Sunday, March 30, 2008

Lehman's latest earnings report

How bad was it really?

They made $489 million, but it looks like they lost $400 million in a scam in Japan. They just didn't tell anybody about it until after they reported their earnings.

Troubled investment bank Lehman Brothers may have been taken for as much as $400 million in a swindle in which con artists used forged documents from one of Japan's largest trading firms.

That loss could amount to more than 80 percent of the $489 million in net income Lehman reported in the three months ending Feb. 29.

But Lehman also fudged their earnings by $600 million. Here's Portfolio's view on it:

For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilities fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million.

Lehman and all the other investment banks are following the accounting rules on this, but that $600 million is hardly the stuff of quality earnings. Indeed, Bernstein’s Hintz called the bank’s earnings quality “weak.”

Lehman characterized this as "debt liabilities measured at fair value" on page 13, on the second to bottom row, on the link below, with the innocuous looking 0.6. (Lehman did their mark-to-market adjustments in billions so it wouldn't look like an exorbitant figure!)

Note (h) explaining it just says this:
Represents the amount of gains on debt liabilities for which the Company elected to fair value under SFAS No. 157 and SFAS No. 159. These gains represent the effect of changes in the Company’s credit spread and exclude any Interest income or expense as well as any gain or loss from the embedded derivative components of these instruments.

The bottom line is that Lehman's earnings were garbage, and we don't have any transparency on their Level III assets, except to know that every quarter, they write off more of them.

And after their earnings, we now find out they got taken for another $400 million, news they knew while closing on a unsecured $2 billion revolving credit facility.

I guess Lehman's definition of risk management is not disclosing their risks.

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