It should be no surprise that the Korea Development Bank (KDB), South Korea's state-owned lender, is in talks to set up a consortium with private banks to invest in distressed U.S. investment bank Lehman Brothers, whose shares are down 75% this year.
A deal could inject as much as $6 billion in capital in return for a stake of up to 25% in the investment bank, which has been hit hard by the downturn in the credit markets and the housing crisis. Shareholders face massive dilution if the deal goes through, with shares potentially dropping to $12 from around $16 now.
KDB Governor Min Euoo-sung says that discussions were under way ''to form a consortium with private banks as (we) believe it is more desirable to acquire Lehman Brothers (LEH) jointly rather than alone.'' Indeed.
Because given its size, KDB simply cannot digest Lehman's outsized and perilous balance sheet on its own.
It's also been reported that Jun Kwang-woo, chairman of South Korea's Financial Services Commission, has balked over letting a state-run institution lead the way in an acquisition of Lehman. "Generally speaking, the private sector should be the leader in such a deal," he has reportedly said.
Cold feet would be understandable given that KDB's balance sheet is about a tenth of Lehman's, and given Lehman's nuclear meltdown on its balance sheet.
Take a look at KDB's balance sheet. When you do the English and currency translations, you'll see that as of December 2007, KDB only had about $110 billion in assets and $21 billion in shareholders' equity.
Swallowing, all on its own, Lehman's $639 billion in assets, much of that damaged, and $613 billion in liabilities onto its balance sheet would have been an Olympic feat for KDB. Ladenburg Thalmann analyst Richard Bove has already said Lehman was ripe for a hostile takeover.
Whatever the takeover scenario, Lehman needs to move fast. Now.
Because given the perilous state of its balance sheet, the only institution able to do a hostile takeover would be the Federal Reserve or the Treasury. And Lehman knows it.
Spreads on mortgage-backed securities versus Treasurys of similar maturities have steadily widened to levels last seen in March, when the markets were on the verge of a national nervous breakdown after the Federal Reserve helped orchestrate the shotgun wedding between JPMorgan Chase (JPM) and Bear Stearns, which was on the brink of collapse.
Lehman is sitting on nearly illiquid $40 billion in commercial real estate as of the end of the last fiscal quarter and another $24.9 billion in potentially toxic residential assets, much of which is thought to be deteriorating rapidly.
Lehman's level 3 assets are also a fire-engine-red flag. Level 3 assets are the illiquid, toxic waste that no one wants in the market and which management prices on its own. Lehman's level 3 assets make up 146% of its tangible common equity, the truest gauge of its book value. That 146% is less than Goldman Sachs (GS), where it is 162%, but far more than Merrill Lynch, whose recent fire sale of collateralized debt obligations (CDOs) to Lone Star Capital, a Dallas vulture fund, at 22 cents on the dollar (more like six cents because Merrill loaned Lone Star 75% of the deal) dropped its percentage down to just 48%.
As its assets erode in value, more writedowns and losses loom on top of the $8.2 billion in writedowns Lehman has already booked. Wall Street estimates have it that Lehman may report losses of around $4 billion when it discloses third-quarter results in mid-September. It is expected that the investment bank will announce at that time job cuts of up to 1,500, the fourth round of job cuts -- bringing the total to 6,400 since June 2007 -- as well as the deal to raise fresh capital to help offset the losses.
Goldman Sachs analyst William Tanona is forecasting a total of $10 billion of writedowns for Lehman, Morgan Stanley (MS), JPMorgan Chase and Citigroup (C) in the third quarter. To date, investment houses and banks around the world have reported more than $510 billion in losses.
Pricetags are being put on everything now at Lehman, with the value of its 575-foot-tall headquarters thought to be worth $1.3 billion, and the value of its asset management business, Neuberger Berman, said to be worth up to $13 billion, far surpassing Lehman's $9 billion market capitalization.
Talk now is of plans to warehouse Lehman's nearly illiquid, difficult-to-value $40 billion commercial real estate portfolio in a separate company, a good bank-bad bank structure in which Lehman's shareholders would be given equity stakes.
Dumping the landfill would be a good move, as it would cleanse Lehman's tattered balance sheet of mortgage-backed securities, leveraged loans and toxic derivatives -- and shore up its battered stock price.