Lehman Bros. reels from subprime fallout - TARA PERKINS

Trigger-happy investors sent shares of Lehman Brothers Holdings Inc. on a roller-coaster ride yesterday, illustrating how quickly investors will react as they wait for the next shoe to drop from the subprime mortgage market.

Lehman Brothers' shares were down 3.5 per cent by early afternoon on rumours that it could be the subprime mortgage market's next big victim. The stock rebounded to $71.65 (U.S.), down 1.93 per cent on the New York Stock Exchange, after the company denied speculation it is struggling with large losses on subprime mortgage securities.

The market is on edge after this week's news that two Bear Stearns Co. hedge funds have very little value left. The performance of those two funds reflects, in part, unprecedented declines in the value of a number of subprime-related securities that were highly rated - at double-A or triple-A - Bear Stearns said in a letter to clients that was obtained by The Wall Street Journal. Preliminary estimates show that there is "effectively no value left for the investors" in one of the funds and "very little" left in the other, the letter said.

The Bear Stearns admission will almost certainly trigger a mass revaluation of portfolios with similar investments in collateralized debt obligations, or CDOs, causing big writedowns at the banks, said Richard Bove, an analyst with Punk Ziegel & Co. He downgraded virtually all of the Wall Street banks yesterday on the Bear Stearns news. He said the collapse of the two Bear hedge funds does not reflect a problem at the firm itself, but reveals troubles with the entire system.
"The banks are overstating the quality of assets on their balance sheets," he said. "When they go back and look at these securities, it could be up to a 15- to 20-per-cent devaluation."

If the assets of the Bear Stearns funds are liquidated, their true market value will likely come to light, Blackmont Capital analyst Brad Smith noted.

"It's quite likely that more information will come to the surface now," Mr. Smith said in an interview. "It's a developing situation that should not be ignored by the market."

Of Canada's big banks, Canadian Imperial Bank of Commerce "is most likely to be impacted given its rapid 2006 entry into this field," he wrote. "Although likely manageable, losses will underscore the build-up of non-traditional risks in domestic banks and may cap [price-to-earnings] levels," he said.

CIBC has acknowledged putting about $330-million into a CDO called Tricadia that's tied to U.S. subprime mortgages. It has stated that the majority of its exposure to these structured credit transactions is rated triple-A.

Shares of CIBC fell 68 cents, or less than 1 per cent, to $97.55 (Canadian) on the Toronto Stock Exchange, having dipped as low as $96.50 earlier in the afternoon.

Standard & Poor's Rating Services, which last week downgraded various classes of U.S. residential mortgage-backed securities (RMBS) with exposure to subprime mortgages, said yesterday it expects to spend several weeks reviewing U.S. RMBS, with a review of CDOs to follow shortly thereafter. While the reviews are under way, it has adopted guidelines for rating new CDO transactions to deal with the uncertainties surrounding future rating actions.

What is a CDO?

Collateralized debt obligations are created by pooling large numbers of residential mortgages into residential mortgage backed securities (RMBSs). Pooling is a way for banks to unload risk from mortgages and is a way for investors to earn a return from interest payments on the underlying mortgages. The RMBSs are then sliced and diced into chunks, or CDOs, with different levels of risk. Those near the top, the ones with mortgages that are most likely to continue payments, would be rated AAA. The CDOs with the riskiest mortgages are rated much lower or not at all.