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Friday, June 13, 2008

Decision Time for Lehman

Balance-Sheet Woes Most Likely to Force Big Strategic Shift

It is time to sort out the Lehman problem.

With its stock falling two days in a row, investors see Lehman Brothers Holdings Inc. as the latest firm weighing on financial stocks.

The problems in Lehman's balance sheet could force the firm to issue a large amount of equity or to sell part, or all, of itself to a larger financial firm.

While such options would be excruciating for the company's management and existing shareholders, that may be what it takes to bolster confidence in the investment bank and to stop concerns about the firm affecting the wider financial system.

Following an 8.1 percent drop Monday, Lehman shares slid 9.5 percent Tuesday. The latest decline came even though Lehman was buying back large amounts of its own shares. Tuesday in New York Stock Exchange trading, Lehman shares were down $3.22 at $30.61, 22 percent below their book value the measure of a company's net worth based on assets minus liabilities at the end of February.

The steep discount to book value apparently reflects investor discontent about the values Lehman has placed on its assets, many of which are backed by distressed real-estate loans. And the discount is also a sign that investors doubt management's ability to navigate this crunch.

Lehman is scheduled to report a loss for its fiscal second quarter, ended May 30, when it reports results the week of June 16.

Lehman's first option is to raise a large amount of capital. The Wall Street Journal reported Tuesday that Lehman was weighing whether to issue as much as $4 billion in new stock. But Tuesday's drop in Lehman's share price the stock was down about 15 percent at one point during the day makes it harder to sell new stock.

Selling at this level would be more expensive for the firm, especially if a buyer demanded a steep discount to the current depressed price. Lehman's market value has fallen to about $17 billion, so even a $4 billion capital raise is nearly equal to about 25 percent of the firm.

And investors may want to see Lehman raise even more than $4 billion to cover any future losses from marking down the value of its assets. Lehman is likely to report large losses on trades made to hedge assets in the second quarter. And critics argue that Lehman has lagged behind in marking down the value of assets backed with distressed residential and commercial mortgages.

There is another important reason why Lehman may need new capital: It likely needs extra cash to forestall another downgrade by ratings agencies.

Standard & Poor's Corp. Monday downgraded Lehman to single-A from single-A-plus, but kept the firm on negative watch. Lehman had indicated that such a downgrade could force it to post about $200 million in additional collateral to back derivatives trades.

Another downgrade could force the firm to post $5.4 billion in additional collateral, according to a note Tuesday from Brad Hintz, an analyst at Sanford C. Bernstein & Co. and a former Lehman chief financial officer.

Lehman's other option is to sell a stake to another firm or to sell out completely. The problem here is that the credit crisis has left few prospective buyers. So who might be left to step up?

At the right price, Lehman may make an attractive target for a private-equity firm or hedge-fund group that wants to add brokerage and investment-banking operations. Blackstone Group CEO Stephen Schwarzman is a Lehman alum who has long wanted to add more investment-banking businesses to his firm.

Citadel Group, a money manager with some sales and trading operations, may want to do the same. J.C. Flowers proposed buying Bear Stearns before its collapse, so interest from that buyout group wouldn't be a surprise.

A large commercial bank may also be drawn to Lehman at a discount to book value, especially if it gets time to go over the investment bank's assets to assess their value.

It is possible that Lehman, which survived the 1998 market meltdown and the credit crisis in March, can weather the latest storm. Lehman does have some time to work out if it wants to do something drastic, like sell out. Lehman can avoid a short-term funding squeeze since it can borrow directly from the Federal Reserve, but the Fed could get impatient if Lehman doesn't do something soon.

So, it can't put off the tough choices for much longer.

By: Peter Eavis & David Reilly
Wall Street Journal