Inside Lehman's Finances: More Reasons to Worry

Scattered within Lehman Brothers' disastrous quarterly results yesterday was the "good" news that it reduced is exposure to mortgage securities. Good news, of course, is a relative term when a bank loses $2.8 billion, which is more than it earned in the last three profitable quarters combined. But the bank boasted that it "reduced exposure to residential mortgages, commercial mortgages and real estate investments by an estimated 15-20% in each asset class" (PDF link). At the same time, it threw in some nouveau accounting that raises some red flags -- as if Lehman needed any more.

When one takes a look at the absolute numbers, the news remains spooky. As of the end of last quarter, Lehman said it held $4.3 billion in mortgage securities. If it reduced those holdings by 15 percent, it would still have $3.7 billion worth of the stuff on its books. But the drop in underlying real estate prices is actually accelerating. The last Case-Schiller index report from late May (PDF) recorded a 14.1 percent decline from the first quarter of 2007 to the first quarter of 2008 -- the largest drop in the series' 20-year history.

This being the case, Lehman's reduced exposure might easily represent nothing more than a markdown of the bonds it holds as opposed to a successful sell-off. Also, the bank could easily be forced to take further write-downs on its still sizeable mortgage-security holdings -- or run into other problems with its business.

For all its efforts to solve problems -- and there has been some progress -- Lehman is still leveraged to the hilt. Borrowing stands at 25 times the firm's equity, although that's down from a "gross leverage ratio" of 31.7 at the end of last quarter. In a wrinkle, however, Lehman highlighted the fact that its "net leverage ratio" -- a less common measure than gross -- fell to 12.5 from 15.4. Lehman says the net-ratio figure is more significant because it counts some "equity-like debt" as equity.

Any way you slice it, though, even with leverage at these reduced levels, the value of the firm's assets don't have to fall very far in order to completely wipe out Lehman's equity.

To add to the confusion, Lehman hedged on exactly what it means by "net leverage." The key passage, which it relegated to a footnote: "Net leverage as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation." Portfolio's Jesse Eisinger looked into the accounting switch last March, when Lehman's news was good, and still found the change "worrisome."

So there's plenty of reason to fear that Lehman remains overleveraged, whether on a gross or net basis. That's true even though Lehman's debt ratio is in line with its peers -- everyone with that kind of leverage is walking a tightrope. Worse, according to a WSJ report on Lehman's conference call, it doesn't intend to reduce its debt ratios any further. But it does intend to sell new shares -- to the tune of $6 billion. The sale will increase equity, providing a cushion just in case its assets fall further.