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The Greatest Value Of Lehman's Loss Lies In Lessons Learned

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By JONATHAN WEIL

Bloomberg News

Published: June 12, 2008

Just because Wall Street is terrible at learning from its mistakes, that doesn't mean the rest of us have to be.

Although it's too late to save any Lehman Bros. Holdings stockholders from the 58 percent drop in the company's share price this year, there are many lessons to be gleaned. At least those are worth something, unlike so many of the mortgage-backed securities now on banks' balance sheets.

Lehman reported a $2.8 billion quarterly loss June 9, the same day it said it had raised $6 billion in fresh capital. Investors seemed surprised, judging by the stock's 15 percent decline since then. They shouldn't have been.
Wall Street stock analysts were predicting a much smaller loss. Yet Lehman's market capitalization, at $19.2 billion, is now almost $7 billion less than the company's $26 billion book value, or assets minus liabilities. That suggests the market believes Lehman hasn't fully cleaned up its balance sheet and that the worst is still to come, management's assurances notwithstanding.

Whatever the case, let's focus on what we can take away from this mess.

First Lesson

When a company attacks short-sellers, run.

You didn't need to know much about Lehman's financial statements to see it was in trouble. All you had to know was that the fourth-largest U.S. investment bank was jousting in the media with fund manager David Einhorn, who had bet against Lehman's stock and told a bunch of other investors (and journalists) why.

Good management teams embrace criticism, address it and move on. Lehman attacked the messenger.

"Mr. Einhorn cherry-picks certain specific items from our 10-Q and takes them out of context and distorts them to relay a false impression of the firm's financial condition, which suits him because of his short position in our stock," Lehman said in May.

The smart read on that line, now obvious, was that there were cherries to be picked. And for a guy whose compensation last year was $34.4 million, you would think Lehman's chief executive officer, Richard Fuld, would have known better.

This is the same strategy once embraced by stock-market flameouts like Overstock.com Inc., MBIA Inc., Biovail Corp. and, yes, Enron Corp. Now you can add Lehman's name to that list.

Second Lesson

There's no such thing as an economic hedge.

Linda Richman, the chronically "verklempt" host of Coffee Talk on "Saturday Night Live," would have loved this one. "Economic hedges are neither economic nor hedges. Discuss," she might say, if only Mike Myers hadn't left.

Lots of banks have downplayed their writedowns by stressing net figures that include gains on so-called economic hedges, or as Lehman calls them, "economic risk-mitigation strategies." In fact, the only thing these terms tell you is that the company made some bets that don't qualify as bona fide hedges under the accounting rules. The words mean nothing, because there is no uniform standard.

Witness Lehman's second-quarter results. The company said its gross writedowns were $3.6 billion. Including hedges, its writedowns were $3.7 billion. In other words, some of the hedges, uh, misbehaved. How's that for managing risk?

Third Lesson

Don't eat the Level 3 mystery meat.

Lehman would have shown a loss for the quarter ended Feb. 29 were it not for $695 million of noncash gains on $9.4 billion of equities that it classified as Level 3 assets.

The designation, which I like to call mark-to-make-believe, means the values included estimates that couldn't be observed in the marketplace. Lehman didn't disclose the names of the company or companies where these gains appeared. Meanwhile, the Standard & Poor's 500 Index fell 10 percent.

If you had concluded this was a tip-off that Lehman's earnings power was declining, you were correct.

Fourth Lesson

Gains on declining debt values mean something.

The Financial Accounting Standards Board has taken a lot of flack about new rules that let companies book earnings based on declines in their own creditworthiness. There's much to be criticized, namely the wide latitude the rule makers gave companies to pick and choose which balance-sheet items they want to measure at fair value.

That said, from the start of fiscal 2007 through Feb. 29 of this year, Lehman posted $1.9 billion in gains from writing down the value of its own debt. It reported $3.3 billion in net asset writedowns during the same period.

Now look at Citigroup. Since Jan. 1, 2007, it has booked $1.7 billion in gains on its own debt. Yet its asset writedowns were $37.3 billion.

Although there's no way for outsiders to know what the right proportion at a given company should be, there's a message in those gains: When the fair value of a company's debt slips, the market is telling you the company's assets must be deteriorating, too. If you had guessed from the ratio at Lehman that its asset values had further to fall, you wound up with the right answer.

Fifth Lesson

Beware CEOs saying "the worst is behind us."

Fuld uttered those words at Lehman's annual shareholder meeting in April. (What was he thinking?!?)

It wasn't then. He doesn't know any better than you do now. Some folks just have to learn things the hard way.

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