After one of the worst weeks in its history, Lehman Brothers (NYSE: LEH ) soared nearly 50% yesterday after reporting earnings that topped analysts' expectations. Its results reassured the market that rumors about Lehman's liquidity were largely exaggerated.
Lehman in layman's terms
Lehman's first-quarter net income was $0.81 per share, down 59% from the $1.96 per share it scored in the same period last year. Analysts didn't expect a phenomenal performance, looking for just $0.72 per share. Reflecting the tough market that investment banks have fared in recent months, total revenue slipped 31% to $3.5 billion, with the biggest declines stemming from the fixed-income department, which fell a whopping 88%.
One major ray of hope came from the investment management division, which saw a 39% surge in revenue. Investment-banking revenue also experienced unexpected gains, growing by 2%. That's a sharp contrast to the big declines of rival Goldman Sachs (NYSE: GS ) .
Dousing the rumors that Lehman might be the next to walk the plank finally got shares to move. After rival Bear Stearns (NYSE: BSC ) was rescued by JPMorgan Chase (NYSE: JPM ) on Sunday, all eyes turned to Lehman. CFO Erin Callan acknowledged the market has been anxious about Lehman. "We know we're always the next name on the list."
Last Friday, it was rumored that ING Groep (NYSE: ING ) , one of Europe's largest banks, had ceased dealing with nearly every Wall Street institution. Soon after, word circulated that DBS Group, one of Asia's largest banks, had asked its traders to steer clear of Lehman.
Even after one of the harshest debt markets this country has ever faced, Lehman maintains a lofty 31.7 leverage ratio, meaning that the firm's assets are 31.7 times greater than its equity. Such nosebleed-level leverage scares the pants off clients who are concerned that banks might not be able to give them access to their funds when requested.
However, Lehman said that although market conditions have eroded, it holds a "liquidity pool of $34 billion and unencumbered assets of $64 billion" -- more than enough to survive whatever curveball the market throws its way.
Proof of Lehman's liquidity was certainly welcome. But Bear Stearns did the same just days before going virtually bankrupt. So much fear surrounds investment banks right now that normally adequate liquidity levels can be vaporized in a flash. No matter how liquid a bank is at one moment in time, skittish clients can yank cash from it faster than it can recapitalize.
Bernanke provides new hope
However, Lehman and other investment banks such as UBS (NYSE: UBS ) and Morgan Stanley (NYSE: MS ) now have ammunition that Bear Stearns didn't have when it collapsed. Over the weekend, the Federal Reserve opened its discount lending window to include investment banks, rather than only commercial banks.
Last week, the Fed also announced that it would begin lending as much as $200 billion to investment banks accepting mortgage-backed securities as collateral. A tough sell in the open market, this will make it easier for struggling banks to raise money quickly.
That's great news for companies like Lehman, which will become one of the first institutions since the Great Depression to be assisted directly by the Federal Reserve. Whether or not it needs the money, just knowing that Bernanke will authorize help to curtail a full-blown collapse may be enough to keep worried investors at ease. Sure enough, Lehman didn't draw on the Fed's discount lending window on Monday, but having it there as an option sent the market a strong message.
What lies ahead for Lehman? With Bear Stearns as a template, investors now have an understanding of what can cause a massive bank to crumble overnight. I'd venture to say Lehman is not out of the woods yet, but taking Bear off the table and having the Fed on its side may have washed enough pessimism out of the market to give investment banks a new shot.
For related Foolishness: