Breaking News: Bloomberg reports that Lehman to form a new company to buy mortgage assets

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.

In case your not sure what FAS 157 is, here’s a quick primer:

The US Financial Accounting Standards Board Rule 157, which became effective for fiscal years that began after November 15, 2007, makes it harder for companies that must assign pricing to those securities considered the hardest to value – Level 3 assets. Essentially, firms are now forced to “mark-to-market” and determine a current fair value rather than use historical cost figures to value assets on the their books.

In the fair value hierarchy, Level 1 assets are simply “mark-to-market” whereby an asset’s value is determined with quoted prices for identical instruments in an active market (ie., an equity security traded on the NYSE).

Level 2 assets, known as “marked-to-model” instruments, are based on an estimate of observable inputs. In estimating value, firms can use pricing models based on net present value of future cash flows and directly observed prices from exchange traded or OTC derivatives. While Level 2 assets are a bit more complex than Level 1, measurement can be rendered with a fairly high degree of confidence. However, Level 3 assets are not so simple.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability. Ultimately, Level 3 inputs, which assist at deriving the underlying asset’s current value, must include information based on extrapolation or interpolation of observable market data.

In the case of Lehman, this sits at the very core of their recent writedown and massive losses. In the last quarter, the firm sold $3.5 billion of Level 3 assets which consisted mostly of mortgage-backed securities. And despite these sales, the firm still has approximately $38 billion in Level 3 assets sitting on the books as of their most recent 10-Q filing. Selling into a weak and uncertain market environment have made matters even worse. And while the firm works to decrease their exposure in Level 3 assets, Lehman makes these sales even more interesting by acknowledging that some of their transactions have taken place with an entity known as R3 Capital Partners.

R3 Capital Partners, launched this past May, is a hedge fund run by an ex-Lehman executive named Rick Rieder. Sounds fishy doesn’t it? I would say so.

Oh and did I mention that Lehman is an investor in this hedge fund. In fact, it currently maintains a "non-voting, minority ownership stake" in the fund.

With that said, I think a few good questions would be:

1. How much did R3 pay for Lehman’s Level 3 assets?

2. Were there any assumptions/conditions built into these deals that actually make these transactions simply a temporary transfer of risk?

3. Could you discuss in further detail the $4.5 billion in assets sold and/or transferred to R3 during Q2?

4. Do any of these executives that run R3 hold Lehman stock? And if so, doesn’t this present a conflict of interest? (The hedge fund’s disclosure documents states that it is possible that R3’s executives “could” be holding restricted stock in Lehman.)

Unfortunately, we probably won’t get the answer to any of those questions. The truth is: they don’t have to.

And so we come back to that darn FAS 157 – it’s forced firms to report market values and not assumed values. Shame on you FAS 157. Look at what you have done to this market.

Tom Brown refutes Meredith's analysis with an Excel chart while his firm blows up 50% in 2007

Meredith Whitney is on fire at the moment. Her calls have been very good and she's not afraid to go out on a limb.

And then you have this quote from Tom Brown (for those of you all who don't know Tom Brown you can read his bio HERE):

"Every cycle there's one analyst who races to be the most bearish, and this time it's her. Honestly, I think we'll look back and see that Meredith Whitney's credibility peaked on July 15"

And I would counter this statement by saying, "every time someone actually makes a good call you always have someone who is jealous or goes against the grain just to get more attention - in this case its Tom Brown."

Brown goes on to accuse Whitney of being "incredibly arrogant" on the basis of her recent opinions. He then takes a personal shot at her: "The only explanation I can see is, she has no idea how to evaluate the possible downside risks."

I sense jealousy on the part of Tom Brown.

If you are interested, HERE is Tom Brown's case for a bottoming of the financial services stocks.

In my opinion, a quick glance at the metrics (bank net charge-offs and loan loss provisions of the past 20 years) he uses to refute Meredith's case are overly-simplistic. There are many more dynamics in place today that did not exist in the 80's and 90's. Using an simple excel chart of charge offs versus loan provisions just won't do it. Reminds me of a concept I remember from my engineering classes in college: curve-fitting. Nice try Tom.

Ironically, Tom Brown's investment firm lost nearly 50% of its value in 2007 due to bets in financial stocks.

In fact, the "oracle" himself made the following bold statement last November: "I think we're really close, if not at the bottom, for the financial services industry," Brown told hundreds of investors at the Value Investing Congress in New York. "There are many opportunities in the most battered sectors."

Wow Tom...a lot has happened since last November. Maybe someone should question your analysis.

Firm tries to restore client confidence

Bloomberg is reporting that UBS, Switzerland's biggest bank, plans to separate its investment banking and wealth management units after the recent subprime meltdowns. All being done to stop the bleeding - an attempt to stop their rich clients from taking their money out of the firm and running for the exits.

More precisely, the firm will separate the firm into three different pieces: wealth management, asset management, and investment banking. This move has prompted critics to speculate that the firm is preparing to facilitate a sale.

The firm saw over $15 billion withdrawn from its wealth management unit during the second quarter.

I wouldn't be surprised to see Merrill Lynch do the same thing.

After $43 billion in write-downs, UBS to split main businesses [NY Times]

UBS to split investment bank from wealth management [Bloomberg]

This shouldn't come as a surprise to anyone but maybe a form of validation:

Oppenheimer analyst Meredith Whitney seeing problems in consumer-based credit to continue over next 12 to 18 months. This comes on the heels of American Express noting a significant credit deterioration among its most affluent clients.

"The wide-ranging effects of the housing downturn are highlighted by the worsening of U.S. cards' credit quality in AXP's affluent cardmember base," Whitney wrote in a note to clients last week.

"Typically, the affluent segment holds up well during downturns, but home price declines have resulted in significant losses in consumer net worth (lower home values)," she added.

American Express said that even its best clients were spending less and taking longer to pay bills. With consumers weaker the company said it was no longer on track to boost earnings per share by 4 to 6% this year.

Whitney slashed her $76 price target on the stock and cut her 2008 earnings estimate to $2.60 from $3.45.

Analyst Whitney gloomy on U.S. spending as top AmEx clients hurt [Reuters]

Gilt-edged AmEx cards tarnishing [Barrons]

American Express cut to perform at Oppenheimer on deteriorating credit quality [Thomson]

When Meredith speaks people listen. She is a sharp analyst that has made some bold calls the past couple of years. Her biggest call: Citi's failures. This interview took place earlier this week on the CNBC set. Among her points in this interview:

1. Expect to see further weakness in housing prices



2. Banks are recapitalizing but very little of that is being used for loans



3. Systemic risk still pretty high for most investment banks



4. In this kind of market, money goes from "weaker" hands to "stronger" hands



5. Credit card industry will have repricing problems with their loan portfolios due to higher regulation

Her calls have been pretty spot-on recently. This interview is probably a bit extreme to the extent that she might be "overselling" the current market conditions. But at any rate, I would recommend that you keep her word in mind. And if you have a problem with her then maybe you should take it up with her husband.

Current Fortune article on Meredith Whitney [Fortune.com]

With a current market value of about $11 billion and Lehman's Neuberger piece valued somewhere in the neighborhood of $8 billion, then an asset sale would then leave the rest of the firm's pieces (investment banking, fixed income, and equity) sitting somewhere around $3 billion. And thats pocket change for a larger bank. In my opinion, a sale, in effect, would be the beginning of an end of the Lehman franchise.

Lehman to sell Neuberger? [Dealbreaker.com]

Lehman mulls sale of Neuberger [CNBC]

I suspect we should know within the next couple of weeks. This is a huge decision for LEH and playing the Neuberger card is like going "all-in" in a high stakes poker tournament. Let's just hope that they don't overplay their hand.

Merrill Lynch star analyst, Guy Moszkowski, not only cut 3Q EPS from $4.28 to $2.80 but also lowered his price objective from $212 to $205 on the basis of lower book value.

EPS was cut primarily on the basis of weaker global markets and an above-average sensitivity to commodity prices and volume.

Goldman should report their 3Q numbers sometime in the middle of September. GS closed the day at $179.55 a share, down $1.22 from yesterday's close.

Institutional money management firms have always been a good business. Maybe not as sexy as prinicpal trading or investment banking but always a dependable revenue stream. They offer highly predictable cash flows without the cost of extensive capital requirements that might go into other business models that sit at these same revenue levels.

Both, Blackrock and Neuberger, are very attractive assets held by Merrill and Lehman, respectively. But in the wake of the recent writedowns, it is thought that both firms are being pondered to be sold. Will they be sold? I would say no, but if they are, then we will know that Merrill and Lehman are seriously desperate for cash. Let's look at both money management firms:

Blackrock Inc. (NYSE: BLK) is an investment management firm that has almost $1.4 trillion in assets under management. Blackrock was founded as the Financial Management Group in 1988 within the private equity firm Blackstone Group. After a number of acquisitions, the firm was spunoff from the Blackstone Group under the name Blackrock and was aggressively branded as an independent money management firm. Then in 1995, PNC Financial purchased BLK where assets under management would grow to $165 billion over the next few years. Shortly thereafter, the firm decided to go public.

Since then, Blackrock acquired State Street Research, a mutual fund previously owned by MetLife, and also merged with Merrill Lynch Investment Managers (MLIM). The MLIM deal, which was completed in 2006, halved PNC's ownership and gave Merrill Lynch a 49% stake in the company.

Neugerger Berman Inc. is an investment advisory firm founded in 1939 by Roy Neuberger to mange funds for high net worth individuals. In 1950, Neuberger became one of the first firms to offer a no-load mutual fund to individual investors and, in 1971, launched a portfolio for institutions which pushed the firm into the foray of institutional based money management.

In 2003, Lehman Brothers bought NB for $2.6 billion in cash and stock which at the time represented about 4% of NB's assets under management. Analysts at the time commented that price was "reasonable" considering the stature of the NB brand. Talk among analysts is that Lehman could possibly fetch $8 billion if it were to sell off NB on the basis of their firm's $130 billion in assets under management.

With respect to a sale of either of these firm, I really don't think that Merrill or Lehman wants to engage into such a transaction. Both money managers are cash flow machines and provide a nice anchor in earnings to an otherwise volatile earnings environment. But it appears that they might need to do so as to increase their firms' liquidity after their massive writedowns. In fact, any asset sales of either of these two firms would probably be followed by a downgrade by the credit agencies which, in turn, could lead to a host of other potential problems.

If in fact they were to sell the assets, my expectation is that Merrill would sell a 10% stake in Blackrock while Lehman would sell off the entire firm. Merrill and Lehman, at a minimum, must demand a sale price of more than 5% of the assets under management and possibly even more. Therefore, $8 billion for Neuberger would be good and $8.5 billion (assuming they sell a 10% stake in BLK) should suit Merrill. Anything less could spell trouble.

KKR LOOKING TO BUY NEUBERGER

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.

SUBPRIME WRITEDOWNS: BLAME IT ON FAS 157!

In case your not sure what FAS 157 is, here’s a quick primer:

The US Financial Accounting Standards Board Rule 157, which became effective for fiscal years that began after November 15, 2007, makes it harder for companies that must assign pricing to those securities considered the hardest to value – Level 3 assets. Essentially, firms are now forced to “mark-to-market” and determine a current fair value rather than use historical cost figures to value assets on the their books.

In the fair value hierarchy, Level 1 assets are simply “mark-to-market” whereby an asset’s value is determined with quoted prices for identical instruments in an active market (ie., an equity security traded on the NYSE).

Level 2 assets, known as “marked-to-model” instruments, are based on an estimate of observable inputs. In estimating value, firms can use pricing models based on net present value of future cash flows and directly observed prices from exchange traded or OTC derivatives. While Level 2 assets are a bit more complex than Level 1, measurement can be rendered with a fairly high degree of confidence. However, Level 3 assets are not so simple.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability. Ultimately, Level 3 inputs, which assist at deriving the underlying asset’s current value, must include information based on extrapolation or interpolation of observable market data.

In the case of Lehman, this sits at the very core of their recent writedown and massive losses. In the last quarter, the firm sold $3.5 billion of Level 3 assets which consisted mostly of mortgage-backed securities. And despite these sales, the firm still has approximately $38 billion in Level 3 assets sitting on the books as of their most recent 10-Q filing. Selling into a weak and uncertain market environment have made matters even worse. And while the firm works to decrease their exposure in Level 3 assets, Lehman makes these sales even more interesting by acknowledging that some of their transactions have taken place with an entity known as R3 Capital Partners.

R3 Capital Partners, launched this past May, is a hedge fund run by an ex-Lehman executive named Rick Rieder. Sounds fishy doesn’t it? I would say so.

Oh and did I mention that Lehman is an investor in this hedge fund. In fact, it currently maintains a "non-voting, minority ownership stake" in the fund.

With that said, I think a few good questions would be:

1. How much did R3 pay for Lehman’s Level 3 assets?

2. Were there any assumptions/conditions built into these deals that actually make these transactions simply a temporary transfer of risk?

3. Could you discuss in further detail the $4.5 billion in assets sold and/or transferred to R3 during Q2?

4. Do any of these executives that run R3 hold Lehman stock? And if so, doesn’t this present a conflict of interest? (The hedge fund’s disclosure documents states that it is possible that R3’s executives “could” be holding restricted stock in Lehman.)

Unfortunately, we probably won’t get the answer to any of those questions. The truth is: they don’t have to.

And so we come back to that darn FAS 157 – it’s forced firms to report market values and not assumed values. Shame on you FAS 157. Look at what you have done to this market.

Meredith Whitney is an easy target for Tom Brown

Tom Brown refutes Meredith's analysis with an Excel chart while his firm blows up 50% in 2007

Meredith Whitney is on fire at the moment. Her calls have been very good and she's not afraid to go out on a limb.

And then you have this quote from Tom Brown (for those of you all who don't know Tom Brown you can read his bio HERE):

"Every cycle there's one analyst who races to be the most bearish, and this time it's her. Honestly, I think we'll look back and see that Meredith Whitney's credibility peaked on July 15"

And I would counter this statement by saying, "every time someone actually makes a good call you always have someone who is jealous or goes against the grain just to get more attention - in this case its Tom Brown."

Brown goes on to accuse Whitney of being "incredibly arrogant" on the basis of her recent opinions. He then takes a personal shot at her: "The only explanation I can see is, she has no idea how to evaluate the possible downside risks."

I sense jealousy on the part of Tom Brown.

If you are interested, HERE is Tom Brown's case for a bottoming of the financial services stocks.

In my opinion, a quick glance at the metrics (bank net charge-offs and loan loss provisions of the past 20 years) he uses to refute Meredith's case are overly-simplistic. There are many more dynamics in place today that did not exist in the 80's and 90's. Using an simple excel chart of charge offs versus loan provisions just won't do it. Reminds me of a concept I remember from my engineering classes in college: curve-fitting. Nice try Tom.

Ironically, Tom Brown's investment firm lost nearly 50% of its value in 2007 due to bets in financial stocks.

In fact, the "oracle" himself made the following bold statement last November: "I think we're really close, if not at the bottom, for the financial services industry," Brown told hundreds of investors at the Value Investing Congress in New York. "There are many opportunities in the most battered sectors."

Wow Tom...a lot has happened since last November. Maybe someone should question your analysis.

UBS to split Investment Bankers and Brokers

Firm tries to restore client confidence

Bloomberg is reporting that UBS, Switzerland's biggest bank, plans to separate its investment banking and wealth management units after the recent subprime meltdowns. All being done to stop the bleeding - an attempt to stop their rich clients from taking their money out of the firm and running for the exits.

More precisely, the firm will separate the firm into three different pieces: wealth management, asset management, and investment banking. This move has prompted critics to speculate that the firm is preparing to facilitate a sale.

The firm saw over $15 billion withdrawn from its wealth management unit during the second quarter.

I wouldn't be surprised to see Merrill Lynch do the same thing.

After $43 billion in write-downs, UBS to split main businesses [NY Times]

UBS to split investment bank from wealth management [Bloomberg]

Meredith Whitney sees AmEx consumer credit situation a major problem over 12 months

This shouldn't come as a surprise to anyone but maybe a form of validation:

Oppenheimer analyst Meredith Whitney seeing problems in consumer-based credit to continue over next 12 to 18 months. This comes on the heels of American Express noting a significant credit deterioration among its most affluent clients.

"The wide-ranging effects of the housing downturn are highlighted by the worsening of U.S. cards' credit quality in AXP's affluent cardmember base," Whitney wrote in a note to clients last week.

"Typically, the affluent segment holds up well during downturns, but home price declines have resulted in significant losses in consumer net worth (lower home values)," she added.

American Express said that even its best clients were spending less and taking longer to pay bills. With consumers weaker the company said it was no longer on track to boost earnings per share by 4 to 6% this year.

Whitney slashed her $76 price target on the stock and cut her 2008 earnings estimate to $2.60 from $3.45.

Analyst Whitney gloomy on U.S. spending as top AmEx clients hurt [Reuters]

Gilt-edged AmEx cards tarnishing [Barrons]

American Express cut to perform at Oppenheimer on deteriorating credit quality [Thomson]

Meredith Whitney: More Weakness Ahead?

When Meredith speaks people listen. She is a sharp analyst that has made some bold calls the past couple of years. Her biggest call: Citi's failures. This interview took place earlier this week on the CNBC set. Among her points in this interview:

1. Expect to see further weakness in housing prices



2. Banks are recapitalizing but very little of that is being used for loans



3. Systemic risk still pretty high for most investment banks



4. In this kind of market, money goes from "weaker" hands to "stronger" hands



5. Credit card industry will have repricing problems with their loan portfolios due to higher regulation

Her calls have been pretty spot-on recently. This interview is probably a bit extreme to the extent that she might be "overselling" the current market conditions. But at any rate, I would recommend that you keep her word in mind. And if you have a problem with her then maybe you should take it up with her husband.

Current Fortune article on Meredith Whitney [Fortune.com]

If Lehman sells Neuberger, then LEH will be bought out

With a current market value of about $11 billion and Lehman's Neuberger piece valued somewhere in the neighborhood of $8 billion, then an asset sale would then leave the rest of the firm's pieces (investment banking, fixed income, and equity) sitting somewhere around $3 billion. And thats pocket change for a larger bank. In my opinion, a sale, in effect, would be the beginning of an end of the Lehman franchise.

Lehman to sell Neuberger? [Dealbreaker.com]

Lehman mulls sale of Neuberger [CNBC]

I suspect we should know within the next couple of weeks. This is a huge decision for LEH and playing the Neuberger card is like going "all-in" in a high stakes poker tournament. Let's just hope that they don't overplay their hand.

Moszkowski cuts Goldman's 3Q EPS

Merrill Lynch star analyst, Guy Moszkowski, not only cut 3Q EPS from $4.28 to $2.80 but also lowered his price objective from $212 to $205 on the basis of lower book value.

EPS was cut primarily on the basis of weaker global markets and an above-average sensitivity to commodity prices and volume.

Goldman should report their 3Q numbers sometime in the middle of September. GS closed the day at $179.55 a share, down $1.22 from yesterday's close.

Blackrock and Neuberger for sale?

Institutional money management firms have always been a good business. Maybe not as sexy as prinicpal trading or investment banking but always a dependable revenue stream. They offer highly predictable cash flows without the cost of extensive capital requirements that might go into other business models that sit at these same revenue levels.

Both, Blackrock and Neuberger, are very attractive assets held by Merrill and Lehman, respectively. But in the wake of the recent writedowns, it is thought that both firms are being pondered to be sold. Will they be sold? I would say no, but if they are, then we will know that Merrill and Lehman are seriously desperate for cash. Let's look at both money management firms:

Blackrock Inc. (NYSE: BLK) is an investment management firm that has almost $1.4 trillion in assets under management. Blackrock was founded as the Financial Management Group in 1988 within the private equity firm Blackstone Group. After a number of acquisitions, the firm was spunoff from the Blackstone Group under the name Blackrock and was aggressively branded as an independent money management firm. Then in 1995, PNC Financial purchased BLK where assets under management would grow to $165 billion over the next few years. Shortly thereafter, the firm decided to go public.

Since then, Blackrock acquired State Street Research, a mutual fund previously owned by MetLife, and also merged with Merrill Lynch Investment Managers (MLIM). The MLIM deal, which was completed in 2006, halved PNC's ownership and gave Merrill Lynch a 49% stake in the company.

Neugerger Berman Inc. is an investment advisory firm founded in 1939 by Roy Neuberger to mange funds for high net worth individuals. In 1950, Neuberger became one of the first firms to offer a no-load mutual fund to individual investors and, in 1971, launched a portfolio for institutions which pushed the firm into the foray of institutional based money management.

In 2003, Lehman Brothers bought NB for $2.6 billion in cash and stock which at the time represented about 4% of NB's assets under management. Analysts at the time commented that price was "reasonable" considering the stature of the NB brand. Talk among analysts is that Lehman could possibly fetch $8 billion if it were to sell off NB on the basis of their firm's $130 billion in assets under management.

With respect to a sale of either of these firm, I really don't think that Merrill or Lehman wants to engage into such a transaction. Both money managers are cash flow machines and provide a nice anchor in earnings to an otherwise volatile earnings environment. But it appears that they might need to do so as to increase their firms' liquidity after their massive writedowns. In fact, any asset sales of either of these two firms would probably be followed by a downgrade by the credit agencies which, in turn, could lead to a host of other potential problems.

If in fact they were to sell the assets, my expectation is that Merrill would sell a 10% stake in Blackrock while Lehman would sell off the entire firm. Merrill and Lehman, at a minimum, must demand a sale price of more than 5% of the assets under management and possibly even more. Therefore, $8 billion for Neuberger would be good and $8.5 billion (assuming they sell a 10% stake in BLK) should suit Merrill. Anything less could spell trouble.