Lehman Brothers Options Action: Deja Vu All Over Again?

Despite all the recent chirping among Wall Street big wigs proclaiming the credit crisis to be almost over, a decidedly bearish tone has returned to the markets. Witness the drubbing of Lehman's stock and the significant increase in put buying in Lehman's options today. While the volumes and volatility are not near the levels they reached during the height of the panic around mid-March, they are still notable. Lehman has worked very hard to dispel the rumors of liquidity problems, and it seemed to have convinced the investing public that it would not face Bear's fate. An interesting article in the Heard on the Street column in the Wall Street Journal this morning discussed how some investment banks were losing money on hedges used to offset losses on CMBS investments. Apparently, banks had shorted the CMBX index as a hedge against their commercial real estate holdings. The index has rallied significantly, while the securities have in some cases declined. Lehman was cited as the biggest loser with analysts expecting write-downs in the $1.5 - $2 billion range on the CMBS portfolio including hedges. Erin Callan, Lehman's CFO, recently called some of the firm's hedges "counterproductive." That's a very creative way of saying Lehman just flushed some of its newly raised equity down the toilet.
Analysts are once again slashing their estimates for investment banks earnings two weeks before the banks are set to report. It is very generous and helpful of them to reduce their overly optimistic projections right before we get the actual news. As I pointed out several months ago the last time we were going through the same ridiculous exercise, it is nearly impossible to project investment banking earnings due to the opacity of their trading positions. Despite horrible news amid unprecedented strains in the credit markets, analysts were gleefully predicting huge hockey stick revenue rebounds by the middle of the year due to the Fed's aggressive liquidity injections. Banking activity would once again surge and everybody would be making money again. Except they aren't. What we're faced with is further uncertainty in the real economy. The probability of soaring defaults on residential real estate, commercial real estate, home equity, auto, and credit card loans as well as soured private equity deals completed at the highs, is increasing by the minute. Consumers are facing record high prices on food and energy coupled with declining equity in their homes. Now the Fed is signaling that it may be finished cutting rates due to inflation fears.
Investors were happy to snap up equity and debt issuance after issuance of the banks and brokers in the past month thinking they were getting a great deal. They aren't so sure anymore. Can Lehman survive another crisis of confidence? If fear exceeds the levels reached in mid-March, it may not. It is a highly levered financial institution that relies on debt to stay alive. Any levered institution can go belly up from one day to the next. Investors who didn't know that before, learned their lesson in March. The parade of broker earnings in the next few weeks will offer some real insight into how investment banks are weathering the storm. Assuming, of course, that you trust the marks on their portfolios...