Investment Banks Update: Lehman Brother's Preferred Offering
Lehman Brothers (LEH) has announced a preferred stock offering to raise $3B in new capital. The preferred will have a yield between 7-7.5% and a conversion premium of 30-35% over the common stock. Though the deal has not closed yet, the word is that the offering is three times oversubscribed. Lehman is running the book themselves so there is no underwriting fees to be paid here and all the capital raised will go to increase Lehman's equity base.
Lehman's stock has been under considerable pressure following the run on Bear Sterns (NYSE:BSC). There were massive out of the money put purchases that contributed to the fear cloud. This has also attracted a lot of retail shorts who are expecting another Bear Sterns-type buy-under. Perhaps they do not realize that even deep out of money puts ($25 strike with stock at $40) can easily double or triple in value with a $5 movement in stock-price; the increase in volatility in large downward moves increases the value of the puts.
The news about the preferred sale sent Lehman's share down to as much as $35.30 from their 4:00PM close of $37.64. The Fast Money crew raised questions about why Lehman had to raise capital in this environment if they were not facing any liquidity issues. Some investors are concerned about the dilution faced by the common equity holders; others are concerned about the potential effect on the dividend for common equity holders.
Asset Sale versus Raising Capital
I think it is important to review the offering in its broader context. It is very clear that investment banks will have to de-leverage. They can do this by either selling assets or raising more equity. In the dysfunctional markets we are in, selling assets is not the most profitable option. However interest rates are low, so raising equity capital via preferred offerings is not that expensive.
Why Raise Capital Now?
Some observers have questioned the need to raise capital when Lehman has been outspoken in announcing that their liquidity situation is excellent. However, we are in an environment where well capitalized investment banks can generate high return on equity with very little risk.
Investment banks now have access to the Fed's balance sheet where they can borrow from the Fed against a variety of collateral, including asset backed securities. The result of the first Term Securities Lending Facility Auction showed that investment banks borrowed at a spread of 33 basis points, i.e. they could use their investment grade bonds as a collateral and get treasuries (as good as cash) at a rate equal to the yield of the treasury plus 0.33%.
So Lehman Brothers can use the $3B they raised to buy $30B in AAA rated mortgage bonds which are currently yielding about 5.5%. They can use the TSLF and park these bonds with the Fed borrowing at the rate between 2.5 to 3%. This allows Lehman Brother's to book a spread of 300 BP leveraged at 10x translating to 30% return on equity.
The 7% dividend on the preferred pales in comparison with 30% ROE! Do note that even before the Fed stepped in LEH had an ROE of around 20%. Reduction in leverage levels will reduce the ROE in the future but it will still be higher than the 7% dividend yield on the preferred.
Balance Sheet Strength
Raising the cash allows Lehman to be better positioned to weather any future writedowns in its portfolio. It also allows them to put their cash to work if distressed liquidation temporarily lowers the price of high quality securities.
There is some concern about the dilution of the common equity. Based on the available news, the preferred will be convertible at a premium of 30-35% of the current stock price. This provides sufficient room for the stock price to grow before the conversion
Lehman's ability to raise a large amount of capital on decent terms while it was under a cloud will help the overall confidence of the capital markets. It will dispel market rumors and help the markets to return to normal sooner. The Treasury and the Fed have been encouraging the banks to raise more capital and will welcome this move. I believe Lehman's move is bullish for the price of the common stock, and investment banks in general.