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Lehman Trading Hurt by Counterparty Worry

Lehman Brothers Holdings has seen its trading earnings hurt as clients worry about the credit strength of unregulated derivatives units, though it has sufficient capital and access to government funding, a veteran brokerage analyst told clients Thursday.

Lehman Brothers
Bert van Dijk
Lehman Brothers

Lehman shares trimmed early gains of as much as 6.7 percent and were up about 3 percent in late Thursday morning trading, slightly ahead of the the Amex Securities Broker Dealer index , which was up 2.8 percent.

Lehman shares sank 19 percent the first two days of this week as some investors speculated the fourth-largest investment bank will report a larger-than-expected quarterly loss and be forced to raise as much as $4 billion of new equity.

The shares rose 2.6 percent on Wednesday, helped by a vote of confidence from a top bond manager.

But Brad Hintz, who follows brokers for Sanford Bernstein, said that while broker-dealer units in the United States, UK, Japan and Germany "are still being fully accepted by the market, cautious credit officers at clients of the firm are limiting trading with the unregulated derivatives subsidiaries of the company."

As a result, Hintz reduced his third- and fourth-quarter earnings estimates for Lehman to $1.13 and $1.10 per share, respectively, down 11 cents each, anticipating reduced earnings from the trading of debt, equities and commodities derivatives.

Hintz, a former Lehman chief financial officer, reduced his 2008 earnings estimate to $3.20 from $3.42, and his 2009 estimate to $5.95 from $6.11.

"We recommend investors remain on the sidelines with Lehman until the firm demonstrates a reduction in leverage and lowers its exposures to troubled asset classes," Hintz said.

Lehman declined to comment.

Separately, Deutsche Bank lowered its price target and 2008 earnings estimates on Lehman, citing higher-than-expected hedging losses and assumption for a new $4 billion common equity offering.

The brokerage cut its price target to $49 from $52 and reduced 2008 earnings view to $2.45 from $3.60 a share.

But Deutsche Bank maintained its "buy" rating on the stock, which was up 97 cents at $32.37 in late morning trading.

The cost of insuring Lehman Brothers' debt with credit default swaps tightened on Thursday, according to data from Phoenix Partners Group.

Lehman's five-year credit default swaps fell to 240 basis points, or $240,000 a year to protect $10 million of debt, down from 263 basis points at Wednesday's close.

Hintz, in his client note, added that Lehman's fixed income derivative business is under pressure after Standard & Poor's cut Lehman's credit rating to single-A from A-plus.

"Such a downgrade makes it less likely for counterparties to enter into long-dated derivatives," he said, and that will erode profit.

Hintz rates Lehman stock "market perform." Hintz said unregulated subsidiaries that are now "somewhat suspect" include Lehman Brothers Special Financing, Lehman Brothers Finance, Lehman Brothers OTC, and Lehman Brothers Commodity Services.

Deutsche said it did not view liquidity as a major issue for Lehman.

While equity risk remains, it does not seem out-sized, said the brokerage.