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Lehman Loss and Offering Change Moody's Outlook

But ratings-service action is tempered, as Lehman's capital moves are seen as a major positive.
Stephen Taub, CFO.com | US
June 9, 2008

The details that Lehman Brothers Holdings Inc. provided about its expected $2.82-billion second-quarter loss — the same day it announced a $6-billion public offering of common and preferred — immediately hurt its standing with Moody's, but in a tempered way.

Moody's Investors Service lowered the outlook for Lehman to negative from stable, while affirming the rating on the company's senior long-term debt and its principal rated operating and guaranteed subsidiaries. Moody's noted that the firm would have been just above break-even in the first quarter of the year had gains on its structured notes been excluded from income.

The raising of capital, "in conjunction with balance sheet de-leveraging/de-risking," was cited by Moody's as a positive step in bolstering both the balance sheet and investor confidence. The rating action, it said "reflects Moody's concerns over risk management decisions that resulted in elevated real estate exposures and the subsequent ineffectiveness of hedges to mitigate these exposures in the recent quarter." It added that "the significant (albeit declining) residential and commercial real estate concentrations remain a risk management challenge and continue to pose down-side risk to the firm."

Moody’s added that any additional net valuation marks that result in firm-wide losses in coming quarters would raise serious concerns about the effectiveness of Lehman's risk management and may create additional market unease about the firm, potentially weakening its franchise. “As such, additional firm-wide losses would likely result in a downward rating action. Stabilization of the rating outlook would require a return to consistent profitability and continued reduction in Lehman's currently outsized commercial and residential mortgage exposures,” it further stated.

For its part, Standard & Poor's said that its rating on Lehman will not be affected by the firm's announcement of the second-quarter loss. "Our recent downgrade of Lehman integrated our expectation that the firm's second-quarter performance would meaningfully deteriorate," it explained. It also asserted that Lehman has maintained a very stable funding profile "in a challenging environment."

Lehman said that it priced at $28 a share its $4-billion common-stock offering of 143 million common shares. The price was more than 13 percent below its common stock’s closing price on Friday. The preferred offering was for $2 billion of 8.75 percent non-cumulative mandatory convertible preferred stock. The preferred will pay quarterly cash dividends at a rate of 8.75 percent per year and will be mandatorily converted on July 1, 2011 into between 30.2663 shares and 35.7142 shares of Lehman Brothers common.

The $6 billion in new financing is in addition to the $8 billion Lehman had previously raised since February. Lehman said proceeds from the offerings will be used for general corporate purposes.

The expected quarterly loss would be Lehman's first since it was it was spun off from American Express Co. in 1994, according to published reports. Lehman also said it expects to report net revenues (total revenues less interest expense) for the second quarter of negative $700 million, reflecting negative mark to market adjustments and principal trading losses, net of gains on certain debt liabilities. In addition, the firm said it incurred losses on hedges this quarter, as gains from some hedging activity were more than offset by other hedging losses.

In addition, the company said it had sold about $130 billion of assets during the second quarter, and reduced mortgage-related assets and leveraged loans by about 20 percent.

CFO Erin Callan said in a conference call that the company is done with its deleveraging program and is using its new capital to expand its business, according to the Wall Street Journal.

"I am very disappointed in this quarter's results," chairman and CEO Richard S. Fuld Jr. said in a statement. "Notwithstanding the solid underlying performance of our client franchise, we had our first-ever quarterly loss as a public company. However, with our strengthened balance sheet and the improvement in the financial markets since March, we are well-positioned to serve our clients and execute our strategy."

Moody's noted that the recent collapse of Bear Stearns highlighted the vulnerability of the secured funding model of broker-dealers on overall market liquidity. "When market liquidity dries up, collateral becomes harder to value, margin disputes arise and liquidity pressure increases on broker-dealers," it added. Its last rating action on Lehman was March 17, when it revised the outlook to stable from positive, and affirmed the ratings.




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