see what the marks look like: this is another area where Lehman (and any other bank) can fudge dramatically.

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