Erin Callan

Erin Callan, lehman cfo, erin callan lehman, lehman brothers, lloyd blankfein, goldman sachs

Why did Bear Stearns fail? Why do I believe that Lehman Brothers will not follow the same fate? Is it because of the relative strength of Lehman’s balance sheet? Yes, but there is a more fundamental explanation.

But before we tackle that issue, let me comment on today’s market action. First, some headlines:

“Dow rallies over 400 points. Stocks chalked up their biggest one-day gain in five years after the Federal Reserve applied a new dose of emergency medicine to heal convulsing credit markets.” Was it just a bear market rally, or is it different this time?

I can prove conclusively that it was another bear market rally. The reason is that the above headline is from Tuesday March 11 – exactly one week ago (I tricked you). And what about today’s 400+ rally? Well, I’ll tell you one week from today.

Moving on to Lehman, the stock was a big winner today: up 43.34% to $45.51, higher than it was last Tuesday. Other big financial movers were Fannie Mae (+27.06%), Freddie Mac (+26.19%), Morgan Stanley (+17.81%), UBS (+16.99%), Goldman Sachs (+16.27%), Merrill Lynch (+13.23%), Citigroup (+10.79%), and, last but not least, Bear Stearns, which jumped up 22.87% to $5.91 – which, come to think of it, is almost triple the JP Morgan bid of $2 a share.

Today's rally was unleashed by Lehman and Goldman, both of which reported that their businesses have fallen off a cliff – with net income down more than 50% year over year – and also said that they continue to see tough times ahead. But fortunately expectations had been beaten down so much that even that was good news.

Lehman said it still holds $31.8 billion in exposure to residential mortgages and $36.1 billion in exposure to commercial mortgages. But liquidity is adequate, with a $34 billion liquidity pool and “unencumbered” assets (assets that can be sold quickly) of $164 billion. Its net leverage – a measure of how heavily it uses debt to fund its assets – decreased in the first quarter from the fourth.

The young and pretty Chief Financial Officer of the firm, Erin Callan, was particularly cheerful, saying: “I am hard-pressed to see the light at the end of the tunnel here."

Lehman recorded an $830 million write-down, or $3.5 billion before hedging and other items, which was puny if compared with Morgan Stanley's $9.4 billion and Merrill's $16 billion. Morgan Stanley and Merrill both had to raise outside capital to help offset the impact of write-downs. Moreover, remember that primary dealers can have direct access to collateralized lending from the Federal Reserve, as of Monday of this week.

After the bank run on Bear Stearns, rumors swarmed last week that Lehman might be next. This is because Lehman is second only to Bear in exposure to the mortgage sector. In 2007 Lehman was the largest underwriter of global mortgage-backed securities, and ranked second to Bear Stearns in underwriting U.S. mortgage-backed debt. As of last November – when Bear Stearns last released a balance sheet – Bear had less than $400 billion in assets, while Lehman had nearly $700 billion. Lehman and Bear are the fourth and fifth biggest US investment banks after Merrill Lynch, Goldman Sachs and Morgan Stanley.

Like Bear Stearns, Lehman has a brokerage business: brokers are lending banks to their clients, such as hedge funds, but brokers themselves rely on bank credit lines to finance their operations. If these credit lines are pulled in – which can happen if the broker is suddenly perceived as less creditworthy – then the broker has to sell assets quickly and shrink its balance sheet. This is where liquidity reserves become vital, and the lack of a sufficient cushion can be lethal, as Bear Stearns found out last Thursday. It is not just the size of the reserves that matters, but also its quality, that is its liquidity, because in times of stress these reserves must be tapped very quickly.

According to a Wall Street Journal article, last Friday Lehman’s CFO Erin Callan received a call from a top Lehman bond trader, who was reporting rumors that ING was pulling its credit lines to all the top Wall Street firms. The rumor turned out to be false, but as we know by now, banks have to be able to manage rumors, not just their balance sheets. And this is where experience comes in.

In 1998, Lehman had to fend off speculation that the collapse of hedge fund Long-Term Capital Management was threatening the company’s solvency. Lehman’s CEO Dick Fuld, and the firm’s Chief Legal Officer, Tom Russo, remember those times very well: if you have a copy of Roger Lowenstein’s When Genius Failed, you can check that both Fuld and Russo where in the same post in September 1998. Their experiences have proved crucial for Lehman in 2008. By contrast, Bear’s CEO, Alan Schwartz, had been at the helm for barely two months, after Jimmy Cayne had finally admitted that he was more interested in playing golf than in running a financial firm. (Bear Stearns was LTCM’s clearing broker, and Jimmy Cayne was Bear’s CEO at the time).

"In 1998, we learned we need a lot of liquidity and we also know we need to deal with rumors as they arise, not long after," Mr. Fuld said in a recent interview. According to the Wall Street Journal article, Fuld has instructed his company to take decisive action whenever the company’s solvency is questioned: any time a trader at another firm refused to do a trade with Lehman, a top Lehman official would immediately call the trader’s supervisor to assure him of Lehman’s strength, and to offer a sweetener. Lehman has also being circulating an internal memo instructing his people of Lehman’s capital and liquidity levels compared with those of its major competitors. If necessary, everybody at the firm would be able to back Lehman’s liquidity position with solid numbers.

Lehman’s executives also took particular care in ensuring that the firm had unfettered access to short term funding through the repo market (at $4.7 trillion market). According to the Wall Street Journal: “Lehman executives began pulling together data on the firm's funding alternatives, including untapped bank lines, in case it faced difficulties in the repo market. The data were fed into an internal memo that was sent to hundreds of top Lehman managers, who were fielding calls from clients concerned about the firm's liquidity. The two pages of "talking points" reviewed in detail the firm's current financial situation, comparing it with rivals, including the rapidly deteriorating Bear Stearns. "Funding philosophy shaped by Lehman's liquidity framework developed after 1998," reads one bullet point. “The firm, the memo said, has diversified and deepened funding sources.”The memo was sent on Sunday, hours before J.P. Morgan announced it was buying Bear.

Never underestimate the financial value of experience.

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