(Image Credit, forbes.com)
David Einhorn is one of most famous hedge fund managers on the planet and a master of company analysis.
He’s the founder and president of Greenlight Capital, a “long-short value-oriented hedge fund”, which he started in 1996 with $900,000. The fund now has $9.27 Billion in assets under management and since inception, according to Greenlight, has returned 1,902% cumulatively or 16.5% annualized, both net of fees and expenses.
One of the reasons Einhorn is so famous was his short call on Lehman Brothers in 2008.
In May 2008 Einhorn gave his now famous famous speech on Lehman Brothers at The Ira W. Sohn Investment Research Conference. The speech was titled “Accounting Ingenuity”, where he highlighted some accounting discrepancies at Lehman Brothers.
Lehman Brothers eventually filed for Chapter 11 bankruptcy protection on September 15, 2008. The filing remains the largest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets.
Let’s take a look at Einhorn’s review of Lehman Brothers titled, “Accounting Ingenuity”…
This is an excerpt from Einhorn’s speech at The Ira W. Sohn Investment Research Conference.
With this in mind, I’d like to review Lehman Brothers’ last quarter. Presently, Greenlight is short Lehman. Lehman was due to report its quarter two days after JP Morgan and the Fed bailed out Bear Stearns. At the time, there were a lot of concerns about Lehman, as demonstrated by its almost 20% stock price decline the previous day with more than 40% of its shares changing hands.
In the quarter, bond risk spreads had widened considerably and equity values had fallen sharply. Lehman held a large and very levered portfolio.
With that as the background, Lehman announced a $489 million profit in the quarter. On the conference call that day, Lehman CFO Erin Callan used the word “great” 14 times, “challenging” 6 times; “strong” 24 times, and “tough” once. She used the word “incredibly” 8 times. I would use “incredible” in a different way to describe the report.
The Wall Street Journal reported that she received high fives on the Lehman trading floor when she finished her presentation. Twenty-two days after the conference call, Lehman filed its 10-Q for the quarter. In the intervening time, I had made a speech at the Grant’s Spring Investment Conference where I observed that Lehman did not seem to have large exposure to CDOs. This was true in as much as Lehman had not disclosed significant CDO exposure.
Let’s look at the Lehman earnings press release (Table 1). Focus on the line “other asset backed-securities.” You can see from the table that Lehman took a $200 million gross write-down and has $6.5 billion of exposure.
Now let’s look at page 56 of the 10-Q (Table 2). See that same exposure of $6.5 billion.
Now let’s look at the footnote 1 of the table, explaining Other asset-backed securities:
The Company purchases interests in and enters into derivatives with collateralized debt obligation securitization entities (“CDOs”). The CDOs to which the Company has exposure are primarily structured and underwritten by third parties. The collateralized asset or lending obligations held by the CDOs are generally related to franchise lending, small business finance lending, or consumer lending. Approximately 25% of the positions held at February 29, 2008 and November 30, 2007 were rated BB+ or lower (or equivalent ratings) by recognized credit rating agencies… [emphasis added]
Last week, Lehman’s CFO and corporate controller confirmed that the whole $6.5 billion consisted of CDOs or synthetic CDOs. Ms. Callan also confirmed that the 10-Q presentation was the first time that Lehman had disclosed the existence of this CDO exposure. This is after Wall Street spent the last half year asking, “Who has CDOs?”
Incidentally, I haven’t seen any Wall Street analysts or the media discuss this new disclosure.
I asked them how they could justify only a $200 million write-down on any $6.5 billion pool of CDOs that included $1.6 billion of below investment grade pieces. Even though there are no residential mortgages in these CDOs, market prices of comparable structured products fell much further in the quarter.
Ms. Callan said she understood my point and would have to get back to me. In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down and instead stated that based on current price action, Lehman “would expect to recognize further losses” in the second quarter. Why wasn’t there a bigger mark in the first quarter?
Now, I’d like to put up Lehman’s table of Level 3 assets (Table 3). I want you to look at the column to the far right while I read to you what Ms. Callan said about this during the Q&A on the earnings conference call on March 17.[A]t the end of the year, we were about 38.8 [billion] in total Level 3 assets. In terms of what happened in Level 3 asset changes this quarter, we had net sort of payments, purchases, or sales of 1.8 billion. We had net transfers in of 1.1 billion. So stuff that was really moved in or recharacterized from Level 2.
And then there was about 875 million of write-downs. So that gives you a balance of 38,682 as of February 29.
As you can see, the table in the 10-Q does not match the conference call. There is no reasonable explanation as to how the numbers could move like this between the conference call and the 10-Q. The values should be the same. If there was an accounting error, I don’t see how Lehman avoided filing an 8-K announcing the mistake. Notably, the 10-Q changes somehow did not affect the income statement, as there must have been other offsetting adjustments somewhere in the financials.
When I asked them about this, Lehman said that between the conference call and the 10-Q they did a detailed analysis and found, “the facts were a little different.” I want to concentrate on the $228 million of realized and unrealized gains Lehman recognized in the quarter on its Level 3 assets. There is a $1.1 billion discrepancy between what Ms. Callan said on the conference call – an $875 million loss – and the table in the 10-Q, which shows a $228 million gain.
I asked Lehman, “My point blank question is: Did you write-up the Level 3 assets by over a billion dollars sometime between the press release and the filing of the 10-Q?” They responded, “No, absolutely not!”
However, they could not provide another plausible explanation. Instead, they said they would review the piece of paper Ms. Callan used on the call and compare it to the 10-Q and get back to me. In a follow-up e-mail, Lehman offers that the movement between the conference call and the 10-Q is “typical” and the change reflects “recategorization of certain assets between Level 2 and Level 3.”
I don’t understand how such transfers could have created over a $1.1 billion swing in gains and losses.
Others have asked Lehman about the large write-up in Level 3 corporate equities. It is hard to imagine, without a clear explanation, how an $8.4 billion portfolio gained $722 million during a period when the S&P fell 10%. This is particularly odd since about one quarter of this bucket is Archstone-Smith, a multi-family REIT that Lehman says it wrote down by a sizable, but undisclosed, amount.
Lehman had told others that it booked a large gain as a result of a pre-IPO financing round that was completed on a power company investment in Asia. The company in question was KSK Energy Ventures Limited, a power development company that operates three small power plants. According to Lehman, it booked a $400-$600 million unrealized gain on the investment in the first quarter.
Ms. Callan told me that during the first quarter “a new party” came in and completed a pre-IPO round in February at a much higher valuation than Lehman paid. She said Lehman valued the stake at a 30% discount to where the new party came in to reflect the restricted securities Lehman held.
KSK Energy Ventures filed a draft red herring prospectus in India on February 12, 2008 that revealed a different set of facts. Lehman had made an initial $112 million investment in KSK Electricity Financing in November 2005. The company completed a restructuring on January 20, 2008, through which Lehman sold its original investment for a gain of about $65 million and concurrently purchased about one-third of KSK Energy Ventures for $86.5 million.
The only other significant shareholder, KSK Energy Limited, owns 65% of the remaining equity and did not contribute capital during this round. I confronted them with the evidence that there was no subsequent round and that Lehman was the lead, if not the only, investor in the January restructuring. Suddenly, the story changed.
Management responded that it was “not sure” if Lehman was the lead on the round. It took what it “thought was the most conservative approach at the time and the low end of what all those data points produced.” Management followed-up in an e-mail stating that in February it had “revalued” its January investment based on a variety of analyses including an expected pre-IPO round, a DCF analysis, forward EBITDA multiples, comparable companies and a third-party research report.
One of my partners remarked, “This seems like one helluva power plug!”.
Additionally, during the quarter Lehman marked down its non-Level 3 mortgage assets by an average of 7%. You can see on the table that it marked down the Level 3 mortgages by $750 million, or only 3%. Though Lehman says that about 20% of the Level 3 mortgage assets are in markets that did better, such as Asia, they also contain many of the lowest quality assets including below investment grade residual interests, investment grade and below investment grade MBS and all of the subprime exposure.
In the real world, illiquid assets carry a discount. In the current melee the opposite seems true: illiquid assets are more valuable because it is easier to convince the accountants that they have not declined in value compared to liquid assets where there is more transparent pricing data.
Lehman had $39 billion of exposure to commercial mortgages at the end of the year. The index of AAA CMBS declined about 10% in the quarter. Lower rated bonds fell even further. Since Lehman’s portfolio is less than AAA, it would seem its write-down probably should have been more than 10 points. Lehman wrote its exposure down less
than 3 points gross.
Part of the commercial mortgage exposure is a venture called SunCal, where Lehman is a lender and equity investor. SunCal is a large land developer, principally in California’s Inland Empire. This is one of the hardest hit housing markets in the country. A number of publicly-traded home builders have written land holdings in this area down to pennies on the dollar. Lehman has not disclosed a material charge on its SunCal investment.
Recently, Lehman analysts have been cutting second quarter estimates due to “hedge ineffectiveness.” According to Lehman, hedges that mitigated the gross losses previously are now reversing faster than the assets Lehman owns. It seems to me that the hedge ineffectiveness might reflect Lehman more aggressively recognizing the gains on its
hedges than the losses on its assets in prior periods.
At the Grant’s Conference, before Lehman filed its 10-Q, I argued that if you assumed Lehman’s balance sheet was accurate, it needed to de-lever and raise capital. Now, I believe the need is much greater.
My hope is that Mr. Cox and Mr. Bernanke and Mr. Paulson will pay heed to the risks to the financial system that Lehman is creating and that they will guide Lehman toward a recapitalization and recognition of its losses – hopefully before federal taxpayer assistance is required.
For the last several weeks, Lehman has been complaining about short-sellers. Academic research and our experience indicate that when management teams do that, it is a sign that management is attempting to distract investors from serious problems.
I think that there is enough evidence to show how Lehman answered the difficult question as to whether to tell the truth and suffer the consequences or not. This raises the question, though, of what incentive do corporate managers have to fully acknowledge bad news in a truthful fashion?
For the capital markets to function, companies need to provide investors with accurate information rather than whatever numbers add up to a smooth return. If there is no penalty for misbehavior – and, in fact, such behavior is rewarded with flattering stories in the mainstream press about how to handle a crisis – we will all bear the negative consequences over time.
At a minimum, what message does this send to some of Lehman’s competitors that probably didn’t have problems quite as acute as Lehman, but who took sizable write-downs, and diluted their shareholders with significant equity raises?
Now, given my experience with Allied and the SEC, I have no expectation that Lehman will be sanctioned in any material way for what we believe it has done. I suspect that some of the authorities applaud Lehman’s accounting ingenuity.
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