Lehman Beats Estimates; Hedges Against Mortgage Losses
Investment bank Lehman Brothers can thank its lucky stars that its mortgage-backed bond underwriting division didn't close more big deals over the past year. The company, which is well-known for its underwriting and fixed-income trading, reported that quarterly earnings were saved by investment banking and equity trading fees, and that losses from underwriting almost derailed the whole show. Fixed-income trading fell 60% as investors worried about interest rates, and when your bread and butter is gone the future looks bleak. Yet, somehow, Lehman survived. With losses piling up at other firms, how did Lehman manage to minimize its losses and stay afloat?
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Shares of Lehman Brothers are down 20% so far in 2007, mostly stemming from the summer's mortgage meltdown. They traded at $80 until mid-June before dropping to $52 in mid-August, a 35% decline. During this time the company's investment banking division was busy, launching deals involving Triple Net Properties, IFCI Limited, and Archstone-Smith. The problem, however, was that pesky subprime mortgage unit. Lehman announced on August 22nd that its subprime lender, BNC Mortgage Corp., would shut it down, and would include a charge of $25m and releasing 1200 employees. The company would continue to issue mortgages through another subsidiary, Aurora Loan Services. The company released better-than-expected 3Q earnings on September 18th.
Several big banks, such as Merrill Lynch (MER: Charts, News, Offers), Citigroup (C: Charts, News, Offers), UBS (UBS: Charts, News, Offers) and Bear Stearns (BSC: Charts, News, Offers) had been hit hard by subprime mortgages, with some of the banks looking to international sources for cash injections. The credit crisis forced Lehman to write off $1.3bn during the third quarter, with an additional $830m coming during the fourth quarter. Though this is a lot less than some other banks (UBS wrote off $10bn), the idea of a company giving up on investments (though they might not have much choice) is the sort of thing that keeps investors awake at night.
One of the few bright spots on Lehman's earnings report - its equity and investment banking business - posted revenues of $1.87bn, up from $900m during the same quarter last year. The banking unit launched a deal to buy Van der Moolen Holding, a Dutch market-maker, which had not been able to remain profitable in the U.S. market. This did not prevent earnings estimate cuts from several analysts; including Goldman Sachs GS. Revenue fell 3% during the quarter, falling from $4.53bn in 4Q 2006 to $4.39bn 4Q 2007. Considering the $830m mortgage write down it could have been much worse.
Investors trying to get a feel for the upcoming earnings reports for other investment banks should take Lehman to heart. The company was able to mitigate bigger losses from its mortgage-backed securities by heavily hedging risk, which is not a strategy that only Lehman knows. Though some companies, such as Morgan Stanley (MS: Charts, News, Offers) have already prepped investors for big write downs, the overall effect on earnings could be lighter than one would expect.
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