Lehman Dodges a Bullet

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This morning at 8 a.m., the world held its breath, fearing the worst, yet hoping against hope that the venerable investment bank Lehman Brothers (NYSE: LEH) could survive the avalanche of subprime debt that threatened its profits. Two minutes later, the earnings release hit the wires and everyone breathed a sigh of relief. Not only had Lehman survived, but its earnings had beaten estimates, down only 3% from the year-ago quarter. The sound of corks popping from champagne bottles could be heard from New York to Tokyo. Everyone kissed and hugged. The world could now be at peace, because the subprime demon had finally been vanquished.

OK, so all that might be a bit over the top. But many eyes were on Lehman's earnings, because it was the first investment bank to report earnings for this quarter. Thanks to its small size and its reliance on bonds, it is perhaps more vulnerable to the subprime mortgage problems than are its larger competitors Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS). Lehman's results might be a good indication of what's in store for the other investment banks, including the beleaguered Bear Stearns (NYSE: BSC).

While earnings were good, not all was rosy at Lehman Brothers. The company wrote down the value of its assets in its fixed-income segment by $700 million, reflecting the decreased value of mortgage-backed bonds on its books. Fixed-income revenue (including the writedown) decreased by 47% from the year-ago quarter. Luckily for Lehman, its revenue in all other segments was up big: 64% in equities, 48% in investment banking, and 33% in investment management.

The worst may not be over for Lehman. If subprime mortgages, and the mortgage-backed bonds derived from them, continue to suffer high defaults and low market prices, the bank may be forced to further write down the value of its bonds in the next quarter. This would be especially likely if the economy were to enter a recession and many mortgage borrowers lost their jobs. Also, leveraged buyouts and other mergers and acquisitions have already declined sharply. Next quarter's investment-banking revenue should drop significantly thanks to this dearth of deals.

Overall, not a bad quarter. But it might be too early to start celebrating the demise of that subprime demon.

For further Foolishness:

• Goldman Digs In Its Heels
• What's on Deck for Investment Banks?
• What the Heck Is Investment Banking, Anyway?