I never got a chance to perform a full forensic analysis of Lehman, but did put a fair size short on them a few months back due to their "smoke and mirrors" PR (oops), I mean financial reporting. There were just too many inconsistencies, and too much exposure. I was familiar with the game that some I banks play, for I did get a chance to do a deep dive on Morgan Stanley, and did not like what I found. As usual, I am significantly short those companies that I issue negative reports on, MS and LEH included. I urge all who have an economic interest in these companies to read through the PDF's below and my MS updated report linked later on in this post. In January, it was worth reviewing "Is this the Breaking of the Bear?", for just two months later we all know what happened.
I came across this speech by David Eihorn and he has clearly delineated not only all of the financial shenanigans that I mentioned in my blog, but a few more as well. Very well articulated and researched.
Here are a few choice excerpts:
"The issue of the proper use of fair value accounting isn’t about strict versus permissive accounting. The issue is that some entities have made investments that they believed would generate smooth returns. Some of these entities, like Allied, promised investors
smoother earnings than the investments could deliver. The cycle has exposed the investments to be more volatile and in many cases less valuable than they thought. The decline in current market values has forced these institutions to make a tough decision. Do they follow the rules, take the write-downs and suffer the consequences whatever they may be? Or worse, do they take the view that they can’t really value the investments in order to avoid writing them down? Or, even worse, do they claim to follow the accounting
rules, but simply lie about the values?
The turn of the cycle has created some tough choices. Warren Buffett has said, “You don’t know who is swimming naked until the tide goes out.” I do not believe the accounting is the problem. The creation of FAS 157 and other fair value measures has improved disclosure, including the disclosure of Level 3 assets – those valued based upon non-observable – and in many cases subjective – inputs. This has helped investors better understand the financial positions of many companies. For entities that are not over-levered and have not promised smoother results than they can deliver, when the assets have fallen in market value, they can take the pain and mark them down. It doesn’t force them to sell in a “fire-sale.” If the market proves to have been wrong, the loss can be reversed when market values improve. For levered players, the effect of reducing values to actual market levels is that the pain is more extreme and the incentive to fudge is greater. With this in mind, I’d like to review Lehman Brothers’ last quarter. Presently, Greenlight is short Lehman. Lehman was due to report its quarter two days after JP Morgan and the Fed bailed out Bear Stearns. At the time, there were a lot of concerns about Lehman, as demonstrated by its almost 20% stock price decline the previous day with more than 40% of its shares changing hands. In the quarter, bond risk spreads had widened considerably and equity values had fallen sharply. Lehman held a large and very levered portfolio.
With that as the background, Lehman announced a $489 million profit in the quarter. On the conference call that day, Lehman CFO Erin Callan used the word “great” 14 times, “challenging” 6 times; “strong” 24 times, and “tough” once. She used the word “incredibly” 8 times. I would use “incredible” in a different way to describe the report. The Wall Street Journal reported that she received high fives on the Lehman trading floor when she finished her presentation.
Twenty-two days after the conference call, Lehman filed its 10-Q for the quarter. In the intervening time, I had made a speech at the Grant’s Spring Investment Conference where I observed that Lehman did not seem to have large exposure to CDOs. This was true
inasmuch as Lehman had not disclosed significant CDO exposure.
Let’s look at the Lehman earnings press release (Table 1). Focus on the line “other asset backed-securities.” You can see from the table that Lehman took a $200 million gross write-down and has $6.5 billion of exposure...
... Now let's
look at the footnote 1 of the table, explaining Other
purchases interests in and enters into derivatives with collateralized debt
obligation securitization entities ("CDOs"). The CDOs to
which the Company has exposure are primarily structured and underwritten by
third parties. The collateralized asset or lending obligations held by the CDOs
are generally related to franchise lending, small business finance lending, or
consumer lending. Approximately 25% of the positions held
at February 29, 2008 and November 30, 2007 were rated BB+ or lower (or
equivalent ratings) by recognized credit rating agencies... [emphasis added]
Last week, Lehman's
CFO and corporate controller confirmed that the whole $6.5 billion consisted of
CDOs or synthetic CDOs. Ms. Callan also confirmed that the 10-Q presentation was
the first time that Lehman had disclosed the existence of this CDO exposure.
This is after Wall Street spent the last half year asking, "Who has CDOs?"
Incidentally, I haven't seen any Wall Street analysts or the media discuss this
I asked them how
they could justify only a $200 million write-down on any $6.5 billion pool of
CDOs that included $1.6 billion of below investment grade pieces. Even though
there are no residential mortgages in these CDOs, market prices of comparable
structured products fell much further in the quarter. Ms. Callan said she
understood my point and would have to get back to me. In a follow-up e-mail, Ms.
Callan declined to provide an explanation for the modest write-down and instead
stated that based on current price action, Lehman "would expect to recognize
further losses" in the second quarter. Why wasn't there a bigger mark in the
Now, I'd like to
put up Lehman's table of Level 3 assets (Table 3). I want you to look at the
column to the far right while I read to you what Ms. Callan said about this
during the Q&A on the earnings conference call on March 17.
[A]t the end of the
year, we were about 38.8 [billion] in total Level 3 assets. In terms of what
happened in Level 3 asset changes this quarter, we had net sort of payments,
purchases, or sales of 1.8 billion. We had net transfers in of
1.1 billion. So stuff
that was really moved in or recharacterized from Level 2. And then there was
about 875 million of write-downs. So that gives you a balance of 38,682 as of
As you can see, the
table in the 10-Q does not match the conference call. There is no reasonable
explanation as to how the numbers could move like this between the conference
call and the 10-Q. The values should be the same. If there was an accounting
error, I don't see how Lehman avoided filing an 8-K announcing the mistake.
Notably, the 10-Q changes somehow did not affect the income statement, as there
must have been other offsetting adjustments somewhere in the financials....
... When I asked them
about this, Lehman said that between the conference call and the 10-Q they did a
detailed analysis and found, "the facts were a little different."
I want to
concentrate on the $228 million of realized and unrealized gains Lehman
recognized in the quarter on its Level 3 assets. There is a $1.1 billion
discrepancy between what Ms. Callan said on the conference call - an $875
million loss - and the table in the 10-Q, which shows a $228 million gain.
Lehman, "My point blank question is: Did you write-up the Level 3 assets by over
a billion dollars sometime between the press release and the filing of the
10-Q?" They responded, "No, absolutely not!"
However, they could
not provide another plausible explanation. Instead, they said they would review
the piece of paper Ms. Callan used on the call and compare it to the 10-Q and
get back to me. In a follow-up e-mail, Lehman offers that the movement between
the conference call and the 10-Q is "typical" and the change reflects
"re-categorization of certain assets between Level 2 and Level 3." I don't
understand how such transfers could have created over a $1.1 billion swing in
gains and losses...
I would like to add that Morgan Stanley is guilty of much of what Lehman is being accused of, and with much more net counterparty exposure and leverage to boot. See The Riskiest Bank on the Street and particularly Reggie Middleton on the Street's Riskiest Bank - Update. I would like to excerpt page 4 of that report here to see how similar the marketing (er, sorry about that again), I mean "financial reporting" of these two companies are:
Worsening credit market to impact Morgan Stanley’s financial position
|Morgan Stanley Write-down -2008||Level 1||Level 2||Level 3||Total|
|(In US$ mn)|
|Financial instruments owned|
|U.S. government and agency securities||-||12||2||14|
|Other sovereign government obligations||-||9||0||9|
|Corporate and other debt||2||2,761||2,223||4,986|
|Total financial instruments owned||642||10,120||5,723||16,485|