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.