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Fed Fires Up Lehman Rally

A steep rate cut spurs big financial sector gains.

Fed

chief Ben Bernanke's big rate cut proved quite the tonic for the hard-hit brokerage sector.

Lehman Brothers

(LEH)

surged 8% and rivals such as

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

rose more than 5% after the Federal Reserve surprised Wall Street Tuesday with a steeper-than-expected 50-basis-point cut in the fed funds overnight lending rate target.

The news came after Lehman posted a 3% drop in third-quarter earnings, despite questions about losses tied to its mortgage business.

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Lehman said Tuesday that it recorded "very substantial valuation reductions" to its leveraged loan commitments and residential mortgage related positions amid a credit crunch this summer. But the losses were offset by gains "related to economic hedges, short positions and liabilities," it said. The result was a reduction in fixed-income revenue of $700 million.

The New York brokerage firm offered little additional detail on the markdowns, frustrating analysts who sought out more detail on just how big Lehman's losses were, and what kind of hedges proved successful.

"As these instruments move ... the dynamic hedging strategies particularly around the mortgage business, which is a business we've always had a lot of hedges on, will move with it," said Lehman's CFO, Chris O'Meara, during the call. "And so knowing the gross numbers, particularly in that business, I don't think is really a meaningful thing."

While

Goldman Sachs

(GS) - Get Report

could have the largest dollar exposure to possible markdowns on leverage loan commitments, Lehman has the "largest dollar exposure to possible markdowns on mortgage retained interests," according to David Hendler, an analyst at CreditSights, in an August note.

"Lehman Brothers EPS could be most negatively impacted by both markdowns in mortgage retained interests and declines in valuations of leverage loan commitments that come onto the balance sheet," Hendler wrote.

Lehman did provide more details when it came to its residential origination business.

The company said origination volumes dropped by almost a third from the prior quarter to $12.5 billion. In addition, overall residential securitization volumes were $23 billion, "down significantly from last quarter driven by lower investor appetite," O'Meara said.

At the end of the quarter, the company had $6.3 billion in subprime mortgage inventory. Of the $6.3 billion in subprime assets, the majority is "whole loan inventory" -- most of which was originated in the last six months. Lehman had approximately $1.6 billion of non-investment grade interests in residential mortgage securitizations.

Lehman has been slashing staff in its origination operations as the market conditions in the industry worsened. The company has cut more than 2,000 positions through the closing of its subprime lender BNC Mortgage and its Korean mortgage operation as well as further restructuring in its mortgage business globally.