Lehman's Options Plays Suggest Fear
Steven Smith
07/03/08 - 11:00 AM EDT
On the heels of the mid-June announcement of a $2.8 billion quarterly loss,
Lehman Brothers (LEH Quote) announced $6 billion in fresh financing, and conceded that an additional capital infusion would likely be required. Option traders smelled blood and starting buying chunks of put contracts. Lehman might be in deep trouble, according to their bearish bets.
To be sure, conditions could still materially weaken for Lehman. The investment bank still has $65 billion in risk exposure, which is likely to be subject to greater stress if the economy weakens further. Since the bank has not disclosed certain large illiquid positions, "investors continue to assume that there is something to hide," notes UBS' Glenn Schorr.
As the stock slipped below $23 a share, volume and implied volatility flew to record levels. The July 20 put traded over 30,000 contracts, the July 15 put traded a whopping 43,000 contracts, and the $10 put traded 15,000 contracts. The prices paid averaged $2.50, $1 and 50 cents, respectively. This represented an implied volatility of nearly 150%, which suggested the option market was pricing in a $7 (or 30%) price move within the five weeks remaining until the July 18 expiration of these options.
This option action was certainly reminiscent of
what occurred in the days preceding the collapse of Bear Stearns. But while that prescient trade certainly reaped a windfall for those on the right side, the holders of Lehman put options seem to be pinning their positions more on hope than price action.
Shares of Lehman have dipped since that put-buying frenzy, sinking to a low of 19.25 on Monday. Rumors spread that the company was up for sale or on the brink of insolvency. Yet the stock refused to break any further and is now trading near the $23 level.
But that breach of $20 level set off a smaller wave of put buying, which pushed implied volatility near the 200% level. While the time decay since the June 11 amassing of puts has basically cut the value of those contracts in half, traders still believe the firm is in dire straights and will fail to remain independent. And any potential buyout might come below current share-price levels, as was the case with Bear Stearns.
At the current pricing structure, the options market is now placing a 50% chance that shares of Lehman can move $10 with the 16 days remaining until expiration. And while we have seen that anything can happen and things can unwind quickly, the clock is ticking. And while Lehman might not meet the criteria of being "too big to fail," Wednesday's statement from Treasury Secretary Henry Paulson made it clear they are adopting a policy to prop up banks to keep the financial system from having a systemic break down.
It's worth noting that Lehman still has $27 a share in tangible book value. And some assets, such as the Neuberger Berman asset arm, remain quite healthy and capable of being monetized. "It could be fruitful for Lehman to pursue partial sale of certain assets, retaining some upside," notes Merrill Lynch's Guy Moszkowski.
As UBS's Schorr adds, the capital-raising efforts in the spring should "put to bed any concerns of a possible re-enactment of the Bear Stearns saga."
So for now, it doesn't look like lightning will strike twice. In my view, Lehman will remain as a survivor, and those puts will expire worthless.
