Lehman's second quarterly earnings, due the week of June 16, are expected to be vastly more negative than its prior quarter, in which Lehman beat earnings expectations and told Wall Street it has lots of liquidity to weather the credit storm.

The markets then heaved a sigh of relief, given the suicidal feeling on Wall Street at the time due to Bear Stearns' near collapse.

Though Lehman is expected to report strong revenues and market-share gains in a variety of businesses, here's what you should watch out for. I've bullet-pointed them below.

Ignored in Lehman's first quarter results was its sagging balance sheet, the fact that Lehman's assets and leverage had risen and also its quirky accounting moves that made its profits and important valuation measures look better. All perfectly legit under the accounting rules, I've warned you about the growing use of accounting gimmicks on Wall Street (see "Bankers Cry Uncle" and "Merrill's Neat End-Run").

Ignored in its first quarter figures were Lehman's tiny writedowns on its most-watched securitized assets of just $200m, which has since drawn growing criticism that the firm is moving at a glacial pace to mark down the value of degraded inventory in the form of bad assets on its balance sheets, assets backed by sour residential and commercial mortgages and other credits.

Talk now is that Lehman's balance sheet is so damaged from bad real estate loans and other credit--it has traded recently below book value--that Lehman may be forced either to issue more dilutive equity, or sell a part, or all, of itself to a larger firm.

Yesterday shares in Lehman traded down as much as 15% on rumors that it is doing possible emergency capital raising of as much as $4b in advance of potentially bigger writedowns when it reports within two weeks. Potential investors named include the Korea Development Bank and Woori Financial Group of South Korea, also CV Starr, the investment vehicle of Hank Greenberg, former chairman and chief executive officer of AIG, and China's State Administration of Foreign Exchange, reports say.

Lehman told Fox Business's Liz Claman yesterday that it doesn't need to raise capital and that "it has no plans to do so." It has already raised $8b, it says it has more than $40b in liquid assets, up from $34b in the prior quarter. It also says that its holding company had unencumbered assets of $64b and its regulated units had $99b at the end of the last quarter. It had $7.6b in cash and equivalents on the balance sheet as of the last quarter.

And while it now has access to funding from the Federal Reserve, Lehman has quelled rumors it's on the brink by stressing it has not gone to the Fed for funds, having only done a test run at the window in mid-April.

However, the stock is now down about 60% from its peak and the potential capital raise, estimated at $4b, would be about a quarter of its $17b market cap. Its market valuation is down from $45b within the past year.  

Yesterday's trading alone vaporized $1.7b off of Lehman's market cap, and the closing price was Lehman's lowest since the summer of 2003, though losses would have been worse absent the stock buybacks the firm did yesterday.

Hold on to this cheat sheet when Lehman reports its quarterly earnings in coming weeks:

*Lehman's teensy write downs.Lehman ended the prior quarter with $67.9b of real estate assets, including residential and commercial loans. It had $39b in illiquid assets that swamp its shareholders equity by about one and a half times, called level 3 assets (see blog "What to Watch Out for at Lehman," and "The Answer to Who's Next on Wall Street"). But it only took a $200m writedown in the first quarter, disclosing too that it had $6.5b in "other asset-backed securities," which includes potentially $1b in toxic collateralized debt obligations. These numbers are important. Lehman also had $14.6b in prime and Alt-A (considered one step away from subprime) mortgage assets last quarter, up from $12.7b in the prior quarter. Watch to see if Lehman continued to increase that line item--sort of like Citigroup's ousted chief executive, Chuck Prince, saying he's continuing to "dance" in subprime last summer.

*Lehman's sagging balance sheet.Lehman's total assets of $786b at the end of its fiscal first quarter was up 14% from the fiscal fourth quarter of 2007 and a steep 40% a year earlier (that's nearly twice the size of Bear's assets at $399b). Of that sum, a big $695b was for its financial instruments and collateralized agreements. Sanford Bernstein estimates that one third of Lehman's assets are illiquid or "less liquid." It also had $761b in total liabilities (compared to Bear's $387b). Lehman now seeks to unload damaged assets, with a reported $100b sold, but it faces a frozen market already struggling to digest the potentially $500b in assets Citigroup is also seeking to dump. Lehman and the rest of Wall Street need to do so because their balance sheets are highly leveraged.

*Lehman's high leverage ratio. This is a key measure. Gross leverage compares how much a company has borrowed versus its assets. It is defined as total assets divided by total stockholders equity. The higher the ratio, the less assets need to fall in value before a company's equity is erased. Lehman says its gross leverage ratio is now at 25:1 versus 32:1 at the end of the first quarter. That means for every buck of assets, Lehman now says it had borrowed $25, down from $32.

Lehman has chopped that ratio down through more than $100b in asset sales, given that the 32:1 ratio in its first quarter was the highest ratio at Lehman since 2000, Sanford Bernstein Research says. That ratio was also much higher than the 28:1 it had recorded in the first quarter of 2007. 

And although much of Wall Street, including Lehman, would like you to use a figure called net leverage which looks a lot better, (for Lehman, it was 15:1 in its first quarter, essentially flat versus the prior four quarters), don't be fooled by that figure as it does not include hedges. Lehman has made wrong way bets on its hedges lately, calling into question its risk management procedures.

*Lehman now includes debt in its calculation of book value. What caught my eye was not just Lehman's tiny $200m asset writedown, but also the way it measured its net worth, in which it included debt instruments as part of equity in order to add extra sheen to that valuation measure.

This is a key measure for Wall Street firms.Lehman concocted a new definition of its hard assets, what is known as "tangible equity," to now include all long-term junior subordinated borrowings. To persuade you, it calls this debt "equity-like" due to their "long-term nature."

Translation: This is merely a weird debt instrument with no maturity date, in other words, they act much like an open-ended line of credit. Did those items help its leverage ratio? Yes. Prior to the last quarter, Lehman capped at 25% of tangible equity the amount of these gizmos as well as preferred stock that it included in its shareholder equity. In the fourth quarter Lehman did not include $237m of them, and $375m in the third. Now, no longer.

*Lehman booked profits on its liabilities.Yes, you read that right--it's a perfectly legit accounting move (under SFAS 157 and SFAS 159) that tosses out the window the concept "quality of earnings." Accounting rules let investment banks count as gains in profits the amount they forgo in their liabilities. When debt falls in value, companies get to book in earnings the difference. Lehman recorded $600m in profits from this move, again, allowed under accounting rules. Meanwhile, it posted $489m in profits. When you see accounting moves like these--again perfectly legit--you should ask, how healthy are the profits from continuing operations?
   
*Wrong way bets on its hedges.Lehman is estimated to have lost $500m to $700m on hedges in the second quarter, potentially widening its anticipated losses in the second quarter, losses that would be the first since Lehman went public in 1994. Lehman apparently used the hedges to offset losses in real estate and other credit.

Specifically, the firm reportedly bet that "indexes tracking markets such as real-estate securities and leveraged loans would fall. If that happened, it would book profits that would make up some of its losses from holding these securities and loans," the Wall Street Journal reports.

Yet some of the indexes actually rose, even though the assets they were supposed to hedge against continued to lose value or stayed relatively flat. Coupled with Lehman's losses from write-downs on assets and ineffective hedges, you may see a profit hit topping $2b, the Journal says. The paper added you may see more layoffs as well.

Footnote: You should ask yourself, how can any firm think it can hedge illiquid assets? Doesn't this sort of sound like the "chaos trade,' basically bets on chaos in the markets, that Bear Stearns entered into to hedge its risk exposures before it nearly collapsed? Shouldn't Lehman just devote its energies to selling those frozen solid assets instead?

*Lehman's put option trading has exploded.Trading of Lehman put options--options to sell the stock and profit if it falls--rose to nearly 284,000 contracts, four times the 20-day average, with bearish bets on Lehman topping bullish ones by 1.6-to-1, analysts note. Check this out: The most-active contracts were June $30 puts, which gained 68% to $3.35, according to one analysis. The open interest in Lehman puts is through the roof. Many of these strikes only pay off if Lehman collapses like Bear Stearns, with the bankruptcy strikes below $15, many expiring this month, implying traders think the clock is ticking (Lehman's shares have already breached other put levels at $35).