In Issue 330, Shares Investment(Singapore) reminded readers that we are not so optimistic on the current situation and feel that the worst might be felt only in the second half of the year, although many analysts have predicted earlier that the market will recovered. Lehman Brothers (Lehman), once a respected investment bank caused many investors to lose millions of dollars. The collapse of Lehman is the largest failure of an investment bank since Drexel Burnham Lambert going under nearly two decades ago.

Warren Buffett once said: “It’s only when the tide goes out that you learn who’s been swimming naked.” This is what happened on the financial markets right now.

Hence, readers should not only look at companies’ EPS, P/E ratio, NAV, ROE, ROA and dividend yield while making investments, but also to examine companies’ cash flow statement as well as balance sheet. In fact, I would consider these as very important.

Let us take a look at Lehman’s income statement, cash flow statement and balance sheet.

(Figures in US$ millions) Income Statement

(Figures in US$ millions) Cash Flow Statement

(Figures in US$ millions) Balance Sheet

Based on the income statement table above, Lehman’s revenue and earnings have been soaring and beating analysts’ forecasts for 5 consecutive years. But let us take a look at its cash flow statement and balance sheet. It is clear that Lehman was highly leveraged. It has been increasing its borrowings at a frantic pace over the years. In FY07, Lehman booked US$6.8b in operating profit and equity of US$21.4b, but it had US$434b in borrowings, meaning that its leverage ratio was 20 times.

Lehman, like many other banks, believed that there was no such thing as too much risk and keep on pouring tens of billions of dollars into hugely risky commercial real-estate transactions even though its cash flow did not come close to covering interest expenses. In other words, credit, both lent by and lent to Lehman, was massively overpriced.

Before Lehman filed for bankruptcy protection, its market capitalisation was US$2.5b as at 12 Sep-09 of its book value of US$19b (estimated by Deutsche Bank analyst Mike Mayo). This looks very cheap. But then it has US$160b hard-to-value Level 2 assets and US$41b impossible-to-value Level 3 assets. Moreover, based on analysis from many other public sources, most of the Level 3 assets are mortgage backed securities and collateralized debt obligations, even if they are AAA rated, the recovery rate is only about 50%. For its Level 2 assets, 10% haircut is actually a conservative estimate. The combination of both resulting to US$36b additional losses, which would more than wipe out Lehman’s book value of $19b plus their market capitalisation of $2.5b. This is leverage in the working, unfortunately at the down side.

Who said that the US financial crisis would not effect Asia or have only relatively small impact on Asian economies? Shareholders are not the only ones getting whacked in Lehman’s failure, Asian buyers of Lehman’s minibonds, could face huge losses stemming from the collapse.

Lehman’s minibonds are bonds that are sold in denominations with a minimum of $5,000 in order to make them available to small investors. It’s a structured note that exposes to the default of reference entities and has assets backed by the underlying securities (which are different from the reference entities). Lehman Brothers uses the funds collected from the minibonds holders to purchase the underlying securities and enter into contracts for interest rate or currency swap. In a bankruptcy, bond investors recover different amounts of their principal based on where they are in the capital structure. While it is possible that Lehman minibonds holders could get back their investment, the market is saying that the once-vaunted investment bank’s debt is worth very little.

No wonder Warren Buffett said: “Derivatives are financial weapons of mass destruction,” and we like to urge readers to invest in what you understand.