Lehman Upgraded By Citi

Reuters is reporting that Lehman has been upgraded from "hold" to "buy" by Citigroup.

With $34 billion in liquidity at the parent company, the ability to get access to over $200 billion in liquidity from the Fed's primary dealer credit facility, and its ability to tap the term auction facility, access to liquidity is a non-issue

The target is $65 on the stock. Bloomberg adds:

Lehman said on March 18 that it had $30 billion of cash and $64 billion in assets that could easily be turned into cash. Lehman's stockpile of cash, money-market instruments, corporate bonds and equities available for sale is the largest among the five biggest brokers.

The Fed has already demonstrated with the TAF, TSLF, and PDCF (Lehman is a primary dealer) that it is happy to inject as much liquidity into the system as necessary. By expanding the collateral on the TSLF, as I predicted they would, they have also signaled their intent to prevent those assets from weighing down the books and further credit creation. Lehman appears quite liquid for now and with the Fed standing behind it liquidity should not be a problem. If anyone is hoping for a spectacular collapse a la Bear, I think they may be disappointed.

That having been said, appearances can be deceiving. Put options, especially deep out-of-the-money puts, on Lehman have recently seen an increase in activity. The article states:

An increase in trading of out-of-the-money put options on March 13 preceded the collapse of Bear Stearns Bear's stock plunged by almost half on March 14 amid concern it lacked sufficient access to capital.

Mish blogged about this on the 13th. He commented that put options were pricing in a bankruptcy for Bear. The situation with Lehman may reflect superior information. However, keep in mind that Lehman is a core wall street player. Bear was seen as somewhat of a maverick. I think it is unlikely that Lehman will collapse on liquidity concerns.

Solvency Not Liquidity

Although I agree with the Citigroup analyst that Lehman is unlikely to collapse overnight, I disagree about the price target and their prospects. He has convincingly argued that Lehman is currently liquid and will remain liquid, but he has prematurely concluded that they are well capitalized and undervalued. There are a few questions about their balance sheet and their latest earnings report. Bloomberg reports:

The firm's net income declined 57 percent in the quarter because of a $1.8 billion writedown on mortgage assets. Merger advisory fees jumped 34 percent, investment-management revenue surged 39 percent and equities rose 6 percent.

In the link above, I have argued that their balance sheet may be suspect. If there are further writedowns in the future, then earnings will suffer, as well as capital. The issue is solvency, not liquidity. The Fed is hoping that its various credit facilities will tide the banks over until the environment improves. Unfortunately, the macro environment does not look like it will recover anytime soon. That the US is in a recession is a foregone conclusion. The statistics do not show it yet, but they are highly suspect. Housing will unlikely bottom for another few years. There also appears to be a significant change of mood amongst consumers. In particular the weakest reading in consumer sentiment since 1973, which was the start of a bad recession. My assessment for Lehman is two-fold:

1. More writedowns. The Fed and banks can hide the true value of the securities they are holding. However, many of the level 3 securities are booked at unreasonable values and will sooner or later meet reality. It could be next month, it could be next year. However, they will experience significant losses as housing worsens and endanger Lehman's solvency.
   
2. Recession will hurt earnings. The secular bear the US is currently in is only half way done. Coupled with the recession, stock valuations are only going down. Unless Lehman is highly diversified, especially in Asia and emerging markets I cannot see how the slow down will not hurt their earnings and valuations further, especially given that Lehman is less well capitalized to grow their business.
   

The solution, of course, is for Lehman to raise capital. Given their current leverage, debt or convertibles would not be prudent. Their only choice is to issue equity. However, the dilution may be significant and existing shareholders will no doubt pose an obstacle.

[update 4/1/08: Lehman has raised $4bn from convertible preferred shares.]

I do not mean to bash Lehman. Many other wall street players are in similar situations. If I single out Lehman it is only because they have been the most active in the mortgage space and their stock has experienced some volatile trading on liquidity concerns.

Short Term Versus Long Term

Although my long term view on Lehman, financials, and stocks as a whole is bearish, it appears that we are long overdue for a short term bounce that may even take out nominal highs. The extreme pessimism as well as near everyones view that another major collapse is imminent has setup a nice contrarian environment.