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Lehman fights on as rumours mount over sale

21 Aug 2008

A noose of market speculation and rumour tightened around Lehman Brothers this week pushing five year default protection on the venerable New York investment bank wider by 70bp to 375bp — equivalent to a lowly double B rated credit.

Analysts and traders increasingly suggest that a sale of the bank is the only option left for Lehman, but that is something that chairman Dick Fuld has maintained will never happen on his watch. The firm has a high proportion of employee ownership, but outsiders are now less sure that he can make good this commitment

Lehman declined to make an official comment this week, but insiders stressed that the business was fundamentally healthy.

"We have a wall of liquidity. There is absolutely no reason for us to sell. People are still trading with us," said one banker in London.

Since the Federal Reserve introduced the Primary Dealer Credit Facility after Bear Stearns collapsed in March, a dealer should not go to the wall because a crisis of confidence exhausts its liquidity. But that has not stopped the cacophony of speculation suggesting that the business is fundamentally flawed and the situation irretrievable.

The negativity surrounding Lehman has cascaded through the rest of the financial sector. The iTraxx senior financial index widened 10bp over the week to 90bp/91bp while the subordinated index widened from 140bp to 165bp/170bp.

The main Europe Index is wrapped around 100bp, around 8bp wider over the week, and the CDX Investment Grade Index (series 10) is at 146bp/148bp — 12bp wider on the week and close to the peaks of early July.

"If you look at levels you can see what is happening. The general view of the market is expressed in spread widening," said a default dealer in London.

There was a stream of damaging news and speculation for Lehman this week. Yesterday (Thursday), the Financial Times reported that Lehman had gone cap in hand to Korea Development Bank and China’s Citic Securities earlier this month but come away empty-handed.

On Tuesday, a JPMorgan analyst predicted that Lehman would make another writedown of $4bn in the third quarter as it seeks to reduce yet further its commercial and residential mortgage related assets.

It was also rumoured this week that Lehman is trying to sell its asset management arm, Neuberger Berman. This would raise much needed capital, but it makes little sense from a strategic point of view. Neuberger Berman provides a steady cash flow and also constitutes much needed diversification in Lehman’s business profile. Without it, it would be even more exposed to the vicissitudes of trading conditions than it is already.

Even if Lehman is forced to opt for a sale, the route is a minefield and there are few obvious candidates. Barclays Bank has been mentioned as a possibility for several months, and earlier this week its five year CDS price widened due to a revival of the rumour, but it ruled itself out of the running when it said this week it was interested only in a US asset management firm.

"My own view is that someone will come and swallow them up," said a source at a dealer in New York. "The reason that this hasn’t happened yet is that no one wants to take all the writedowns and all the nasty stuff."

If a buyer is not forthcoming and counterparties do end up pulling the plug then the US Treasury or Federal Reserve might have to broker a deal in the same way it did when Bear Stearns collapsed — but on a much larger scale.

"It will have to take the assets and put them in an SPV and say thank you and goodnight to the shareholders," said a credit analyst in London.

Given the stated view of Barclays this week, it is now being lined up as a potential buyer of Neuberger. "If Barclays bought it, it would be a good thing for them, but it wouldn’t be for Lehman," said a financial credit dealer in London yesterday. It suggests a winding down of its franchise, a prized part of its business being sold off."

Speaking about the credit crunch in general, Kenneth Rogoff, the former chief economist of the IMF, said early this week that the market has not seen the worse of the crisis and that a failure by a leading financial institution — "a whopper" — is on the cards. Lehman bankers are said to have been furious when these pronouncements appeared.

Fannie and Freddie whimpering for mercy

As with Lehman Brothers, so it goes with Fannie Mae and Freddie Mac, as speculation of a US Treasury bailout once again approached fever pitch this week.

"The likelihood that the government will have to do something is pretty high now," said Ira Jersey, a credit strategist at Credit Suisse in New York yesterday.

A bailout solution may well be in place before the end of the third quarter, depending on the success of the agencies in the capital markets in September, say the doom-mongers.

The Treasury secretary had hoped that the raft of measures designed to help the agencies rushed through Congress last month would prove sufficient to restore confidence, but it is getting likelier that the Treasury will have to dig deep into Uncle Sam’s financial reserves.

"Paulson made a few erroneous remarks. He said he will not use the Treasury’s new funding arrangements, but as soon as you say something like that the market will force the issue," said a credit strategist in London.

Others analysts agreed. "The Fed will have to either put up or shut up," said another in London yesterday (Thursday).

The extent to which it will have to put up is unclear and depends on the strategy the Treasury chooses to adopt. It might try and ‘sugar coat’ it, said one analyst, and inject about $25bn. This would cover the shortfall for the next six quarters or so, but if it wanted to bankroll all the subprime, Alt A and prime mortgage losses it would have to stump up at least $100bn and perhaps $150bn, suggest analysts.

That a large-scale Treasury debt raising is on the cards is demonstrated by the steepening of the yield curve seen this week. The market anticipates greater issuance in the belly of the curve.

The Treasury could then take a senior preferred share position in Fannie and Freddie, essentially obliterating existing shareholders. How much this matters is a moot point as the shares are largely worthless now anyway. Both have lost over 60% of value since the law was signed a month ago and traded well below $4 a share.

This is tantamount to nationalisation, as most onlookers realise. But the clarity and certainty it would provide would be salutary for the market.

"The more explicit the action the better. It would go a long way to taking away the systemic risk," said Mehernosh Engineer, senior credit strategist at BNP Paribas in London.

Others agreed. "If you do a little, you create a new problem and increase the chances of doing it again. Why not do something larger?" asked Jersey.

But the agencies and their regulators must agree to any plan to provide more capital, and, low though the share prices are, they may baulk at the destruction of the shareholders.

On Monday, Freddie Mac sold a five year bond at the vertiginous level of 113bp over Treasuries — in recent history the GSEs sold debt at a very thin margin to Treasuries. However, given that the agencies can pass this cost on and face no competition to speak of, the pricing makes little difference to their businesses. Only a complete shut-out from the market would matter.

The agencies widened by about seven or eight basis points this week to 48bp/49bp, and then rallied yesterday as the prospect of a government bailout appeared to increase. But the bid to buy default protection on institutions backed by the Federal authorities is never particularly strong. Indeed, one credit analyst described the GSEs’ CDS price as "fictitious."

Banks widen with GSEs, Lehman

The general gloom surrounding the financial sector inflated Icelandic bank spreads as well after their recent rally. Kaupthing widened about 30bp to 650bp/500bp but is still much narrower than it was a month ago. Glitnir is in the same range and Landsbanki is 450bp/500bp.

IKB also widened around 100bp to 400bp/450bp after KfW agreed to sell 90.8% of it to distressed debt expert Lone Star for an undisclosed sum. IKB needs to refinance around Eu10.6bn of maturing debt in the remainder of 2008 and 2009, and it is far from clear how it will do this.

The bond insurers have suffered acutely. MGIC widened 40bp on Tuesday to 900bp/920bp and another 25bp on Wednesday to 925bp/940b as a direct result of the uncertainty surrounding the agencies. It is now wider than at any time in last month.

MBIA widened by 1.5% yesterday to 25.5% while Radian widened by 0.5% to 38.5%. It was equally grim for some of the other bad boys of the financial world. AIG traded wider to 360bp/380bp while Washington Mutual was able to widen only half an upfront point to around 23%.

Sallie Mae, the student loan organisation, confirmed it has received emergency federal funding and it widened by 20bp to 465bp.

Last week it was reported that the collapse of the securitisation market had made it likely that student loans would be withheld from thousands of US students about to start college. The funding allows $20bn of new loans to be made.

Aiful, the Japanese consumer finance company, widened by 30bp to 730bp/740bp and a range of high beta names in the sector followed suit. These names are seen as particularly vulnerable to macro global developments.

Gunboat diplomacy heightens concern

Recent events in Georgia have widened default spreads in the old Soviet sphere of influence. Russia’s successful revival of gunboat diplomacy has raised fears it may use similar tactics against other neighbours, particularly Ukraine.

The Republic of Ukraine widened by 70bp from the start of the conflict to a high of 472bp this week, before it fell back to 455bp/465bp.

The Republic of Kazakhstan has widened by 50bp to 250bp/260bp and troubled bank Kazcommertsbank is 100bp wider at 800bp.

The cost of credit protection against Russian debt also widened 3bp this week to 131bp-134bp, the highest price seen since April.

Simon Boughey

21 Aug 2008