Lehman Brothers to the Market: Your destiny lies with me!

Our discussion of Bear Stearns' collapse (check out the comments, some really good stuff there) and what may or may not have prevented it is not entirely academic. Witness the trials and tribulations of Lehman Brothers, the new Dark Lord of the Credit Crisis. Today the Wall Street Journal is reporting that Lehman is looking to raise $3-4 billion in new capital, probably via straight common equity. Lehman has come out saying they don't "need" to raise capital, but they aren't ruling it out. If you read the Journal piece closely, you can see that Lehman isn't really contradicting the story. The Journal says...

"The amount of new capital under consideration suggests Lehman's quarterly loss could be larger than the $300 million or so that some analysts have been expecting."

So the possibility of Lehman's loss being exceptionally large is speculation on the Journal's part. Perfectly reasonable speculation, but speculation none-the-less. Lehman's non-denial denial, if it can be believed, only implies that they won't be forced to raise new capital because their losses are so large.

Getting back to Bear Stearns. The preponderance of evidence is that Bear Stearns would have been profitable in 1Q 2008. And yet they were about to be bankrupt mere days before reporting that profit. It is clear that Bear Stearns would have been able to continue operating had they been able to remain liquid.

According to the Wall Street Journal's excellent 3-part series on Bear's collapse, Bear Stearns CEO Alan Schwartz was confused and frustrated by the persistent rumors about his firm. He knew they had big mortgage exposure, but seemed to believe they were strong enough to get through it. But according to the Journal, as early as December, Bear's trading partners were growing uneasy. PIMCO told Bear to raise equity after nearly demanding an unwind of billions in trades, according to the story.

Its downright criminal that Schwartz continued to ignore these warnings. It may have been mere rumors that took Bear down, but Bear (and the Cayne/Schwartz team specifically) stuck their heads in the sand and refused to do anything to quell the rumors. Consider the apparent sequence of events:

• Trading partners tell Bear they are uneasy and want to see more equity capital.
• Bear does nothing.
• It starts getting around the investment community that Bear is too leveraged, but won't raise capital.
• The conclusion is that Bear's management is either deeply in denial about their condition or they are unable to raise capital.

That sequence is more or less known at this point. Note that even if one were to assume that Schwartz had been right, and Bear did have plenty of cash/hedges to offset mortgage losses, it wouldn't have mattered. Take the most positive possible spin on what seems to have happened next, and Bear is still toast.

• Bear's lenders hear the concerns that PIMCO and others have. (Again, taking the most positive spin possible) Lenders don't necessarily think Bear is in immediate trouble, but still don't want to be caught as the last ones out if things turn south. Lenders like Rabobank decide not to renew short-term lending programs.
• Prime brokerage clients, realizing that prime brokerage is a completely fungible service, have all risk and no reward by sticking with Bear. Note that they don't have to be panicking in order to reach this conclusion. If there is a 1 in a thousand chance of a disaster, with no reward for the 999/1000 outcome, why take that risk? These accounts start pulling out.
• A classic bank run ensues.

But what would have happened if Bear Stearns had bolstered their capital base back in November or December? We'll never know, of course, but there certainly is a pretty good chance their major trading partners and lenders would have felt more comfortable. More confident. And more confidence is all it would have taken.

Back to Lehman. Some readers may remember that in 1998, during the Long-Term Capital Management collapse, Lehman was supposedly teetering. At the time, Lehman took the tact of simply denying the rumors. According to various reports I've read, ten and current Lehman CEO Richard Fuld wants to be more aggressive this time around. The firm has already raised $6 billion in new capital (vs. writedowns of $3.3 billion). Its sounding like whether or not they have big losses to report, they are looking to raise more.

I for one really hope they do. And I hope they do it via straight common equity. Because the more Wall Street accelerates their deleveraging, the sooner the financial system can regain solid footing. Lehman seems to understand that a stable financial system is better for their bottom line, and hence short-term pain of equity dilution will ultimately be in their long-run interests.

I also hope that Lehman and others move to write down what needs to be written down. Bear Stearns collapsed because no one understood what they owned and what risks they had courted. The more Wall Street's stuff gets written down, the less the public will worry about it, and the less chance we'll see another run on the bank.