It could be said that one of Lehman Brothers' (NYSE:LEH) biggest challenges is the fact that it's not named Goldman Sachs (NYSE:GS). After Lehman announced results right on par with what Wall Street analysts had expected for the quarter, its shares fell as much as 5%. It must not have been quite enough for investors after Goldman beat analysts' estimates by 36% yesterday.
Nearly all of Lehman's top-line growth for the quarter came from its equity capital markets business, which was up 42% year over year, and investment management, which grew 20% over the prior year. Lehman's fixed-income capital markets department, its largest business area, grew a sluggish 3%, partially due to the pullback in the residential mortgage market. On the expense side, compensation and benefits stayed roughly flat versus last year as a percentage of revenue, but a 21% jump in non-compensation expenses were a bit of a drag on profitability.
It's all about risk
The rallying cry of the brokerages is that adequate risk management is the key to weathering changes in economic and capital market conditions. We heard a similar message from Goldman yesterday, and we're likely to hear it again tomorrow, when Bear Stearns (NYSE:BSC) reports. Risk management is the crown jewel for these firms, and it's for that same reason that, now that the future is looking a little murky, companies are turning to Lehman for advisory services on how to manage their own risk.
For the past four years, the markets have gone steadily up and to the right, and volatility has been steadily declining. But we may be seeing an end to that now. During this time, risk management will be crucial for these big brokerages as they continue to put more of their own capital (versus customers' capital) on the playing field. So one might logically ask at this point whether it is perceived opportunity or hubris that has Lehman continuing to increase its net leverage ratio, which is now at 15.4 times versus 13.5 times last year, and nearly double its value at risk -- a measure of the losses the firm could take if conditions turn particularly vicious.
And speaking of risk ...
Subprime is almost synonymous with risk these days. Risk from this area is certainly applicable to Lehman, since it originates, purchases, and securitizes residential mortgages. Lehman's first line of defense to questions over exposure to subprime fallout is the fact that the firm's contribution from that business is fairly small. Past that, Lehman's CFO painted a similar picture on the conference call to what we're hearing elsewhere -- that overall economic conditions remain positive and the problems with subprime are currently contained and don't seem to be spreading to other areas of credit or affecting economic activity.
As the economy continues to try to decide which direction it wants to go, we may get a chance to see just how effective Lehman's risk management is. As for the recent results, Lehman may not start with a "G," but over the past few years it has put up results as nice as that other firm's, and shareholders have been rewarded in kind.
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Fool contributor Matt Koppenheffer owns shares of Goldman Sachs, but does not own shares of any of the other companies mentioned. You can visit Matt's CAPS page here, or check out his blog here. The Fool's disclosure policy is all about keeping you out of risky situations.
