Lehmans' fight for survival

Senior executives at Lehman Brothers have been dusting off their Korean phrase books again, as the on-off talks with the country's state-owned bank appeared to be back on. We may find out in the next few days whether they need to book themselves in for a full language course, or whether they need only master one phrase: Thanks, but no thanks.

The latest flurry of speculation came after the Korea Development Bank confirmed it was negotiating the purchase of a big stake in the troubled Wall Street firm, and said that it was a bit closer to persuading sceptical regulators in Korea that propping up Lehman would be a good idea.

It was the latest tug on the yo-yo to which Lehman's share price is currently attached, pulling the stock higher, before doubts set in and hopes began to unravel.

The up-and-down motion is typical these days. Lehman Brothers, once a bastion of Wall Street, one of its most powerful investment banks, is in such a crisis that its shares now trade more like a penny stock. The credit crunch has wrecked its balance sheet, ruined its growth strategy and raised doubts about its very survival.

Dick Fuld, the longest-standing chief executive of an independent Wall Street investment bank, has weathered storms before, not least the Long-Term Capital Management debacle a decade ago. But nothing like this. He is engaged in a desperate fight to save the company he has run since 1993. Analysts are expecting Lehman will have to confess another $3bn-$4bn of losses on mortgage derivatives when it reports third-quarter figures on 18 September; Mr Fuld will need to show some sort of plan to replace those losses, shore up the balance sheet and keep the company financially secure.

Right now, every choice is unpalatable. If Lehman survives, it will be as a shadow of its former self. "The options in staying independent are narrowing," says Cubillas Ding, senior analyst at Celent, a finance industry consultancy. "Lehman is caught between the rock and a hard place: on one hand, the imperative to survive, and on the other hand, the desire to negotiate the best terms without giving itself away. With the market the way it is, any negotiation is a tight rope to walk."

The talks to sell a large stake to Korea Development Bank (KDB) appear to have legs because it the simplest way to shore up Lehman's balance sheet, bringing in a much-needed cash infusion that could be as large as $6bn. At yesterday's market price, that would suggest the Koreans get a one-third stake in the recapitalised company, but Mr Fuld has previously balked at selling at the market price, which he says is volatile and temporarily depressed by the uncertainty.

Some analysts, for their part, have told him to get his head out of the sand. Last month, Dick Bove, pugnacious analyst at Ladenburg Thalmann, warned that a refusal to accept market realities would simply tempt someone into making a hostile bid directly to shareholders.

Mr Fuld is trying to avoid the impression of presiding over a garage sale of Lehman's assets, but behind the scenes that is already what is happening.

Since the credit crisis struck, wiping out half a trillion dollars of investments held across Wall Street, all banks have been slimming down the holdings of their massive trading desks, in order to reduce their levels of risk. Lehman, which had taken on more leverage than any other bank but Bear Stearns, and therefore had the weakest ratio of assets to potential liabilities, has been deleveraging more ferociously than most. It has needed to, to shore up the confidence of investors and its trading partners. A Bear Stearns-style run on the bank, which collapsed Lehman's august rival back in March, is unlikely now that investment banks can borrow directly from the Federal Reserve. But Lehman will need to persuade trading partners of its long-term viability if it is to win significant new business.

If it is not nailed down, it is going on the block. Trading desks are slimming their investment portfolios. Boom-time excesses are being rolled back, with luxuries such as apartments for use by travelling executives now being put up for sale. Next to go, more than 1,000 people, possibly up to 6 per cent of Lehman's global workforce.

Mr Fuld has invited bids for Lehman's $29bn commercial property portfolio, and for even for its sacred cash-cow, the asset management business centred around Neuberger Berman, a fund management business it bought in 2003. If such large chunks are sold off, it will give ammunition to those on Wall Street who believe Lehman will be too small to survive as an independent firm.

The asset management division could raise $7bn, even if the private equity bidders currently examining the books – sensing Lehman's desperation – are haggling ferociously on price. "Lehman could likely find a buyer for the business at a reasonable price, which would be a far less dilutive option in comparison with selling new equity today," says Morningstar, the investment analysis group, in its most recent report on the company. "That said, Lehman would be losing a stable revenue-generating business if it goes this route."

There are other creative options under discussion, including spinning off, rather than selling, the commercial and real estate portfolios. That would give shareholders a stake in a company that would gradually run down the portfolio, and might end up making more money than selling the assets at depressed prices in today's gummed-up credit markets. There are technical complications about financing such a transaction, however, which would require regulatory approval in the US.

So Dick Fuld is keeping numerous balls in the air for as long as possible, before plumping for what is likely to be a combination of recapitalisation and cost-cutting plans. It will be tricky maths, particularly since trading conditions at what remains of the company are still heading south – as they are across Wall Street. Meredith Whitney, analyst at Oppenheimer & Co, says: "Since the onset of the credit crunch last summer, almost $2 trillion less liquidity has flowed through the US capital issuance markets versus the year prior. For example, last year during this time, almost $900bn of mortgage-backed paper was issued in the US. This year to date, the comparable number is $140bn. And while debt and equity underwriting volume has ground to all but a halt for several months, trading volumes have now slowed materially. These companies simply cannot cut expenses fast enough to offset revenue declines."

The sale of a stake to KDB or other outside investors will be a nasty hit to Lehman Brothers shareholders, who are already reeling from the dilution to their stake by other emergency fundraisings earlier in the year. Standing at a spaghetti junction of options, Mr Fuld must persuade first himself, and then existing shareholders, that going down this path is less unpalatable than selling the company's assets piecemeal. In short, he must persuade shareholders that Lehman is worth saving.