Is Lehman Headed for a Fall?

Wall Street rumor is a vicious creature. And it's been swirling around Lehman Brothers (NYSE: LEH) ever since the fall of Bear Stearns. There's got to be one prime candidate headed for a fall, and Lehman has been nominated to be the star of the show, cast as the next sacrificial lamb.

The latest rumor was that the world's largest bond fund PIMCO, the hedge fund giant SAC and other institutions were bailing out on Lehman, which then promptly rolled over and crashed 18%. The rumor was quickly squelched by Pimco's Chief Investment Officer Bill Gross who said on CNBC that Pimco is reducing neither the length of the trades with Lehman, nor the dollar amounts. And a spokesman for SAC Capital also came out saying that they're doing business as usual with Lehman.

Here's the thing - It's not important (except to the SEC) who puts out these rumors or why. The all important question is - Why is Lehman, and not any other firm, the target for all these rumors and the speculation. What makes it so susceptible to these rumors? Fact is that this rumor mill, while being a self-fulfilling kind of system, isn't all that off the mark, when it comes to finding the weakest victim ready to go belly-up.

So it's best to stick to 'what is', taking into account the rumors and all. 'What is' is that Lehman shares have lost 81% from a high point last year of $74.09 achieved on July 17, 2007. Even more damaging is the fact that bond investors are not so optimistic about Lehman's future and their credit-default swaps went up sharply on Friday to a four month high.

Also fact is that Lehman does have $60.8 billion worth of real estate, mortgages and related securities as of May 31st, the value of which is definitely going to keep dropping over the next year. Factor in Lehman's small equity base (currently $1 for every $25 borrowed) and you get an idea of why Lehman is so susceptible.

At this stage, the basic problem Lehman has is of ignoring the rumors, and keeping traders on board. Lehman is helped in this fight by the fact that the Fed is keeping the discount window open for primary dealers. If Bear Stearns had had this facility, it might never have gone down.

But it's not enough help for Lehman. What Lehman needs is to stay afloat until the real estate market rebounds. That's more than a year away, and the only way to survive this year is by de-leveraging and raising capital again. After declaring a Q2 loss of $2.8 billion, Lehman raised about $6 billion by selling $2 billion of convertible preferred stock and $4 billion of common shares. Lehman has sold about $130 billion in assets since April, and is taking steps to further reduce its leverage by selling about $120 billion more in assets this year. All this would bring its leverage ratio down from 25 to 15. Bear Stearns went belly-up with a leverage ratio of 34.

All these steps, while helping the firm to stay afloat over the next year, will also result in more pain for shareholders in the form of losses from discounted asset sales and write-downs in the next quarter or two, and diluted earnings over an extended period. The share will keep dropping, at least until the year end, and possibly even beyond. And every time Lehman announces a downgrade, the rumors will fly. But Lehman is not going to be the next victim. They are not going to collapse. They won't be in need of a bailout. It's an orderly retreat.

References:
http://www.guardian.co.uk/business/feedarticle/7643997
http://blogs.wsj.com/marketbeat/2008/07/11/lehman-taking-a-beatingagain
http://www.nytimes.com/2008/06/10/business/10lehman.html
http://www.bloomberg.com/apps/news?pid=20601109&sid=awH4lSOm6eDk

Comments

[Jimmy Lathrop:]

Lehman's story is going to be repeated amongst hundreds of banks. A long period of selling in order to recapitalize balance sheets will acts as a constant undertow in all indexes. Government intervention and black box selling programs providing buying support can't avoid this impending decrease in asset prices across all categories, the economy dying by a thousand cuts rather than two or three slashes.

2008 Jul 13 02:50 PM

[kaboom:]

the companies that are "victims" of rumors also have other traits that are similar across all that have run into trouble: 1) excessive leverage, 2) exposure to real estate, 3) off balance sheet assets, etc. and the regulatory jerkoffs are seeking to cast blame for lower prices on the shorts instead of on the business practices that lead to insolvency.

2008 Jul 13 06:50 PM

[pelican:]

"Here's the thing - It's not important (except to the SEC) who puts out these rumors or why."

***Has to be the most idiotic statement I've read in some time. Spreading false rumors undermines coinfidence in the system and can be a self-filling prophesy. Stocks prices falling making it harder to raise capital. Maybe GE doesn't get hit as hard by false rumors. But those rumors, perpetuated by unscrupulous traders preying on companies where confidence is much more critical to day-to-day operations, matter to people who work at those companies and may lose their jobs, investors who may lose their money, and in a broader sense the intergrity of the financial system itself. So rumors are not that far off the mark, huh? I remember five/six years ago Tyco traded below $7/share because a rumor surfaced that they were going bankrupt. Post-Enron, somebody thought they could take advantage of the fear prevalent at that time and so the rumor was TYC's businesses really didn't have any revenues. It was ludicrous. Tyco acquired companies like AMP, CIT, etc., unrelated to each other, when they were booking real profits, and yet people got so hysterical at one point that for a while they somehow convinced themselves that Tyco would go belly up. Was there reason to be concerned? Sure. The CEO was stealing from the company. But how do you get from that to a $50 billion company which people back then, for a short while, started to think had no real revenues? Answer: viscous rumors.

LEH has been the target because everyone remembers Bear Stearns. WM and a host of others are is in worse shape than LEH but they aren't targeted like LEH because its not as easy to kill with false rumors. I don't necessarily disagree with your analysis of the fundamental landscape for LEH. But so many such as yourself seem to downplay the seriousness of the impact these rumors have, and there is a tendency to dismiss them too easily. BSC's leverage ratio could have been 35, 55, or 15, it wouldn't have mattered as long as confidence erodes and customers' anxiety levels have risen to the point where they no longer want to do business. If the rumors are strong enough and go unchecked the potential to bring down a GS is there too.

2008 Jul 14 12:55 AM

[Fish Gone Bad:]

Do you remember that song from Men Without Hats, The Safety Dance? "We can dance, we can dance, everything is under control". Perhaps not. Einhorn was so so very right. Lehman has now not only melted, but OMFG really melted. Time will tell if Einhorns's (Greenlight Capital RE) insight is more than a one trick pony act.

2008 Jul 14 01:20 AM

[R2D2:]

Does anybody have any information on Lehman's crooked R3 scheme?? I can't believe no one is following this one...

2008 Jul 14 08:04 AM

[williambanzai7:]

What attracts flies? Lehman.

2008 Jul 14 02:24 PM

[Quentin:]

trouble with Lehman is that they deserve what's coming to them. too many excesses and risk taking in the past. rumor mongering is part and parcel of today's trading environment. cannot live without it. today is sell on facts... sell more on rumor ! lehman has also not been too clear in their disclosures to shareholders and public. say everything is fine and then major changes at senior level. does this signal everything is fine. lehman is letting the rumor get the better of them. they need to put out clear and concise statements rather than having to defend themselves each time a rumor starts. perhaps beging to have weekly information about their financial position with question and answer session with analyst.

2008 Jul 15 05:35 AM