Lehman Brothers-What's Next?

Lehman Brothers is done cutting down its balance sheet and says it's ready to take some of the $6 billion in capital it raised this week and make riskier trading bets based on "opportunities" it sees in the markets.

The question is whether people believe Lehman still has plenty of new opportunities to rebuild after the credit crisis decimated Wall Street's powerful fixed-income machine.

Though it has diversified into deal advisory and other activities, Lehman is still a big force in the fixed-income business, and that will likely mean its return to the profits it has enjoyed in recent years is still a way off. Its second quarter closed with an unexpectedly large $2.8 billion loss, thanks in large part to $4 billion in write-downs.

While Lehman was getting bigger in the structured products businesses that have been caught up in the credit crisis, the big commercial banks elbowed into more plain vanilla bond activities and now dominate the quarterly rankings of underwriters, says CreditSights analyst David Hendler.

"The competitive landscape has changed dramatically and makes it difficult for a fixed-income centric company like Lehman to thrive," Hendler says.

Lehman's second quarter, officially announced next week, was a period in which revenues were pressured almost across the board compared to the same quarter last year, before the credit crisis erupted.

Ratings agencies have taken a dimmer view on investment banking outlooks lately. Moody's (nyse: MCO - news - people ) put Lehman on negative outlook Monday, while Standard & Poor's went ahead and cut Lehman's credit ratings last week along with the ratings of Morgan Stanley (nyse: MS - news - people ) and Merrill Lynch (nyse: MER - news - people ).

And because of that downgrade, clients of the firm are limiting trading with Lehman's unregulated derivatives subsidiaries, says Brad Hintz, an analyst at Sanford Bernstein.

"We expect this pullback by counterparties will hurt the earnings of the firm's fixed income, equities and commodity derivative franchises," Hintz said in a research note last week.

Lehman disputes it is having trouble with counterparties.

But, perhaps acknowledging that it has been criticized for playing its cards too close to its vest in its disclosure of exposures, said it has taken a cumulative $17 billion in write-downs since last year, including $11 billion from residential mortgages, $3.5 billion from commercial mortgages and $2 billion from leveraged deal financings.

It offset them by $7.5 billion in gains from its hedging activities, which broke down in the second quarter and so couldn't help make up for losses as it had in prior quarters.

In addition, it sold $130 billion of assets during the quarter, the much discussed de-leveraging that all Wall Street banks are undergoing. But that doesn't mean it won't have more write-downs ahead.

The pre-announced quarter results Monday didn't quiet one critic, David Einhorn of Greenlight Capital. Einhorn, who is betting on a decline in Lehman shares, says Lehman has issues with its financial disclosures, hasn't taken write-downs that accurately reflect its exposure and needs to reduce leverage and raise capital.

Even though Lehman did take write-downs, reduce leverage and raise capital in the second quarter, he says it's not enough. "Lehman is raising $6 billion that they said they didn't need to replace losses that they said they didn't have," Einhorn said Monday.

"Since the credit markets actually improved this quarter, such losses primarily reflect losses that might have been taken in prior quarters. A preliminary analysis of the pre-release and conference call suggests that there are still unrecognized losses on the balance sheet."

The uncertainty around Lehman, despite the company's efforts to dispel it, makes it a takeover possibility, Hendler says, though it's difficult to say just which bank would make the first move.

Among the U.S. banks with big, diverse balance sheets, JPMorgan Chase (nyse: JPM - news - people ) is busy integrating Bear Stearns (nyse: BSC - news - people ) and wouldn't have the appetite for another deal, at least not for an investment bank. Citigroup (nyse: C - news - people ) has its own issues of reducing leverage. Bank of America (nyse: BAC - news - people ) is facing the closure of its deal for Countrywide Financial (nyse: CFC - news - people ). Wachovia (nyse: WB - news - people ) just fired its chief executive and seems ill-inclined for deal-making, unless it involves the sale of itself to some other company.

Foreign banks, particularly Barclays (nyse: BCS - news - people ), have been rumored to be interested in buying a chunk or all of Lehman. But they also have been dealing with the effects of the credit crisis.