Lehman Brothers: What Went Right, and Why the Rumors Were Wrong

Far from going out of business, as some feared in the fall, Lehman has thrived through deft handling of a tough credit environment.
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suits, crude jokes and year-end bonuses, the rumor mill is a major feature of Wall Street life. Late last summer, as global markets roiled in the wake of Russia's debt default and

Long Term Capital Management's

near-unraveling, the ability of

Lehman Brothers

(LEH)

to continue as a going concern provided tremendous grist for that mill.

As the financial markets did an about-face in October, so did Lehman's fortunes (or, at least, the perception thereof). The brokerage firm not only survived the downturn (and the scuttlebutt), it profited while many competitors suffered losses and

Bankers Trust

(BT)

was forced to seek the solace of a buyout from

Deutsche Bank

.

On Jan. 7, Lehman posted fiscal fourth-quarter profits of 51 cents a share, down 60% from the prior year but 30 cents better than the

First Call

consensus estimate. Note that Lehman's fourth quarter ended Nov. 30, so the results include all of September and October, two of the more challenging months of the downturn -- particularly in the bond market, where Lehman is such a big player. The day after the earnings were released, Lehman shares closed at 59 7/8, culminating a 142% rise from the lows of early October.

In the debt market, Lehman corporate bonds continue to trade cheaper vs. those of other brokers, but their spreads have tightened considerably both within the group and compared with Treasury bonds. Lehman 10-year paper, quoted as much as 450 basis points above comparable Treasuries at its worst in the fall, traded just 185 basis points above today, traders said.

Meanwhile,

Standard & Poor's

affirmed Lehman's ratings on Dec. 18 and removed it from CreditWatch, where it was placed Sept. 25. S&P was the last of the major rating agencies to affirm Lehman's ratings in the wake of the late summer concerns; none issued downgrades.

TheStreet.com

reported on the rumors back in the dark days of October, and prudence dictates a revisit to determine what went right at Lehman.

"I think the positives that happened are that the

Fed

came in to provide liquidity and there was a rebound in equity markets and a better-than-expected response in fixed-income," says an analyst at

Merrill Lynch

. "They were able to have positive mark-to-market on inventory positions because of that. They basically were able to control their own liquidity concerns."

'I'd be a buyer of it here,' says portfolio manager Brian Gilmartin. 'The industry is definitely a lot stronger and much better at managing risk than it was 10 years ago.'

Back on Oct. 6, Merrill Lynch's lead brokerage analyst, Judah Kraushaar, wrote that Lehman was "relatively more vulnerable to the current market environment" than its peers. Kraushaar could not be reached for comment this week and his associate requested anonymity. Merrill currently has near-term neutral and long-term accumulate recommendations on Lehman.

"I think they've reduced their risk profile, reduced their balance sheet and leverage, but that doesn't mean there shouldn't have been concerns in September," the Merrill source says. "It's a vicious cycle: If your counterparties benefit, you benefit."

That perhaps was no coincidence, as the credit quality of Lehman's counterparties has improved. At the broker/dealer (vs. holding company) level, 40% of Lehman counterparties had risk ratings off Aa or higher as of Aug. 30, with none at B-plus or lower, according to Lehman spokesman William Ahearn. That compares with 33% at Aa or higher and 1% at B-plus and below at fiscal year-end 1997.

A Hit from Brazil, but Exposure 'Minimal'

Still, that's not to say the firm or its stock is bulletproof now: Lehman shares fell 6.6% Wednesday and a further 2.5% yesterday as worries about Brazil rattled stocks in general and financials in particular.

Ahearn says the firm's exposure to Brazil is "minimal." Analysts estimate Lehman has a total Latin American exposure of about $155 million, mostly on the fixed-income balance sheet and in other derivatives products. Moreover, no one is seriously saying the developments in Latin America threaten Lehman's survival.

That Brazil's devaluation caused concerns isn't surprising, but "I think that's an opportunity for people familiar with their story," says Brian Gilmartin, portfolio manager at

Trinity Asset Management

in Chicago, who is long Lehman. "I'd be a buyer of it here. If the industry can get through what they experienced in August, September and October without a credit downgrade or capital problems, they've proven their longevity. The industry is definitely a lot stronger and much better at managing risk than it was 10 years ago. Lehman's performance is reflective of that."

A review of the company's conference call with analysts produces one obviously reason for the performance: Lehman is "no longer a fixed-income house," according to John Cecil, the firm's CFO.

Lehman ranked second in global fixed-income sales and trading for the third consecutive year, Cecil said, citing

Institutional Investor's

rankings, and was seventh globally in high-yield market share (vs. 11th in 1998) while maintaining its dominance in the mortgage-backed securities market. But fixed-income comprised just 38% of Lehman's revenues in fiscal 1998, down from above 53% in 1994 and 1995, Cecil reported.

Diversification Pays Off

Thus, the widening of credit spreads and resultant near cessation of trading and underwriting in all but the safest fixed-income securities did not damage Lehman as much as many feared it would at the time.

During the call, Cecil and Lehman CEO Richard Fuld said the results demonstrate the company's successful attempts to diversify its revenue stream, with a focus on high-margin business such as investment and merchant banking, equities, and the high-net worth retail market. Combined, these businesses represented about 50% of total revenues in 1994 and 1995; in 1998 they totaled about 80%.

Mergers and acquisitions was the "shining star" for Lehman in 1998, Ahearn adds, although all the business lines improved. While most firms increased their M&A activities in 1998, Lehman's market share as lead adviser more than doubled from the prior year, to 13.2% from 5.2%, he said, citing results from

Securities Data

. This, despite not being the lead on any of the megamergers so prevalent in 1998.

Gilmartin, who was buying Lehman during the height of the rumormongering, says the answer to Lehman's success isn't so complicated, it's more that concerns were overblown. The risk back in September "was systemic, not particular to Lehman," he says. "If hedge-fund loans were called, it would have forced Long Term Capital to dump assets on the Street, and they would have got hit on asset side, the liability side and they capital side as they marked it down. If Lehman would have had problems it would have been indicative of problems everywhere else."