Lehman Brothers: Accomplishing What Bear Could Not?

This week’s news that Lehman Brothers (LEH) maybe forced to undertake a substantial capital raise has caused significant distress in the company’s stock and the financial markets in general.  Lehman Brothers, like other investment banks, is at its core built on two things: liquidity and trust.  Unfortunately, when either of these is lost, investment banks tend to cease to function as independent companies.  Bear Stearns (BSC) is only the most recent example of this occurring.

Lehman Brothers' efforts to raise fresh capital have caused the market and the company’s trading partners to fear that the company is running short of liquidity and free capital.  When these trading partners, such as hedge funds, asset management companies and other institutional investors, become afraid that Lehman Brothers will be unable to keep up its side of the trades that it undertakes, due to a lack of capital on the investment bank’s part, it is only natural for these firms to lose trust in the company.  If Lehman Brothers trading counterparties pull their business from Lehman Brothers due to a lack of trust, they will affect the firm’s liquidity position, leading to a vicious cycle.  If handled poorly such a scenario could very easily bring down the company.  This same vicious cycle managed to force the sale of Bear Stearns to JPMorgan Chase & Company (JPM) in March. 

In order to restore confidence in the company the executives of Lehman Brothers must reaffirm to the market that the firm is in strong shape.  The best way to do this is for the firm to undertake a massive capital raise as it shows that outside sophisticated investors, along with management, believe that the company can survive the current storm in the credit markets.  According to the Wall Street Journal, Lehman Brothers is attempting to raise $3 - $4 billion dollars before its quarterly report in mid-June to help the company offset the losses it has experience in the credit market during the current quarter. This is on top of the $4 billion dollars that the company raised earlier in the year.

This capital is vitally important for the company, as it will allow the firm to survive what have been at times ineffective hedges and any future write-downs in its mortgage portfolio.  The market has viewed this new capital raise as a sign of weakness; I however, view it as a sign of strength.  If the company were really in as bad a shape as shorts such as David Einhorn have stated, then why would other sophisticated investors throw more money at the company?  Lehman Brothers' balance sheet, to state it simply, is huge; this has been one of Einhorn’s most useful weapons as it has allowed him to continually point to deeper problems in the company.  Any large investor being solicited by the company for capital would likely be allowed to go through the balance sheet in detail before making an investment.  If they were to invest after going through the balance sheet, I would feel confident that the worst would be behind the company. 

The very fact that Lehman Brothers has already pulled down $4 billion this year and is actively seeking more stands in stark contrast to Bear Stearns, which received a paltry $1 billion from Citic Securities (most of which was earmarked for investing in Citic Securities at a future date).  According to the most recent series on Bear Stearns in the Wall Street Journal, the management team of the company led by Alan Schwartz had six opportunities during the firm's final months to take in further capital, all of which fell through.  While Schwartz was quoted in the WSJ as saying that, “I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference” it should be clear that the firm’s inability or for that matter its unwillingness to raise capital was what allowed the firm to fail.  Bear Stearns simply failed to protect the trust that it had built up between itself and its clients. 

In raising further capital Lehman Brothers is not marching down the path of Bear Stearns as some market pundits would suggest.  The situation the company currently finds itself in is very much the antithesis of what Bear Stearns found itself in and for that we should all be thankful.  Lehman Brothers management clearly realizes that they have a responsibility to their bondholders, shareholders and the financial community at large to remain a functioning player in the financial market.  Raising further capital is in my opinion a net positive for the firm and allows them to fulfill their responsibilities.  While dilution will likely occur, it should be considered a necessary evil, as ensuring the firm's survival is paramount.   

If the current capital raise is completed as expected the firm will likely restore the markets trust in the firm as well as pad its liquidity position, doing so will ensure a bright future for Lehman Brothers.  

Disclosure: None

Comments

[venividivici:]

A so called "prudent speculator" pumping idiot speculators. Keep pumping old boy! Lemon needs all the pumping they can get.

2008 Jun 05 08:52 AM

[Zenvestor:]

With all due respect, I don't agree with evaluating the potential of a company simply based on what a handful of institutional investors may or may not do. After all, if one was to base one's investment decisions simply on what the rest of the crowd is doing, you would have invested heavily in subprime mortgages two years ago. You are assuming that institutional investors are somehow a measure of "prudent" investing. And as we all know, the last year has proven that even the venerable UBS made some astoundingly imprudent investments. Fundamental analysis of Bear Stearns is the only true measure of Lehman's health and that's what Einhorn is doing.

2008 Jun 05 10:40 AM

[Prudent Spe...:]

Zenvestor, you are right buying a stock based on what a handful of institutional investors do is not smart investing. Perhaps my article wasn't clear enough. I in no way would advise anyone to invest in Lehman Brothers given the current situation. It is important to note though that others would and the fact that Lehman can convince them to do so is a good sign for the market in general. Their success in raising capital should stand in stark contrast to Bear Stearns which failed miserably in its own efforts to raise capital. In my opinion, there is a clear difference between the two as a result. That is why I believe that you can't throw Bear Stearns and Lehman Brothers into the same boat.

2008 Jun 05 05:32 PM