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Lehman May Have to Raise Capital If It Sells Assets

Lehman Brothers Holdings is expected to follow in Merrill Lynch's footsteps and sell a lot of risky assets at a loss. But shedding the assets may create another headache for Lehman -- the need to raise large amounts of new capital, including common equity.

Lehman Brothers
Bert van Dijk
Lehman Brothers

Any capital raise would be painful for Lehman and its shareholders, given that the company just raised $6 billion in June and trades at a significant discount to its book value, or the net accounting value of its assets.

But Lehman , the fourth-largest U.S. investment bank, may have little choice as it wrestles with roughly $65 billion in mortgage-related assets, particularly after Merrill Lynch agreed to shed $30.6 billion in toxic assets at a fire-sale price of 22 cents in the dollar, analysts said.

"Lehman's caught between a rock and a hard place. They're getting more and more pressure from regulators and investors to add reserves or mark these things down," said David Hendler, an analyst at independent research firm CreditSights in New York.

"In normal times, they could wait it out, but the market wants it done now," Hendler added.

The New York Post reported on Friday that Lehman was talking to potential buyers about selling $30 billion in assets. CNBC television reported Friday that Lehman was in talks with BlackRock to sell mortgage securities and other assets. Both Lehman and BlackRock declined to comment.

Lehman's chief financial officer told Merrill analyst Guy Moszkowski recently that the investment bank was willing to sell assets at a loss if the deal materially reduced risk, the analyst said in a report.

Lehman had roughly $65 billion in mortgage and real estate-related assets on its balance sheet as of May 31.

Selling at a loss seems increasingly likely after the Merrill deal last week. Lehman's assets may be of much higher quality, but Merrill's low sale price for mortgage-linked securities implies that many banks' assets connected to mortgages may be marked down further.

Lehman wouldn't have to sell assets at much of a loss before it had to raise capital.

Brad Hintz, an analyst at Sanford C. Bernstein, wrote in a note Monday that any loss much greater than $1.5 billion -- which translates to selling $30 billion at a discount of at least a 5 percent to their current value on Lehman's books -- would likely force Lehman to issue at least some common equity.

Selling assets at enough of a loss would force Lehman to record a quarterly charge -- eating into capital for an investment bank that many investors already believe is undercapitalized. Any big reduction in Lehman's capital could bring pressure from regulators and rating agencies to raise capital.

Depending on the price that the assets are sold for, Lehman might have to raise $4.5 billion to $7 billion in capital to offset losses, CreditSights' Hendler said. Given that Lehman's market capitalization, or value in the stock market, is currently about $13 billion, such a capital raise could leave existing shareholders owning a much smaller portion of the company.

Neuberger for Sale?

If Lehman needs to raise more capital, it may consider selling all or a portion of its asset management business, analysts said -- a move mentioned in media reports as a possibility for weeks.

Investment banks have increasingly been looking to sell assets instead of issuing shares since shedding businesses that provide a relatively low amount of revenue may be less painful for shareholders than dramatically boosting outstanding shares.

Merrill sold back its 20 percent stake in Bloomberg, the news and financial data company, to Bloomberg Inc for $4.4 billion in July.

It also said last month it was in advanced talks to sell a controlling stake in its Financial Data Services unit, in a deal that could value the business at more than $3.5 billion.

Lehman's asset management unit, which includes the Neuberger Berman business that Lehman bought in 2003, generated about $1.88 billion in net revenue in 2007. Analysts estimate the unit could sell for about $8 billion.

Selling a business to raise capital may be better than issuing shares, but it is generally not pleasant, in part because getting a good price in a sale is tough now. Few buyers have the capital to make big acquisitions, and any potential acquirers know the sellers are anxious to sell assets.

Merrill Chief Executive John Thain told investors in June that he saw the Bloomberg business as worth between $5 billion and $6 billion, but the investment bank ended up selling it for less than that.

The Neuberger business is a steady generator of earnings for Lehman, which has helped stabilize Lehman's overall profits.

Time to Buy?

Lehman's current market valuation reflects investor concern about potential write-downs and capital raising, analysts said.

Its shares traded on Monday at $18.52, or about 0.56 times their book value, a measure of accounting value.

The other major U.S. investment banks all trade at a premium to their book value, and during better times, investment banks typically trade at twice their book value. Lehman's trading so far below book value signals that investors foresee significant future write-downs.

Concern about future write-downs may be baked into Lehman's shares, but if the quality of the bank's assets shows signs of worsening, and raising capital again becomes necessary, shares may fall further, said Michael Cuggino, portfolio manager at Permanent Portfolio funds, which manages about $3.8 billion.

"We're concerned enough about it to stay away from the stock," Cuggino said.

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