April 2, 2008: 3:24 PM EDT
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How Lehman aced its liquidity test

The firm spent the past year preparing for just the scenario that brought rival Bear Stearns down.

By Roddy Boyd, writer

Doomsday on Wall Street
Lehman Brothers stopped a run-on-the-bank, unlike crosstown rival Bear Stearns.

NEW YORK (Fortune) -- Wondering how Lehman Brothers staved off the panic that brought down Bear Stearns last month? Here's a clue: While former Bear Stearns chief Jimmy Cayne was off playing bridge, Lehman Brothers was busy putting together a hand that allowed the firm to trump bearish investors when the market turned.

Lehman's success in sailing through last month's liquidity crisis involved both pluck and luck. Closing on Tuesday's overnight $4 billion convertible preferred offering and securing a $2.5 billion credit facility from a 40-bank syndicate, as the New York brokerage did last month, took pluck. Getting access to the Federal Reserve's discount window - an unprecedented move that, when the Fed made it in March 17, allowed the broker-dealer to borrow cash like a commercial bank - was a bit of luck.

The 148-year-old firm needed both: Senior executives at rivals and hedge fund managers told Fortune.com that just two short weeks ago, a consensus was forming in the marketplace that Lehman (LEH, Fortune 500) was the next Bear Stearns. But while Lehman's success in raising capital has taken the firm off Wall Street's death watch and buoyed shares across the financial sector, perhaps the biggest factor in the firm's survival was its decision to spend the past year trimming its short-term borrowing exposure.

A glance at Lehman's 10-K for the year ended Nov. 30 shows that the firm labored over the past year to reduce a technical but crucial funding measurement: its net repo liability. This is a measurement of the firm's liability in its book of overnight and short-term loans, or repurchase agreements. The firm had just under $19.1 billion more borrowed than it had lent out, down from $24.5 billion a year earlier. In contrast, Bear's gap surged to $74.5 billion from $31 billion a year earlier. What's more, if worse had come to worst, Lehman has about $197 billion in emergency liquidity to close this gap, while Bear (BSC, Fortune 500) had just $42 billion.

Put frankly, if Lehman really had faced a backlash from its short-term lenders or even many of its prime brokerage customers, the emergency funding sources (like cash, credit lines, and very liquid securities like Treasuries) should have been enough to keep the firm afloat. Lehman spared no effort in getting that message out in the market in the wake of Bear Stearns' near collapse, though it wasn't a message investors immediately embraced.

A look at the cost of insuring a $10 million block of Lehman's debt in the credit default swap market nicely shows how investor sentiment on the firm quickly shifted.

On Friday, March 14, when Bear was in its death throes, the cost of insuring against a default on Lehman's debt shot out to a range of $470,000 to $495,000 per $10 million in default insurance. That's 470 to 495 basis points, in Streetspeak - up from the low 300s in the prior days. On Monday, March 17 - before the market could digest the specifics of the Fed's decision to expand access to the discount window - Lehman's spreads shot out to 550.

Discounting the nonsense Lehman's executives have been floating about short-sellers and their alleged rumor campaign, it appears that the market's considered opinion on Lehman in the crucial middle week of March was at best mixed. Traders who had to bet directly on the firm's short-term health clearly viewed it as a different risk than Bear Stearns, whose credit default swaps were trading at 1,100 basis points, or a stunning $1.1 million per $10 million in insurance, before trading stopped altogether. But concern was unmistakably building.

Today, worries about Lehman's solvency are dissipating. Lehman's credit default swaps are now trading at the 225 level, versus 160 for Morgan Stanley (MS, Fortune 500) and 125 for Goldman Sachs (GS, Fortune 500).

But, as the elevated spread on Lehman credit default swaps shows, staying afloat doesn't necessarily make for smooth sailing ahead.

If the statements yesterday of its rivals UBS (UBS) and Deutsche Bank (DB) are to be relied upon, March was truly brutal in key secondary markets for mortgage-backed securities. And Lehman has some $87.3 billion in real estate securities on its balance sheet - more than $13 billion of which are classified in the Alt-A category, covering mortgages to borrowers whose credit quality is between that of prime and sub-prime. That's the category that gave Deutsche Bank such a headache, and declines in those markets could set Lehman up for a big writedown next quarter.

That said, Lehman is still profitable. Two weeks ago it even managed to post quarterly earnings above analysts' reduced earnings estimates, though revenue was down 20% sequentially and by nearly 33% year-over-year. And as Portfolio.com noted, more than $600 million of Lehman's latest-quarter earnings were attributable to accounting gains tied to the decline in the value of its outstanding bonds. You could argue that, with just $489 million in net income, Lehman avoided a quarterly loss only through the convention of fair value accounting.

The firm's weakening earnings power, and the dilution associated with this week's surprise capital raise, could mean a cloudy future for the firm's shareholders. But as the Bear Stearns case shows, a cloudy future is preferable to no future.  To top of page

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