Lehman pays up for independence

NEW YORK (Fortune) -- Lehman Brothers took the rare move of pre-announcing its third quarter earnings to quell the rampant speculation surrounding its financial health.

Now that investors have greater insight into the firm's estimated $3.9 billion quarterly loss (on $7.8 billion in write-downs), they need no longer speculate. They can see why they need to be afraid.

The scariest fact is the one Lehman discussed not at all: Not a single dollar of capital came into the firm despite efforts by Lehman that spanned the globe. No sovereign fund, rival brokerage, private equity firm or bank appears ready to assume an equity stake in Lehman's franchise as its management values it.

That's left Lehman two cards it's decided to play: The spinoff to shareholders of its $32.6 billion commercial real estate portfolio and the sale of about 55% of its investment management division, including its well respected Neuberger Berman unit.

It's easy to understand the motivation behind the spinoff, to be known as Real Estate Investments Global. Lehman wants to get investors' and analysts' daily focus off the firm's disastrous investments in commercial real estate.

But it's hard to see what if anything REI Global does for the battered Lehman investor in the near term. While it gets these collapsing assets off of Lehman's balance sheet, the firm still has to capitalize the new company with $6 billion or $7 billion - money it has had little success in raising.

In addition, there could be several billion dollars worth of credit lines guaranteed by Lehman, which chief financial officer Ian Lewitt said he hopes will be "syndicated," or sold from its books into the marketplace.

But given the difficulties in the syndicated loan market, this seems somewhat wishful thinking. And with a ratings downgrade of Lehman debt possible (both Standard & Poor's and Fitch Ratings have a cut under consideration,) this may well be expensive financing to boot.

Lewitt argued that REI Global's shareholders will get a company that has $5 billion annually in cash flow, which should allow it to pay both a modest dividend and service its debt. He said that the new company's portfolio held up under a series of stress tests. It had better: Stress is exactly what commercial real estate looks to be facing in the near term.

It should also be noted that if the capital and real estate markets return to something like a state of normalcy, REI Global investors could end up with a nicely appreciating asset. Given where things stand today, those investors need patience and a high degree of risk tolerance.

The sale of the investment management division sale, to be done via an auction for which bids are due Friday afternoon, is a card that Lehman's management would almost certainly rather it didn't have to play.

The Neuberger Berman led unit provides an extremely reliable source of steady earnings. While Lehman's earnings release notes that only about 5% of pre-tax income should be affected by the investment management sale, from a product mix the sale pushes Lehman closer to a pure play on trading and underwriting. Not to put too fine a point on it, but volumes and profits from those markets are in varying stages of freefall.

Still, retaining a minority stake in this unit and its recurring revenue stream might stave off a two-notch ratings downgrade below Lehman's current A/A1 level.

The big agencies haven't made such a move yet, but independent research boutique CreditSights chopped its ratings on Lehman's long-term debt to BBB+, with a "negative" outlook.

In a note released late in the morning, CreditSights said that while the moves undertaken were "a step in the right direction," they might not be enough to calm down liquidity providers, including banks and trading counter-parties.

Indeed, traders of credit default swaps seem to be no calmer Wednesday. The cost of insuring a $10 million block of Lehman debt for one year spiked to just over $600,000 in late morning trading, up from Tuesday's $550,000 close. In comparison, the cost of insuring similar blocks of Goldman Sachs debt was $190,000 and $235,000 for Morgan Stanley.

On Monday morning, the cost of insuring Lehman debt was around $320,000.

Unlike its slightly smaller former rival Bear Stearns, Lehman has access to a primary dealer credit facility administered by the New York Federal Reserve that was created after Bear's demise.

But this is not a cost-free resource. Loans provided to Lehman from the New York Fed (guaranteed by some form of collateral, like Treasury bonds or the more liquid mortgage securities) would almost certainly result in a loss of operational flexibility for Lehman management.

The consensus among several institutional investors, skeptics and Lehman holders alike, was that the firm's actions Wednesday bought another three months of independence in which it could try to fashion a brighter future. The question remains however: At what cost?