May 23, 2008: 1:37 PM EDT
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Writedown bug could bite Lehman

The brokerage firm's accounting is back under scrutiny.

By Roddy Boyd, writer

NEW YORK (Fortune) -- Lehman Brothers has some explaining to do.

Shares of the big brokerage firm have dropped 13% over the past three days amid renewed questions about the health of Lehman's (LEH, Fortune 500) balance sheet. The setback comes just over a month after finance chief Erin Callan led a public relations blitz that aimed to dispel worries about Lehman's financial standing following the collapse of rival Bear Stearns (BSC, Fortune 500). Callan's efforts were aided by a surprisingly solid first quarter earnings report and a $4 billion preferred stock sale that was strongly oversubscribed.

But David Einhorn, the manager of the Greenlight Capital hedge fund, reopened the case against Lehman in a speech Wednesday. Einhorn, who along with any number of other value-oriented, long/short hedge fund managers is short Lehman, says the firm hasn't taken sufficient writedowns on its $6.5 billion collateralized debt obligation book to account for the sharp decline in the value of this sort of paper. Einhorn laid out his argument in a speech at the Ira Sohn Investment Research Conference.

A Lehman spokesman declined to comment, although the firm has made clear that it dismisses Einhorn's claims root and branch because of his short position.

But based on price-checks in the secondary market, Einhorn appears to have a good point. It seems highly unlikely that the $200 million in writedowns Lehman took in the first quarter - representing just 3% of the CDO portfolio's value - begins to account for the hit that this paper would take were it to come to market.

The CDOs Einhorn is scrutinizing include various asset-backed securities, primarily auto- and credit-card loans, with some small business and franchise loans. There is no mortgage-bond exposure in these CDOs, but that's not to say the bonds are pristine. About 25% of the portfolio, or $1.62 billion, is rated noninvestment grade, with ratings of BB-plus or below.

Not to put too fine a point on the matter, but merely finding a buyer for a $1.62 billion portfolio of sub-investment grade loan CDOs would be an achievement in this market. There is, in fact, an excellent chance that no buyers exist for these securities, given the apparent problems with the underlying collateral. Portfolio managers in contact with Lehman's own trading desks told Fortune that the firm appears to value such "scratch and dent" loans held by other firms at deeply discounted levels, with no guarantee that the Lehman desks would even bid on this paper themselves.

All that said, two dealers say a reasonable bid, could one be found, might be 10 cents on the dollar. That suggests Lehman could be looking at a writedown of more than $1 billion on this portion of its holdings alone.

To be fair to Lehman, the rest of the portfolio isn't nearly as problematic. Still, these CDOs - nearly $5 billion worth - could also be subject to discounts beyond the 3% Lehman seems to have decided on, and the discounts will only get deeper if the rating drops lower.

Of course, according to its 10-Q filing, at the end of the first quarter Lehman had $786 billion in total assets. So the decision of whether to write down a billion dollars or two could easily fall short of materiality. But it's nearly impossible to carry off an argument that the 3% haircut Lehman has taken so far on its $6.5 billion portfolio is remotely adequate. Were Lehman to seek a buyer for the entire portfolio at once, a bid of 50% of face-value might be generous. Whatever Einhorn's motivation, it appears clear that the firm's investors would do well to brace for at least one more round of asset writedowns. To top of page

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