Is the Lehman situation patently illogical, or brutally logical?

With its shares down another 12% this morning, The Wall Street Journal is reporting that the 158 year old Lehman Brothers (LEH:NYSE) is actively trying to sell itself in an en bloc transaction. How could this be happening?

Every single market player in the world well knows that Lehman has the ability to borrow as much money as it needs from the U.S. Federal Reserve, which means that it can convert vast amounts of its US$639 billion of assets (as at the May quarter) into good collateral. Unlike the situation that brought Bear Stearns to its knees (see prior post “U.S. Fed action comes too late to save Bear Stearns” March 14-08), brokers and banks around the world need not worry about “keeping lines open” since there is no practical chance that Lehman will go bankrupt and leave a counterparty hanging.

At the same time, any business needs clients, customers and revenue to stay relevant. In a bear market environment, Wall Street is finding it very difficult to keep the coffers filled. M&A volumes are down, equity offerings are being delayed, IPOs are being pulled, CDOs and their brethern are no longer generating a penny of profit.

Which brings us back to Lehman. As every public company CFO knows, it is no fun to raise equity under the spotlight. With all of the rumours about a potential equity investment from South Korea-based banks, the market clearly expected that a deal would happen. Once it went off the rails, assuming it was ever even on them, Lehman shares began to weaken further.

But it wasn’t until the U.S. government stepped in to corral Fannie Mae and Freddie Mac that the market seemed to focus on where Lehman was headed. With the benefit of hindsight, traders figured that Lehman’s efforts to sell assets or find minority investors for its money management division were no longer sufficient to keep it independent.

But, in reality, what has changed to drive the stock down this low? Lehman has assets in excess of US$600 million, and let’s assume for a moment that the firm’s auditors have done a good job ensuring that those assets are worth the value they are being carried on the balance sheet for. With the Federal Reserve standing behind Lehman’s balance sheet, why the need to sell the business at single digits, 93% below the price of just one year ago.

That’s what happened to Bear Stearns, since they didn’t have the luxury of the Fed window available to them. But here? At Lehman?

What the market is really telling us, at US$3.73/share, is that either:

1) it doesn’t believe that Lehman has correctly priced the value of its assets (current book value is US$37.86/share as at May 2008),

2) that Lehman doesn’t have enough liquidity to finance continued losses from writedowns, or

3) that the current Lehman 2009 EPS forecast of US$2.34 (the current average of 19 different equity research analysts) are wildly offbase, and that 2009 may well be a year of negative earnings.

And possibly a combination of all three. That’s where the brutal logic of the recent Lehman trading comes into play.

Whatever the outcome, you have to hand it to Warren Buffett; he sure avoided some sleepless nights (see prior post “From the desk of Dick Fuld, Lehman Brothers CEO” July 17-08). For my money, I just don’t see the need for a sale at Lehman, assuming the WSJ story is accurate. But, one always has to remember that the folks inside a company generally know a lot more than you do about what is going on in the engine room.

There’s a market rule about not “fighting the tape”. Perhaps that’s what Dick Fuld has concluded.

MRM