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Lehman in Free Fall as Default Fears Mount

Dan Freed

Updated from 12:45 p.m. EDT.

Lehman Brothers(LEH Quote) shares fell 45% Tuesday, as a prospective deal to raise capital hit a snag and concern the firm would default on its debt mounted.

Lehman Brothers shares fell $6.36, or 45%, to $7.79 at Tuesday's close after Dow Jones reported that Jun Kwang-woo, chairman of the Financial Services Commission in South Korea said Korea Development Bank and Lehman have ended discussions. Mr. Jun could not be reached and a Lehman Brothers spokesman declined to comment.

Lehman's stock is off 88% from its 52-week high. Richard Bove, an analyst at Ladenburg Thalmann, predicted that the government would broker a private investment in or takeover of Lehman or one of its businesses overnight before the market opened on Wednesday.

Late Tuesday, the company said it would announce its expected third-quarter results, along with "key strategic initiatives" at 7:30 a.m. EDT on Wednesday.

Fear surrounding the firm was evident in Tuesday's trading of derivatives insuring against default on Lehman debt.

Swaps on Lehman Brothers debt indicate a 35% chance the firm defaults, according to Tim Backshall, chief strategist at Credit Default Research, a provider of market data and analysis. The price of insuring against $10 million worth of Lehman debt rose from $322,000 to over $500,000 on Tuesday.

"The market is pricing in pretty much Armageddon right now," Backshall says, noting that the price of default protection on Lehman is higher now than it was during the March weekend when the federal government brokered the sale of Bear Stearns to JPMorgan Chase(JPM Quote) to prevent it from going out of business.

Lehman Brothers continues to talk to other investors, including Nomura Securities, Bloomberg reported.

Lehman also is looking at several options to avert the kind of loss of investor and lender confidence that caused the failure of Bear Stearns. Among those is an equity investment, a sale or spinoff of its $40 billion in troubled real estate assets and a sale of its investment management business.

Though Bove doesn't believe Lehman will go bankrupt, he believes if it did, it would embolden short sellers, causing them to take down much of the financial system one company at a time.

"If it can't be stopped, we'll have a good old-fashioned depression," he warns.

Lehman's shares have been hardest hit among the four large U.S. brokerage houses since the near-failure of Bear Stearns. Like Bear, Lehman's fortunes are strongly connected to the real estate and fixed income markets, which has been at the center of the current economic crisis.

Lehman Brothers has shaken up top management several times in recent weeks, including over the weekend, when it announced leadership changes in its fixed income and international operations.