On Thursday, March 27, Lehman Brothers CFO Erin Callan found herself in a career-defining situation. Rumors that the storied firm was in danger of collapsing were widespread. The fire sale of Bear Stearns Cos. to JPMorgan Chase & Co., underwritten by the Federal Reserve Board and announced on March 16, had made it clear that market perceptions of any firm’s vulnerability could actually precipitate a failure. And a 31 percent plunge in Lehman’s share price on the two days surrounding the Bear rescue suggested that the views were pretty negative.
The perception in the market was that if Bear went down, “we’re the next obvious guy,” Callan tells Institutional Investor. “We’re the next smallest. So we’ve just got to do what we can do to address it.”
Lehman executives had already sought to stress the firm’s soundness to investors on March 18, when they reported first-quarter earnings of $489 million. It was a sharp drop of 44 percent from a year earlier but still comfortably in the black, and Lehman’s subprime-related write-downs of $3.3 billion were modest compared with Merrill Lynch & Co.’s $31.7 billion and Morgan Stanley’s $12.6 billion. Executives reportedly even asked the Securities and Exchange Commission to investigate the possibility that short-sellers of Lehman stock were bad-mouthing the firm’s health. But with $67.9 billion in residential and commercial mortgages and mortgage-backed securities on its books, Lehman was still vulnerable to speculation and needed to act.
“We had a look at it as a management team and said we need to control our own destiny here,” Callan says. “There will be rumors, we can’t control that. So what are the levers that we can pull as a team that let us take back control of our own destiny?”
Executives at first considered seeking a large equity investment from a sovereign wealth fund, just as Citigroup, Merrill Lynch and UBS had done, but decided they wanted to work with investors who already knew Lehman well, Callan says. Then the firm’s chairman and CEO, Richard Fuld, received a call from General Electric Co. CEO Jeffrey Immelt offering his company’s support, possibly in the form of an equity investment, she says. (A spokesman for GE declined to comment.) Shortly thereafter, one of Lehman’s longtime investors contacted the firm and offered to bid on a convertible equity deal. Executives received one more call from an investor, then rang up another of their largest shareholders and quickly realized they could raise some serious cash. “By the weekend we basically knew we pretty much had $3 billion together,” Callan says.
After the New York market closed on Monday, March 31, Lehman’s convertible sales team began taking orders. Before the market opened the following morning, the deal was done. Lehman had sold $4 billion of 7.25 percent preferred stock, which can be converted into common stock at a 33 percent premium to the price prevailing at the time of the deal. More than 80 percent of the issue went to just four investors, Callan says, but she declines to name them.
The deal was a resounding success, to judge by Lehman’s stock price, which surged nearly 18 percent on the day the share sale closed. It also helped fuel a marketwide rally that sent the Dow Jones industrial average up 3.2 percent. But although the shares held most of that gain, they remained down 31 percent since the start of the year as of late last month, compared with declines of 11 percent for those of Morgan Stanley and Merrill Lynch and 16 percent for those of Goldman, Sachs & Co. And Lehman, like its peers, continues to face a much more challenging environment going forward.
Immediately after the deal, Meredith Whitney, a banking analyst at Oppenheimer & Co., lowered her 2008 earnings estimate for Lehman to $4.43 a share from $5. “The core shift from ‘originate and sell’ to ‘originate and hold’ business simply puts a cap on returns for the industry,” she wrote.
