Ex-SEC Chief Cox says SEC could bring Lehman Case

Reuters

A bankruptcy examiner's report showing that Lehman Brothers may have filed misleading financial reports could lead to U.S. Securities and Exchange Commission charges, the former head of the SEC said on Tuesday.

Christopher Cox, who was chairman of the SEC when Lehman declared bankruptcy in September 2008, also said that neither the SEC or the Federal Reserve was aware that Lehman used so-called "Repo 105" transactions to artificially reduce its apparent leverage, as alleged in the report.

"The examiner's report of evidence that Lehman filed misleading financial reports and failed to disclose material accounting information... may provide the basis for SEC law enforcement action in that case," Cox said in testimony prepared for the U.S. House of Representative's Financial Services Committee.

Cox did not clarify whether he believes the SEC may be able to charge the firm or individuals.

Former Lehman Chief Executive Richard Fuld said in prepared remarks for the same hearing that he only learned of the firm's use of Repo 105, a controversial accounting technique, a year after the investment bank filed for bankruptcy.

The committee is exploring the public policy implications of investment bank Lehman's failure and the findings of the bankruptcy examiner.

Cox, whose agency was the primary supervisor for Lehman and other investment banks, did not appear in person, but submitted eight pages of testimony.

He said international bank capital standards at the time were not adequate to protect Lehman and other firms from shocks to the financial system.

Cox said he is concerned new stricter capital and liquidity rules are not yet in place.

"In my view, it remains a matter of the utmost urgency, in particular for commercial bank holding companies, whose ranks now include not only such large and systemically important entities such as Citigroup and Bank of America, but also the nation's largest investment banks," he said.

He also said that in the final days before Lehman filed for bankruptcy, it was still not clear to top government officials and Wall Street executives whether there would be federal support for Lehman.

"The lack of such clarity may have contributed to the demise of Lehman in September 2008," Cox said.

Lehman Examiner to Testify That S.E.C. Sat on Its Hands

NY Times

From left, Securities and Exchange Commission Chair Mary L. Schapiro, Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy F. Geithner testified before the House Financial Services Committee on Tuesday. 

 

The court-appointed examiner who dissected the Lehman Brothers bankruptcy is expected to criticize the Securities and Exchange Commission on Tuesday for its decision to “stand by idly” as the investment bank veered toward collapse.

The S.E.C. knew that Lehman did not have adequate liquidity and had exceeded its own limits on risk-taking but in essence did nothing, the examiner, Anton R. Valukas, will say in testimony released in advance by the House Financial Services Committee.

One of the most damning findings in Mr. Valukas’s 2,209-page report last month — that Lehman used accounting gimmicks to hide the extent of its indebtedness — was not known to the S.E.C. He wrote: “I saw nothing in my investigation to suggest that the S.E.C. asked even the most fundamental questions that might have uncovered this practice early on, before Lehman escalated it to a $50 billion issue.”

Prepared testimony of Richard S. Fuld Jr., Lehman’s chief executive, says that he had no knowledge of the accounting maneuvers, known at the firm as Repo 105 transactions. “I have absolutely no recollection whatsoever of hearing anything about Repo 105 transactions while I was C.E.O. of Lehman,” his statement says. “Nor do I have any recollection of seeing documents that related to Repo 105 transactions.”

The committee, which is examining the implications of Mr. Valukas’s report, has also summoned Treasury Secretary Timothy F. Geithner to testify, and Ben S. Bernanke, the Federal Reserve chairman. Mary L. Schapiro, who took over the S.E.C. in January 2009, has also been called.

But the testimony of Mr. Valukas is likely to be the high point of the hearing. His statement says there was no way of knowing whether the S.E.C. could have saved Lehman from a failure in September 2008 that caused the credit markets to seize up and threatened a wider catastrophe.

“But what is clear is that had the government acted sooner on what it did or should have known, there would have been more opportunities for a soft landing,” it says. “The markets might have been spared the turmoil of Lehman’s abrupt failure.”

Mr. Valukas wrote, “The S.E.C.’s role was not to simply absorb and acquiesce to Lehman’s decisions; the S.E.C.’s role was to supervise and regulate to protect investors and the markets.”

Both the Federal Reserve and the Treasury Department grew increasingly concerned about Lehman’s survival after the near collapse of Bear Stearns in March 2008, but both entities deferred to the S.E.C. as Lehman’s presumed regulator.

The S.E.C. chairman at the time, Christopher Cox, told Mr. Valukas that he believed that the agency’s jurisdiction “was limited to Lehman’s broker-dealer subsidiary and that it was not the regulator of Lehman itself.”

All five big investment banks — Lehman, Bear, Goldman Sachs, Morgan Stanley and Merrill Lynch — had voluntarily submitted to an S.E.C. regulatory program from 2004 to 2008. But Mr. Valukas said it was pretty much toothless.

“The S.E.C. made a few recommendations or directions here and there, but in general it simply collected data; it did not direct action, it did not regulate,” he wrote in his testimony.

Mr. Bernanke’s testimony states that “the Federal Reserve was not aware that Lehman was using so-called Repo 105 transactions to manage its balance sheet,” but adds that knowledge of the gimmicks would not have changed its view that “the capital and liquidity of the firm were seriously deficient.”

The statement notes that the Fed placed two examiners on site to monitor Lehman’s financial condition after it began taking part in an emergency lending program the Fed created in March 2008. “Beyond gathering information, however, these employees had no authority to regulate Lehman’s disclosures, capital, risk management, or other business activities,” it says.

Barclays Responds to Lehman

The Wall Street Journal

Barclays PLC is firing back in a court filing at accusations that the bank pocketed a secret windfall when it bought Lehman Brothers Holdings Inc.'s core U.S. operations days after it collapsed.

In its first detailed response to Lehman's allegations, London-based Barclays said the failed investment bank is making "a gross distortion" about the complex negotiations over the sale of Lehman's broker-dealer business. Barclays said Lehman and its creditors, which are fighting to claw back billions of dollars in assets, simply want to rewrite the terms of the deal because it was "too good for Barclays."

The filing is a response to claims by Lehman and its creditors that Barclays received possibly $12 billion in excess assets that were never disclosed. Lehman said the final details of the deal "bore little or no relation" to what was approved by the judge overseeing Lehman's bankruptcy case.

Barclays Capital agreed to buy the business a day after Lehman's bankruptcy filing in September 2008. After scrambling to put together the agreement, both sides continued to hammer out details while grappling with Lehman's deteriorating assets in the wake of its collapse, according to court documents.

At one point during those negotiations, as Barclays replaced the Federal Reserve's position in a repurchase agreement with Lehman, it received far less than the nearly $50 billion in securities it was supposed to get in exchange for $45 billion in cash it advanced to Lehman, Barclays said in the Friday court filing. The problem, which created "massive uncertainty and risk," wasn't rectified for months, it added.

Barclays also said it is still owed $3 billion in additional assets that it never received from the Lehman sale.

Lehman spokeswoman Kimberly Macleod said in a statement Friday that the deal at the time was described to Lehman's board and the court "as an equivalent exchange of value, with no embedded gain for Barclays."

"Because the court was never told, it never approved such a gain for Barclays," she said.

The court-appointed trustee, who is in charge of liquidating Lehman's broker-deal unit and who has joined Lehman's effort to recover assets, said in a statement that Barclays's argument is based on "strained interpretations of the sale agreements."

Lehman's lawyers have previously said that Lehman executives who negotiated the deal on behalf of the company "secretly structured" the agreement so that Barclays received a $5 billion discount on the value of securities it took when it replaced the Fed financing, plus billions of dollars in additional assets after the sale was approved.

But Barclays called this hidden discount "a fiction." Lehman, it said Friday, is relying on stale values for the securities that were delivered to Barclays under the repo. These assets were worth "little more" than the $45 billion in cash advanced to Lehman, it said.

The bank also argued in the filing that the extra assets added to the deal were disclosed to the court before the sale was approved and that the agreement never put a cap on the value of what they might be worth. It rejected Lehman's claim that the deal was structured as a "wash," with the assets equaling the liabilities it was assuming. Barclays made clear from the start, it said, that it expected to see an immediate accounting gain from the deal.

Barclays in February reported a gain of more than $4 billion from the sale, according to an earlier court filing by Lehman Brothers. In its court filing Friday, Barclays said that result was "far from guaranteed," given the turmoil rippling through global financial markets at the time, it said.

"One thing was certain, however: had the deal turned out differently, such that the plain text of the purchase agreement caused Barclays to incur a loss because the assets were worth even less than feared, Barclays would not have had the right to come back to court a full year later to ask for revised terms," Barclays said in its court filing.

Fuld Banished To Back Office

No Room at Headquarters As Barclays Takes Helm; Who Gets His Old Digs?

Napoleon cooled his heels on Elba. The Dalai Lama lives in Dharamsala, India. And Lehman Brothers Holdings Chairman and CEO Richard Fuld Jr. will be banished to 1271 Sixth Ave.

The building at 1271 Sixth Ave. holds some Lehman employees for whom there is no space in the main midtown Manhattan headquarters at 745 Seventh Ave. That included many of the administrative and back-office jobs as well as the corporate-communications team.

Now 745 Seventh Ave., festooned in cerulean blue, is the center of operations for the investment bank of Barclays, and there is no room in the new order for Mr. Fuld.

The move means Mr. Fuld will no longer hold the corner office at Lehman. On Monday, he and other senior Lehman executives who weren't offered jobs by Barclays are officially leaving the 31st floor of Lehman's headquarters and moving to the 45th floor of 1271.

While there, Mr. Fuld and some of his executive compatriots will go about their business of wrapping up what is left of Lehman. There isn't much left now, with the sale of Lehman's Americas business to Barclays, the European and Asian businesses in the hands of Nomura Holdings, and investment management in the fold of private-equity firms Bain Capital and Hellman & Friedman. But Lehman Brothers still is involved in the bankruptcy process, and Mr. Fuld and his cabinet are the cleanup crew.

The big question: Will Barclays President Robert E. Diamond Jr. get Mr. Fuld's old corner office?

By: Heidi Moore
Wall Street Journal; October 2, 2008

Where Was Lehman’s Board?

Figure Head Puppets Should Face Litigation for Empty Suit Behaviors

Nine of them are retired. Four of them are over 75 years old. One is a theater producer, another a former Navy admiral. Only two have direct experience in the financial-services industry.

Meet the Lehman Brothers Holdings Inc. external board directors, a group of 10 people who, perhaps unknowingly, carried the health of the world’s financial system on their shoulders the past 18 months.
lehman0915_art_200v_20080915172050.jpg
Lehman Brothers employees signed in green a portrait of Lehman Brothers CEO Richard Fuld, Jr.,outside the New York headquarters Monday, Sept. 15, 2008 in New York. (Associated Press)

As the world nervously awaits the effects of the unprecedented Lehman Brothers liquidation, one can’t help but wonder how and why this board let its long-time chairman and patron, Richard Fuld Jr., cling to both hope and power.

Perhaps it was because Mr. Fuld wanted it that way. Over the years, Mr. Fuld had become the living embodiment of the securities firm, creating a top-down culture that sometimes had a military feel to it. Most mornings, Mr. Fuld rode alone in an elevator up to his executive suite. His colleagues simply call him “The Chairman.” And it is telling that press accounts of Lehman’s capital-raising efforts focused entirely on the efforts of Mr. Fuld, and make nary a mention of the 10 other members of Lehman’s board.

Who was on this board? Until the 2008 arrival of former US Bancorp chief Jerry Grundhofer, the group was lacking in current financial-knowledge firepower. A number of the members did have past financial-markets expertise, but most of their working lives were tied to a different era: The one before massive securitization, credit-default swaps, derivatives trading, and all the risks those products created.

The board’s members include John Macomber, 80 years old, a former McKinsey & Co. consultant and chief executive of chemical-maker Celanese Corp; John Akers, 74, former IBM chief; Thomas A. Cruikshank, 77, chief executive of Halliburton Co. prior to Vice President Dick Cheney; and Henry Kaufman, 81. In the 1970s and ’80s, Kaufman, the chief economist at Salomon Brothers, was known as “Dr. Doom” for his bearish views on the U.S. economy. Ironically, in April, Mr. Kaufman termed the credit crisis a “global calamity” and criticized the Federal Reserve for “providing only tepid oversight of commercial banking.”

Other current members include: Sir Christopher Gent, 60, the one-time chief of mobile-phone company Vodafone PLC; theater producer Roger S. Berlind, 75; former Telemundo Chief Executive Roland Hernandez, 50; Michael Ainslie, 64, former chief executive of Sotheby’s Holdings; Marsha Johnson Evans, 61, one-time head of the Red Cross and a former Navy rear admiral.

Until 2006, Lehman’s board included Dina Merrill, the 83-year-old actress once featured in the old Katharine Hepburn movie “Desk Set,” as well as “Caddyshack II.”

How much was Lehman’s board monitoring the company’s on-going risk as it began accumulating its portfolio of real-estate assets and securities? In both 2006 and 2007, the risk committee of Lehman’s board met twice each year, according to Lehman’s SEC filings.

By: Dennis K. Berman
Wall Street Journal; September 18, 2008

Lehman Woes Pressure AIG, Merrill Lynch

Falling Shares Raise Questions About Capital

As the endgame plays out for Lehman Brothers Holdings Inc., pressure is rising on two other financial behemoths to take action to convince investors to stick with them.

On Friday, credit-ratings firm Standard & Poor's threatened to downgrade American International Group Inc., citing the significant decline in the company's share price and the increase in credit spreads on the company's debt. Meanwhile, AIG will likely hold an analyst call Monday morning and could announce a series of steps aimed at reassuring investors, including possible asset sales, a person familiar with the matter said.

AIG has hired J.P. Morgan Chase to raise money and is working with BlackRock, the asset management firm, on how to value its assets. One potential buyer could be private equity firm Blackstone Group, according to a person familiar with the situation. The firm didn't comment.

A rapid plunge during the week in the price of AIG shares -- the stock fell more than 30% on Friday alone -- coupled with equally worrisome signs for the insurance giant in the debt markets, appeared to increase the heat on management to act.

News of AIG's plan marked a turnaround in tone for the company, which just Thursday had maintained it was sticking with its schedule to unveil by late September the strategy of new chief executive Robert Willumstad. The company's stock has fallen steadily in recent weeks and is now down 79% this year.

Meanwhile, shares of securities firm Merrill Lynch & Co. fell 38% in the four trading days since concerns emerged about Lehman's viability as an independent company when talks to sell a stake to a Korean bank ended.

While both Merrill and AIG were roiled as Lehman-generated concerns rippled through the market, each has distinct sets of problems. The concerns about Merrill center on its holdings of the same kinds of assets, commercial real estate and residential mortgages, that required write-downs by Lehman. Those write-downs fueled the need for Lehman's own restructuring plan, announced on Wednesday.

Investors also are concerned that Merrill, despite having purged itself of most of its exposure to toxic mortgage assets, could have the weakest balance sheet of the three major independent securities firms that would remain after the demise of Bear Stearns in March and a sale of Lehman. The other independents are Goldman Sachs Group Inc. and Morgan Stanley.

Some Wall Street analysts estimate that if Merrill took markdowns comparable to Lehman's, it could face an additional $3.5 billion beyond the $5.7 billion hit announced on July 28 that accompanied Merrill's sale of mortgage assets to Lone Star Funds. That, some analyst say, could require Merrill to raise even more capital, further diluting investors, after the firm raised more than $23 billion in several different steps since last December to shore up its balance sheet.

New Lehman-like write-downs for Merrill could mean "they have another capital raise" in store, said David Trone, an analyst at Fox-Pitt, Kelton.

Others maintain the two investment banks' portfolios and business lines differ. Analysts say Merrill's $17.6 billion in commercial real-estate assets are higher-quality than Lehman's, which were written down by $1.7 billion to $32.6 billion. Lehman has holdings in apartment owner Archstone-Smith and California land developer SunCal Cos., whose value has weakened sharply.

Merrill also has $5.4 billion of commercial mortgage-backed securities and $5.9 billion of Alt-A mortgages, made to borrowers who don't fully document their income. Lehman wrote down its At-A mortgages by 38% during the third quarter. Merrill also has $33.7 billion in high-quality home loans to its brokerage customers.

Glenn Schorr of UBS AG said Merrill has "a bigger, more diversified franchise" than Lehman, particularly with its league-leading army of brokers serving individual investors, plenty of cash and an extra capital cushion in its 49% stake in money manager BlackRock Inc. However, he adds, Lehman's fate shows "the fragile nature" of investor confidence.

As for AIG, which has posted $18 billion in losses over the last three quarters, it's in a chicken-egg game. As it's stock and debt woes brew, it could face a ratings downgrade that would force it to raise capital. But the lower its stock price, the harder it becomes to raise capital. On the plus side, as an insurer, AIG has advantages that some other financial institutions don't.

It isn't vulnerable to a run on the bank for its standard insurance policies -- those typically are promises to pay future claims, not accounts subject to withdrawal. And AIG has a number of strong businesses it could sell to raise capital -- businesses that aren't as directly impacted by market conditions as those of investment banks. These include life insurance and property/casualty insurance operations in the U.S. and abroad, in addition to a consumer lending unit, a mortgage insurance unit and an aircraft leasing unit.

Still, investors and analysts weren't assuaged. Prices of some junior AIG debt fell Friday to distress levels of as little as 35 cents on the dollar, down from 65 Thursday morning. The current price represents a yield of 16%, said Tom Atteberry, a partner at First Pacific Advisors, LLC. AIG's most recently issued bond, a $3 billion 10-year note issued just a month ago, traded Friday at about 79 cents on the dollar, down from 93 Thursday.

By: Randall Smith, Liz Rappaport and Liam Pleven
Wall Street Journal; September 13, 2008

Lehman Faces Mounting Pressures

Stock Drops 45% as Capital-Raising Talks Falter; Firm Discusses Sale of Assets

Lehman Brothers Holdings Inc. came under mounting pressure Tuesday after hopes faded for an investment deal with a Korean bank, helping to trigger a 45% fall in the firm's shares.

Lehman's troubles mark the latest installment in the worst financial-system crunch in decades, coming just two days after the U.S. government announced its plan to take over the two giants of the mortgage business. U.S. stocks fell Tuesday, giving back gains that had greeted the weekend bailout of Fannie Mae and Freddie Mac.

The drop in Lehman shares highlights the continuing nervousness in markets as the company attempts to raise fresh capital to offset sharp declines in the value of its assets. Shares of Lehman, which is heavily exposed to troubled real-estate investments, have been under pressure for months and were down about 80% this year before Tuesday's drop. Investors have been frustrated as Lehman has taken months to pull together a plan to raise capital to absorb expected losses.

On Tuesday, credit-rating services Standard & Poor's and Fitch Ratings placed their ratings on Lehman on review for downgrades. S&P cited uncertainty about the firm's ability to raise capital, "based on the precipitous decline in its share price in previous days." If downgraded, Lehman may be required to post billions of dollars in collateral to its trading partners on derivative contracts and other agreements.

In an attempt to assuage investors, Lehman said late Tuesday that before markets open Wednesday, it will offer a preview of its third-quarter earnings and announce "key strategic initiatives."

The people familiar with the firm said Lehman plans to announce it is in talks with money manager BlackRock Inc. to sell a package of primarily British residential real-estate assets. Also, Lehman is expected to announce a separate plan to spin off some commercial real-estate assets into a new company, referred to internally at Lehman as SpinCo. The remaining portion of the firm, shorn of much of its distressed real-estate assets, is being called CleanCo, these people say.

Lehman has been shopping for investors to buy a piece of its investment-management unit, which includes the profitable asset-manager Neuberger Berman. Three private-equity firms are in the running for this division, with bids due late Friday night. People familiar with the company say this piece could bring in about $5 billion.

The 158-year-old financial firm was trading normally with counterparties on Tuesday. Rival Wall Street firm Goldman Sachs Group Inc. said it was doing business with the firm.

Lehman, one of four big independent firms remaining after the near collapse of Bear Stearns Cos. in March, declined to comment.

The firm's situation differs markedly from that of Bear Stearns, which was taken over earlier this year after it ran into a liquidity crisis. Unlike Bear Stearns, Lehman has access to new Federal Reserve facilities that can provide short-term funding when the markets won't, in addition to the ability to exchange illiquid assets for safer securities such as Treasurys.

That makes a sudden run on an investment bank less likely than it was a few months ago. The facilities for dealers weren't in place when Bear Stearns faced its crisis. The Fed does not disclose which institutions are using these facilities.

Deal Falters

Lehman's declines came after the Korea Development Bank, which has been in talks with Lehman about a capital infusion, said Tuesday it had closed the door on a possible deal. Discussions between Lehman and KDB ended in early August, according to a person familiar with the talks.

KDB said Wednesday it has ended talks with the investment bank "due to differences in transaction terms with Lehman and in consideration of the domestic and international financial market situation." It didn't elaborate.

But persistent rumors that a deal was still possible continued to bolster the firm's stock. The share decline helped drag down the rest of the market, which had rallied strongly on Monday after the bailout of Fannie and Freddie. Financial stocks tumbled more than 6%, including a 10% decline for Lehman rival Merrill Lynch & Co. and a 14% drop for Wachovia Corp., which is also struggling under the weight of bad mortgage loans.

By 4 p.m. Tuesday, the Dow Jones Industrial Average had shed 280 points, nearly wiping out the 289-point gain from Monday's session. Lehman shares last swapped hands at $7.79 each, their lowest level in 10 years.

The severe stock drop showed how skittish investors remain about Lehman, a bond-focused firm that moved aggressively into the commercial real-estate market and leveraged loans over the past few years, and often produced record profits between 2004 and 2007.

As the value of those investments has unraveled, Lehman has scrambled to raise capital to absorb the ensuing losses. Lehman's market capitalization stood Tuesday at $6 billion, down from $37.2 billion at the start of 2008. It has lost $4 billion in market capitalization in the past two days alone.

"It is a chicken-and-egg issue," said Tanya Azarchs, an analyst at S&P. When Lehman looks as if it's having trouble raising capital, shares fall. When shares fall, raising capital by selling shares gets harder. "Regardless of whether the rumor is true or not, in a way it becomes self-fulfilling."

Markets expect that continued losses on residential and commercial mortgage securities will force Lehman to seek still more capital than the $12 billion it has raised already this year. The firm's capital, or its shareholders equity -- about $32 billion -- is the cushion that protects creditors from any losses on its roughly $640 billion in assets.

Analysts are predicting the firm will lose as much as $4.6 billion and faces several billion dollars in write-downs on its real-estate portfolio.

Bonds issued by Lehman also lost value Tuesday, pushing some of their interest yields to more than eight percentage points above those of comparable Treasury securities. Debt investors "are understandably worried that the Federal Reserve and the Treasury Department don't have an unlimited appetite for bailout transactions," Kathleen Shanley, an analyst at Gimme Credit, said in a note on Tuesday afternoon.

In the market for credit-default swaps, where traders buy and sell private contracts that act like insurance against debt defaults, the annual cost of protecting $10 million of Lehman debt from default over five years jumped to $520,000 on Tuesday afternoon, versus $325,000 on Monday, according to data from Phoenix Partners Group. The higher cost indicates investors see a growing risk that the firm could default on its obligations.

In March, the cost of protection on Lehman's debt briefly hit a high of $580,000. Contracts on Bear Stearns's debt had peaked at around $820,000 before the investment bank was taken over by J.P. Morgan Chase & Co.

Lehman's preferred shares also tumbled to new lows, a development that could hamper the company's ability to raise additional capital by issuing more of these hybrid stock-debt securities. One issue -- Lehman Series J preferred shares -- fell more than 24% on Tuesday to $9.15, down from their issuance price of around $25. Lehman pays a fixed annual dividend of 7.95% on these shares, and their current prices reflect a yield of 16.6%, according to PreferredsOnline, a database for U.S. preferred securities. That means that to attract outside investors to new preferred shares, Lehman would have to pay prohibitively expensive annual rates of 16% or more.

Rating on Review

S&P, in placing its single-A rating on Lehman on review for a downgrade, said it might end up affirming the ratings but could also downgrade them by more than one notch. Lehman's short-term credit ratings could also be cut, which could affect its ability to tap money-market funds for cash in the short-term debt and overnight repurchase agreement markets.

Adding to the turmoil: The firm, which has 24,000 employees, cut 1,000 to 1,500 jobs Tuesday, its fourth round of layoffs this year. As employees cleared out their desks, colleagues stayed glued to television screens, watching Lehman's share decline. Outside the company's headquarters in midtown Manhattan, one employee, who declined to be named, said: "The market is biased against us."

Over the weekend, Lehman executives grew heartened by the government's rescue of Fannie and Freddie. They expected the plan to soothe the markets, particularly the battered financial sector.

Investors appeared agitated about Lehman, however, which for months has been loath to provide details about how it would find new capital. By failing to announce a solution before now, Lehman has backed itself into a corner.

In theory, the steep drop in its market value should make Lehman a more attractive takeover target. A more likely scenario may be for Lehman to continue to muddle through, using access to the Fed's discount window to fulfill its counterparty obligations.

"Clearly the company does not believe that it has a serious balance-sheet problem and it simply refuses to take what it believes are fire-sale prices for its key assets," Richard Bove of Ladenburg Thalmann & Co. said before Tuesday's stock drop. "Buyers seem to believe that Lehman is overvaluing its assets and refuse to hit the bid."

By: Susanne Craig, Randall Smith, Serena Ng and Matthew Karnitschnig
Wall Street Journal; September 10, 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