Lean times ahead for Lehman
The stock bounces back on an upgrade, but the firm's balance-sheet and revenue-growth challenges aren't going away.
NEW YORK (Fortune) -- Top execs at Lehman Brothers must feel like they have the proverbial Kick Me sign taped to their backs.
Rumors about the venerable firm's financial prospects have ripped their once-highflying shares this week. Lehman (LEH, Fortune 500) got a bit of a respite Wednesday after Merrill Lynch upgraded the stock to buy, saying a nearly 20% decline over the first two days of the week meant that Lehman "has over-corrected to the downside." Perhaps. But a look at the firm's books suggest that investors could yet face more pain.
Analysts project Lehman later this month will post its first quarterly loss since going public in 1994. As a result, Wall Street now expects Lehman to raise as much as $5 billion in new capital, almost certainly at a discount to its recent market quote of $32 and change - a price that itself represents a nearly 50% decline since early January.
Not helping matters was Standard & Poor's recent downgrade of Lehman's credit rating one notch to single-A, with a negative outlook remaining in place. The agency, whose review was prompted by the Bear Stearns collapse, said that while Lehman has "a good liquidity platform and funding structure," it also retained a "higher risk exposure," presumably to credit- and mortgage-related debt.
A Wall Street Journal account of Lehman's trading desks buying back its own stock Tuesday also angered firm management - and likely weighed on stock and swap prices. Lehman execs insist the latest repurchases were minor and related to stock option grants.
Stock repurchases are often taken as a bullish sign of company leaders' confidence in their prospects. But in this case any substantial purchases by Lehman of its own stock would scare savvier investors among the firm's already shaken shareholder base. They would see any attempt to buy stock at current prices - while simultaneously offering stock at a discount to institutional investors - as a cash-burning attempt to temporarily sway market sentiment.
A Lehman spokesman declined to discuss the firm's capital-raising efforts.
On Tuesday, as Lehman's stock briefly dipped more than 15%, the firm released a statement from Treasurer Paolo Tonucci stating Lehman had $40 billion in "liquidity" at the end of the second quarter and hadn't accessed the Federal Reserve's borrowing facilities. The comments eased fears of a run on Lehman like the one that helped sink Bear Stearns.
But while Lehman has the wherewithal to soldier on, its balance sheet presents a less than inspiring picture. The firm had $786 billion in assets supported by $20 billion in equity capital at the end of the first quarter, so any writedowns could counter the firm's recent efforts to reduce its leverage.
And as it happens, Lehman's assets values are very much in question. As pointed out two weeks ago by Greenlight Capital's David Einhorn, who maintains a short-position in Lehman's stock, the firm has a looming headache in $6.5 billion worth of collateralized debt obligations backed by asset-backed securities. As the firm's own filings disclose, 25% of this paper is rated BB or below. Those CDOs are effectively worthless, traders say. The remaining ABS CDOs are worth perhaps 50 cents on the dollar. That suggests the firm could be looking at a substantial writedown on its CDO holdings.
Nor is the operating environment for Lehman's key residential- and commercial mortgage-backed securities franchises likely to improve in the near future. A key CMBS AAA-index declined sharply last quarter and, as its filings indicate, the firm has $39 billion worth of exposure on its books. The future could hold some writedowns there, too.
CreditSights, an independent research boutique, says Lehman's likely revenue problems in the near future stem from the firm's reliance upon "new age" business lines such as structured finance, private equity and leveraged lending to buyout firms. All three areas have been devastated in the recent credit collapse.
So while Lehman may have ample access to liquidity, shareholders are still looking at lean times ahead. 
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