Is It Getting Personal at Lehman?

Barron’s

 

UP AND DOWN WALL STREET DAILY  

 

By RANDALL W. FORSYTH

The broker buys back shares when it was thought to be issuing equity. Recall the CEO's vow to "hurt the shorts."

Voltron says: “Bring it!”

IS IT BUSINESS OR IS IT PERSONAL? In The Godfather, the distinction was clear. On Wall Street, sometimes it isn't.

Tuesday evening, our sister site, WSJ.com, reported that Lehman Brothers Holdings (ticker: LEH) went into the market to buy its own shares -- less than 24 hours after the investment bank reportedly was mulling issuing $3 billion to $4 billion in common equity.

This would mark a turnabout bordering on the bizarre. One day, a company is in need of additional capital to shore up its balance sheet being rent by losses and writedowns. The very next day, this same company has a surfeit of capital that cannot be economically put to work, arguing for money to be returned to common shareholders. Or so finance textbooks would assert.

Can a corporation be under-capitalized one day and over-capitalized the next? Not likely. But perceptions about Lehman's financial strength continue to be in flux.

Rumors flew Tuesday that the broker had borrowed from the Federal Reserve, to avail itself of a privilege only recently expanded beyond commercial banks. "We did not access the Primary Dealer Facility," as the Fed's loan program to investment banks is called, Lehman's treasurer, Paolo Tonucci, said.

That reassurance helped to lift Lehman shares off their lows, from a loss as much as 15% Tuesday, to a decline of 9.5%, or 3.22, to 30.61, on massive turnover of over 133 million shares, more than four times. Still, over just the past three days, Lehman's stock has fallen 18%, bringing it to its lowest level since August 2003.

Buying in stock when its price is low makes sense on the surface, but not necessarily for a financial institution employing substantial leverage and dependent on access to financing a balance sheet with assets of uncertain value in a dicey market.

But there can be other motivations.

At Lehman's annual meeting in April, just a month after the deal for Bear Stearns to be taken over by JPMorgan was announced, CEO Richard Fuld declared: "I will hurt the shorts, and that is my goal." The shorts are traders who have borrowed Lehman shares and sold them short in the expectation of buying them back at a lower price.

There have been a vocal cadre of bears on Lehman. They contend it faces further writedowns of assets, notably those related to subprime mortgages, and has to raise additional equity as a result. Thus far, Lehman has shored up its capital by issuing $4 billion in equity and $6 billion in long-term debt.

According to veteran analyst Richard Bove at Ladenburg Thalman, Lehman also has attempted to make its balance sheet more liquid by shortening the maturity of its assets. He estimates Lehman has $34 billion in very liquid assets to protect against a run on the investment bank.

"What the company did not do, and is now attempting to do, is shrink the size of its balance sheet," Bove writes in a research note. "In the first quarter, Lehman actually ballooned its balance sheet to $786 billion from $691 billion. It did this to garner increased earnings by jumping volume on thin spreads. This is a classic maneuver by a financial company and is virtually always a mistake."

Now, however, Lehman is attempting to reverse course and shrink its balance sheet to maintain its credit ratings. "This, of course, compounds the first error," Bove continues. When the Street knows a firm needs to liquidate assets, it exacts a high price. That means Lehman likely will find it tough to sell off assets and will have to take losses, he says.

Bove estimates Lehman only broke even in the quarter ended May 31 owing to bad financial hedges. And that may prove too optimistic. The resulting possible losses could force the company to raise an additional $4 billion in equity, which would result in 15%-20% dilution.

"Lehman is in for a long, tough period ahead," Bove concludes. "It is making too many classic mistakes. What is shocking is that these mistakes are being made by people who should know better."

But if the CEO's avowed goal is to "hurt the shorts," it makes perfect sense to use scarce liquidity to buy back shares, even when prudence would suggest issuing equity.