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Lehman's Fuld comes out swinging

The embattled CEO passes his first test, but a return to profitable growth will test even his mettle.

By Colin Barr, senior writer
Last Updated: June 16, 2008: 8:36 PM EDT

NEW YORK (Fortune) -- Lehman Brothers chief Richard Fuld reasserted himself Monday, but fully reviving the struggling investment bank will test even his steely resolve.

Lehman (LEH, Fortune 500) shares rose more than 5% Monday after Fuld took responsibility for the firm's $2.8 billion second-quarter loss. More importantly, the firm also offered vastly expanded detail on its mortgage portfolio and the mark-to-market losses it has taken, in a bid to silence critics of its accounting and ease worries that Lehman is heading for a Bear Stearns-like collapse. Execs said Lehman's liquidity is as good as it has ever been, and Fuld said repeatedly that he stands by the portfolio values Lehman has assigned to its assets.

"I'm comfortable with our valuations at the end of the second quarter," Fuld said on a conference call with analysts and investors. Referring to the Sarbanes-Oxley law that holds executives responsible for their firm's accounting, he added, "I am the one who ultimately signs off."

Fuld's strong comments mark a sharp change from his previous reticence during the credit crunch. He is revered at Lehman for having led the firm out of the 1998 maelstrom that saw Russia default on its debt and the Long Term Capital Management hedge fund collapse. This year, though, Fuld had been content to let Erin Callan, Lehman's finance chief, take the lead in communicating with shareholders - even as the housing bust threw the firm's profits into a nosedive and numerous execs at rival firms were cashiered.

That changed last week, when Fuld demoted Callan and another longtime Lehman exec, president Joseph Gregory, after a sustained selloff in Lehman shares made it apparent that investors had lost confidence in the firm. Now, Fuld is the executive who will be held responsible if Lehman continues to founder.

"We've made a number of changes," Fuld said Monday. "Now it's now my job to make sure we execute."

Despite Fuld's confident tone, it's clear that executing a recovery at Lehman won't be easy. Fuld noted that Lehman has a "track record of taking market share coming out of difficult cycles," and finance chief Ian Lowitt and operating chief Bart McDade - the officers who replaced Callan and Gregory - promised the firm would deploy recently raised capital to boost revenue and bring profitability back into line with investors' expectations.

But analysts noted during the question-and-answer session that Lehman has a long way to go before its results match up with those promises. Oppenheimer analyst Meredith Whitney asked how the firm could produce a projected 15%-or-so return on equity, reflecting annual profits as a proportion of the firm's net worth, with its quarterly revenue at a recent level of around $4.2 billion.

Lowitt conceded that Lehman wouldn't be able to hit that return-on-equity target with revenue at current levels. He said Lehman hopes to get its quarterly revenue up into the $5 billion range, reflecting nearly 20% growth. How does Lehman expect to produce this sort of growth in such a difficult market? Lowitt wouldn't say, noting that "markets continue to be challenging." He also declined to offer a timeline for bringing the ROE figure up to par, though "we're very confident we can get there," he said.

The news was generally better on Lehman's balance sheet. Explaining the firm's expanded documentation of its residential and commercial mortgage positions, Lowitt said, "We recognize we need to make these things more apparent to investors" and promised to provide further detail in coming quarters. The greater volume of information on Lehman's portfolios should help investors make more informed judgments about the prospect of future writedowns.

Even so, some analysts said there was a need for even greater transparency. Deutsche Bank analyst Mike Mayo questioned whether Lehman would stand by its portfolio marks, noting that in the past execs at other firms had pronounced themselves comfortable with their books, only to see huge writedowns later. AIG (AIG, Fortune 500), which on Sunday replaced CEO Martin Sullivan after three years atop the insurance giant, is the latest offender on that score. Fuld insisted that he stands firmly behind Lehman's numbers. "When I say I'm comfortable," he told Mayo, "understand I am the one who signs the quarterly document."

Even those who believe in Fuld doubt the firm has fully regained its footing, however. Ladenberg Thalman analyst Dick Bove told Bloomberg Monday that the expanded Lehman disclosure was "superb" and that clients continue to have confidence in the firm - in stark contrast to Bear Stearns, where prime brokerage customers were fleeing headlong the week before the Fed brokered a fire sale to JPMorgan Chase (JPM, Fortune 500).

But even if Lehman's portfolio marks are good, Bove sees more mortgage-related problems ahead, thanks to the failed hedging strategy that led to more than $500 million in second-quarter losses. Lehman execs say their hedging efforts have saved them some $7 billion over the past year, and pledged to keep up with their plan, calling last quarter's losses "aberrant." But Bove believes they're fooling themselves.

"I can't say enough negative things about the way they've been hedging the portfolio," he said Monday on Bloomberg television. He took particular issue with the firm's use of derivative indexes such as the ABX, which charts the performance of instruments used to hedge against losses in subprime mortgages. "Hedging against popular indexes is a mistake." To top of page

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