Lehman Shrugs Off Subprime

Big brokerages continue to churn out huge, huge gains.
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This spring's subprime shakeout couldn't hold back

Lehman Bros.



Lehman said second-quarter revenue from securitized products, including residential mortgages, fell from first-quarter levels. But the Wall Street firm's numbers were otherwise so robust that investors bid up the broker's stock in Tuesday afternoon trading.

While global securitization volumes generally rose sequentially, "securitization margins were compressed in the quarter, particularly in subprime transactions, which had a negative impact on the overall economics of the business," said Lehman's CFO, Chris O'Meara, during a conference call.

The Lehman report comes as investors keep a watchful eye on credit quality and related issues in this week's brokerage earnings reports. Dozens of lenders to homebuyers with poor credit histories have gone out of business in the last year, due to a spike in delinquencies and defaults on recent loans.

Lehman did not disclose how much of its total securitizations were from subprime loans or its cousin Alt-A -- loans made to better-quality borrowers but without full documentation. Revenue in Lehman's fixed income business dropped 14% from a year ago to $1.9 billion.

O'Meara reiterated that over the past six quarters, the subprime business contributed less than 3% to Lehman's total revenue. He said competitive pressure in the mortgage loan business is nothing new.

Lehman originated $17 billion in loans in the second quarter, due to higher Alt-A loan volume and non-U.S. loan activity. U.S. subprime origination volumes, at around $4 billion, were flat when compared with the first quarter, the company said.

On a bright note, though, O'Meara said the company was seeing signs of improvement related to its U.S. mortgage business.

"Although we believe that the U.S. subprime business will continue to face headwinds for the near term. ... we are seeing some positive signs, such as gradual improvement in pricing power for lenders and a pickup in secondary-market investor activity including for noninvestment grade positions," O'Meara said. "Overall there has been a reduction in subprime origination capacity in the market and the credit quality for originations has improved. We believe the securitization business environment improved toward the back end of the quarter, including for subprime, and we have a strong non-U.S. residential pipeline for the second half of the year."

"This is turning out to be a vintage challenge here -- where the '06 vintage is one that is particularly challenged but the newer originations, which are being originated to a higher credit quality, are the subject of great investor demand at this point," he said.

The mortgage business aside, Lehman's second-quarter profit soared past estimates, driven by higher international business and investment banking revenue.

In the quarter ending May 31, profit rose 27% from a year ago to $1.25 billion, or $2.21 a share.

"The mortgage business is in a very challenging situation," O'Meara said. "But we're really excited about the diversification. We really want to emphasize how great we feel about the success of the development of the businesses outside the U.S. The U.S. businesses are still strong and have great margins -- just down a bit from what we saw in the first quarter."

Jeff Harte, an analyst at Sandler O'Neill & Partners, writes in a note that he views Lehman's results favorably, "given that it demonstrates Lehman's waning dependence on fixed income trading to drive earnings."

Shares of the company were up $1.53, or 2%, to $77.21.