Lehman to disclose more write-downs

Market focus has returned to Lehman Brothers, one of the world's main investment banks. The bank is expected to report a quarterly loss in excess of $300 million (Dh1.1bn) when it releases results in mid-June. The loss is likely to force the need for a large capital raising exercise.

Estimates at this stage for a fresh capital injection are between $3bn and $5bn. This is a substantial amount but is needed to help cushion its balance sheet. On the back of the credit crunch, significant asset write-downs, weaker earnings and liquidity concerns, Lehman's shares are down by 50 per cent this year. This compares with peer banks such as Goldman Sachs and Morgan Stanley which are down by around 20 per cent. Over the past year, Lehman has raised $6bn in capital.

The bank came under the spotlight in March at the time of the Bear Stearns rescue as concerns about its liquidity were rife. Lehman's funding position, along with other US investment banks, were boosted following the decision to enable investment banks to borrow directly from the Federal Reserve against a variety of collateral. The size of the fall in Lehman's share price is however significant and reflects the market's concern that it holds more securities, relative to its size, linked to both the highly troubled residential and commercial real estate market, than other large US financial firms. Lehman's second-quarter results are also expected to show more difficulties. The firm is saddled with billions of dollars in hard-to-sell commercial real estate assets and leveraged loans and is expected to face further write-downs on these portfolios. During the second quarter, Lehman was hit by hedges used to offset losses in real estate and other securities. Lehman bet that indexes tracking markets such as real estate securities and leveraged loans would fall. If that had happened, it would have booked profits that would have made up some of its losses from holding these securities and loans. To add to Lehman's woes, its credit rating has also recently been cut to A from A+, although fellow investment banks such as Morgan Stanley and Merrill Lynch have also been reduced. Exacerbating the downgrade is that the bank has retained its negative credit outlook.

The downgrade and retention of the negative outlook reflects an operating performance under pressure, additional write-downs on exposures, and the negative effects of hedges. Funding concerns also remain. This will be exacerbated if there is any change in market sentiment and creditworthiness of the firm. Lehman is more diversified by geography and product than Bear Stearns was, but lacks the broader asset management and corporate finance business of Goldman Sachs and the retail brokerage networks of Morgan Stanley and Merrill Lynch.

Putting more pressure on both Lehman's and its share price is the fact that hedge funds have been shorting the stock. Goldman, the biggest investment bank by market value, was put on a negative outlook in March, but has so far escaped being downgraded. Goldman has one of the heaviest brokerage concentrations in trading and investment banking but possesses strong management, good liquidity position and a strong risk management framework. Lehman has recently denied borrowing from the Fed as its share price falls to its lowest level in five years. It claims to have $40bn in liquid assets. The uncertainty surrounding Lehman's is adding to the general unease around financial stocks both in the US and the UK. For nine months now, banks have been on shaky ground with funding difficulties, narrowing margins and huge asset write-downs. Excessive leverage has also been a problem.

Many banks have loaded up on debt in order to increase their returns on equity when asset prices were rising. The leverage ratio (assets divided by equity) at Lehman's has risen from 24 in 2005 to 31 in 2007.

This compares to Bear Stearns' leverage rise from 26 in 2005 to 33 in 2007. Banks have also been exposed to product leverage via CDOs which needed only a slight deterioration in the value of underlying assets for losses to escalate rapidly. In addition, financial institutions were exposed to liquidity leverage through structured investment vehicles and asset liability mismatches.

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