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Five Things You Need to Know: Lehman Reports Profit Increase Even as Fixed-Income Revenue Falls; Why Lehman Matters; On Tap: Protectionism; China Now Exporting Cheap Foreign Inflation; Mortgage Brokers Urge Government Intrusion Only AFTER Sales Close


What you need to know (and what it means)!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Lehman Reports Profit Increase Even as Fixed-Income Revenue Falls

Sweet headline, ain't it? Lehman Brothers (LEH) provided a strong kickoff to the earnings season for the major brokerage firms, posting a 27% increase in fiscal second-quarter profit. Goldman Sachs (GS) and Bear Stearns (BSC) report on Thursday. Morgan Stanley (MS) reports next week.

  • For Lehman's fiscal year second quarter ending May 31, the brokerage firm reported a profit increase of 27%, fueled largely by equity-trading revenue, which doubled, and a 76% increase in underwriting fees.
  • Equity-trading revenue reached $1.7 billion, an all-time high for the firm.
  • Total revenue rose to a record $5.51 billion, up from $4.41 billion reported a year earlier - what is interesting to note, however, is that 48% of that total came from non-US sources, compared to 40% in the first quarter and 37% last year, according to Bloomberg.
  • Meanwhile, revenue from fixed-income trading fell 14% - that's important because Lehman is the largest underwriter of mortgage bonds. (Bear Stearns is the largest underwriter of mortgage-backed-securities.)
  • The firm said "Continued weakness in the U.S. residential mortgage market business" contributed to the decline in fixed-income revenue.

2. Why Lehman Matters

The concerns over the brokerage reports heading into this week were all about the continuing problems in subprime mortgages and the reverberations back through the fixed-income areas of the major brokers, especially Lehman and Bear Stearns. But those concerns are superficial.

Here's what really matters about the Lehman results and what to look for going forward.

  • The news brief and headline writers will note the 14% decline in Lehman's fixed-income trading and the fact the company noted "continued weakness" in the the U.S. residential mortgage market. Nothing wrong with that. We did it too, above.
  • But there are other factors at work here that deserve closer scrutiny.
  • Last year the SEC eased capital requirements for Lehman, Goldman Sachs, Morgan Stanley, Merrill Lynch and Bear Stearns as part of new capital-adequacy standards.
  • Under the previous capital requirement standards the firms had to set aside a certain percentage of every dollar of capital at risk to make sure they could remain solvent during a market crash or financial crisis.
  • The rules are complex, but the bottom line is firms are now allowed to use non-cash assets (read: derivative contracts) to count toward their capital adequacy requirements, thus freeing up additional cash to increase leverage and (it is hoped) returns.
  • Lehman, for example, reported return-on-equity of 25.8%, compared to 23.7% last year, according to Bloomberg.
  • Lehman's leverage ratio - total assets relative to shareholders' equity - rose to about 28% from 26% last year, Bloomberg said.
  • Coincidentally (or not) the recent jawboning from the Fed (cf. Chairman Ben Bernanke's speech on subprime loans last week) has been all about the lack of any "major spillover" from the subprime mortgage market.
  • The reports by the brokers this week (Goldman and Bear) and next (Morgan Stanley) will appear to further justify that position as they report flat to declining revenues from fixed-income operations but better-than-expected profitability thanks to investment banking revenues, initial public offering underwriting and increased leverage.
  • Don't you just love it when a plan comes together?

3. On Tap: Protectionism

Thanks to a larger-than-expected Chinese Foreign Trade Surplus, larger-than-expected inflation (see Number 4 below), and a poorer-than-should-be-expected understanding of global economics, U.S. lawmakers will unveil legislation tomorrow designed to pressure China to revalue its currency.

  • The legislation, sponsored by Senator Charles Schumer (D-NY) outlines this country's plan of action when countries "including China unfairly undervalue their currency,'' according to a statement released by four senators in Washington, Bloomberg reported.
  • The announcement of the legislation will follow close on the heels of the Treasury Department's semiannual currency report tomorrow.
  • The semiannual report bears close watching because there is some chance that China will be formerly labeled a "currency manipulator."
  • What exactly does that kind of name-calling mean?
  • Formerly labeling China a currency manipulator would kick in formal, mandated procedures requiring the Bush administration to negotiate with China over its exchange rate.
  • The "currency manipulator" label has not been used since 1994, so in some respects it is a big deal.
  • As a side benefit, formerly labeling China a "currency manipulator" could potentially quiet efforts by lawmakers to implement sanction, tariffs or other more dangerous protectionist measures.
  • Although Americans on the one hand don't like the idea of losing jobs overseas, they certainly don't mind paying less for inexpensive Chinese-made goods that are inexpensive as a direct result of the yuan's weakness relative to the dollar.
  • That has kept China largely in the driver's seat with respect to the yuan... and is the chief reason we haven't been all that interested in doing anything about the yuan except making some bold-sounding statements now and then.
  • A strengthening currency would ultimately lead to higher prices paid for both companies and consumers.
  • But now there's a change no one may have expected.
  • China is on the borderline of moving from a net exporter of deflation to a net exporter of inflation.

4. China Now Exporting Cheap Foreign Inflation

China's annual consumer price inflation in May hit a 27-month high, according to the National Bureau of Statistics.

  • Inflation rose to 3.4% last month from 3% in April, the National Bureau of Statistics said.
  • Food prices, which make up about 30% of the consumer price basket, rose 8.3% from a year earlier.
  • Non-food inflation remained subdued, with prices up just 1% from a year earlier.
  • Yi Xianrong, an economist with the Chinese Academy of Social Sciences (CASS), told Reuters the jump in food prices rises was inevitable.
  • "You just look around -- many things are getting pricey and liquidity is flooding into China, so why wouldn't food prices go up?"
  • In a related story: China is moving to restrict production of ethanol from grains to reduce pressure on food prices.
  • The state-run Xinhua News Agency reports that producers have been told to switch to crops not widely eaten in China, such as sorghum.

5. Mortgage Brokers Urge Government Intrusion Only AFTER Sales Close

Ran across an interesting story on the front page of the New York Times this morning illustrative of hypocrisy now running rampant over government intervention in mortgage lending.

  • Apparently, there's a new battle heating up over when (not if, mind you, but when) it's appropriate for the government to intervene in the private lives of citizens.
  • Perhaps nowhere are these new battle lines being drawn more clearly than in Illinois, according to today's New York Times article.
  • With a growing number of homeowners running into problems paying their mortgages, Illinois came up with an idea to protect homeowners from lenders - and themselves, the New York Times story notes.
  • "A single mother and a homeowner on [Chicago's] south side, [Cassandra] McKinney briefly entertained the idea of taking $50,000 of equity out of her home to pay off debts, at an initial interest rate of 9.5 percent, sharply higher than her existing mortgage. But after attending a new mandatory state program to counsel borrowers on their mortgages, she realized the loan was too expensive and unnecessary," the article said.
  • "The counseling helped me understand that this was on the excessive side," McKinney told the Times.
  • However, in January, a little more than three months after the program began, Gov. Rod R. Blagojevich suspended it after critics complained that the government was wading too deeply into the personal financial lives of its citizens.
  • "Mortgage brokers, real estate agents and minority community leaders said that the effort, while well intentioned, put a damper on real estate transactions in the largely black and Hispanic neighborhoods in southwestern Chicago where the program operated," the Times article said.
  • Right. See, the government should only intervene in citizens' lives after the sales are closed. Otherwise, it's bad for business.
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