Wednesday, September 10, 2008

David Einhorn on Lehman Last Year

Via Seeking Alpha again, Amit Chokshi's notes on David Einhorn's presentation on his Lehman (NYSE: LEH) short idea at last November's Value Investing Congress in New York:

Value at Risk (“VaR”) is not appropriate for measuring risk:
  • Einhorn compared investment bank VaRs to actual results for recent quarters, which showed that actual results were off by multiples of VaR estimates in some cases.
  • Risk managers should focus on the tails of bell curves and also be prepared for fat tail risk - 5-10 sigma events are not uncommon1.
  • FAS 159: Profit from One’s Demise
    • Fair value accounting standard that allows asset and liabilities to both be marked at fair value.
    • This accounting mechanism allows for income to be recognized as liabilities are marked down to fair value.
    • FAS 159 is acceptable for market risk but not for idiosyncratic risk.
    • The Street is comfortable with FAS 159 but does not seem to grasp all aspects of the ruling.
  • Lehman Brothers (LEH) – short idea
    • Looks vulnerable due to lack of transparency regarding writedowns
    • Could be following its “playbook” from 1998 liquidity crisis
  • LEH had mortgage exposure but took no writedowns
  • The market recovered and LEH pulled through
  • Could that happen now?
    • LEH stock has held up because of “good” quarters
  • 2008 EPS estimates remain unchanged at $7.75 which would follow a record year in 2007
  • Sellside believes the chance of a writedown at LEH is minimal
  • LEH 10-Q reveals no significant loss on Level III investments which Einhorn is skeptical of
    • In 2006, fixed income accounted for 48% of LEH income while securitizations accounted for 15% of income.
    • LEH should be much more exposed to losses than what has currently been reported.
  • LEH either recognizes larger losses (which will be a negative surprise) or LEH will likely under-earn competitors that have taken larger losses and cleaned up their balance sheets relative to LEH.

  • Lehman was trading at about $60 per share last November when Einhorn gave this presentation. Today it closed at $7.25 per share.

    1Not to be picayune about it, but if I remember my statistics correctly, by definition, 5- and 10-sigma events are of course uncommon, and also by definition, bell curves (normal distributions) don't have fat tails. I think Einhorn's point (simplified, apparently, for his audience) was that in finance returns usually do not follow normal distributions; their distribution curves have fat tails, indicating that extreme events are far more likely to occur than they would under a normal distribution. This is true, and has been, as far as I know, widely accepted for some time.

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