Tuesday, June 3, 2008

Lehman Says Cash Holdings Rise As Rumors Swirl

Lehman Brothers Holdings (LEH) shares closed down nearly 10% Tuesday as investors worried about dilution from a potential capital increase, and as the firm disputed rumors that it had borrowed from the Federal Reserve.

Investors' concerns about Lehman's liquidity and ability to fund its operations were so great that Lehman issued a statement Tuesday afternoon denying rumors it was forced to borrow money from the federal government to support its business operations.

"We did not access the primary dealer facility (Fed Window) today," said company treasurer Paolo Tonucci, breaking a "quiet period" in the weeks between the end of the fiscal second quarter on May 30 and the actual reporting of results in mid-June. "The last time we accessed the facility was on April 16 for testing purposes."

Prior to the statement, Lehman's shares skidded as much as 14.6% to $28.90 following a report in The Wall Street Journal that the company is likely to report a loss in its fiscal second quarter and shore up its capital by raising between $3 billion and $4 billion of new equity. Shares closed Tuesday down $ 3.22, or 9.5%, to $30.61. In recent late trading shares are down to $30.50.

Investors who have seen Lehman's shares decline 58% in the past 12 months would not welcome further dilution. But their distaste must be balanced against the company's need for capital following billions of dollars of credit-related writeoffs in recent months.

Lehman's denial of liquidity problems echoed the situation a few months ago, when the smallest of the four big investment banks fought off similar rumors in the wake of problems at Bear Stearns Cos. Bear Stearns, now owned by JPMorgan Chase (JPM), nearly collapsed when customers fled and financing dried up over fears about its ability to fund its daily operations.

Lehman on Tuesday said that its pool of available cash has actually increased in recent months. "We ended the first quarter with liquidity of $34 billion, and finished the second quarter well above $40 billion," Paolucci said in a prepared statement.

On Monday, Lehman's debt was downgraded by Standard & Poor's Rating Services, a move that could prove costly to the firm. The downgrade may explain why the investment bank may have to raise as much as $4 billion of new equity, analysts said on Tuesday.

By Lehman's own calculations, under derivatives industry rules it could be forced by counterparties to post $200 million of additional collateral on its trading positions once its debt was cut one notch - and $5.4 billion more if its rating falls another notch. On Monday, Standard & Poor's Ratings Services lowered its long-term rating on Lehman to A from A+, and kept it on negative outlook to signal that more could come.

The calculations on collateral were given in the company's first-quarter 2008 filing with the Securities and Exchange Commission, and may have changed since the positions were stated as of Feb. 29, 2008. Moreover, Lehman has said it calculates the contingent collateral as part of its liquidity planning. It also may have collected its own cash collateral from other broker-dealers since S&P also cut the ratings of Merrill Lynch (MER) and Morgan Stanley (MS) by a notch on Monday.

Even without the rating action, however, the costs of Lehman's heavy derivatives exposure is high. As of Feb. 29, its trading partners could have demanded $4.3 billion of collateral from the company, according to its filing.

The rating downgrade and its consequences could represent a lot of lost capital for Lehman, particularly when it and rivals were already struggling to reduce leverage by raising equity and shedding assets. The cash posted to support its derivative positions would have to come from a unit that does not have the preferred borrowing privileges that the Federal Reserve Board recently gave to Lehman and other big investment banks.

"As a result of this significant potential burden, we would not be surprised if Lehman raises additional capital to be prudent and improve the changes that it avoids another rating downgrade," Sanford Bernstein analyst Brad Hintz wrote in a note to investors on Tuesday.

Hintz, a former chief financial officer at Lehman, lowered his second-quarter earnings estimates for Lehman to 15 cents a share from $1.38 last week after the firm said it suffered losses on hedge positions.