Wall Street rumor is a vicious creature. And its been swirling around Lehman Brothers (NYSE: LEH) ever since the fall of Bear Stearns. There's got to be one prime candidate headed for a fall, and Lehman has been nominated to be the star of the show, cast as the next sacrificial lamb.

The latest rumor was that the world's largest bond fund PIMCO, the hedge fund giant SAC and other institutions were bailing out on Lehman, which then promptly rolled over and crashed 18%. The rumor was quickly squelched by Pimco's Chief Investment Officer Bill Gross who said on CNBC that Pimco is reducing neither the length of the trades with Lehman, nor the dollar amounts. And a spokesman for SAC Capital also came out saying that they're doing business as usual with Lehman.

Here's the thing - Its not important (except to the SEC) who puts out these rumors or why. The all important question is - Why is Lehman, and not any other firm, the target for all these rumors and the speculation. What makes it so susceptible to these rumors? Fact is that this rumor mill, while being a self-fulfilling kind of system, isn't all that off the mark, when it comes to finding the weakest victim ready to go belly-up.

So its best to stick to 'what is', taking into account the rumors and all. 'What is' is that Lehman shares have lost 81% from a high point last year of $74.09 achieved on July 17, 2007. Even more damaging is the fact that bond investors are not so optimistic about Lehman's future and their credit-default swaps went up sharply on Friday to a four month high.

Also fact is that Lehman does have $60.8 billion worth of real estate, mortgages and related securities as of May 31st, the value of which is definitely going to keep dropping over the next year. Factor in Lehman's small equity base (currently $1 for every $25 borrowed) and you get an idea of why Lehman is so susceptible.

At this stage, the basic problem Lehman has is of ignoring the rumors, and keeping traders on board. Lehman is helped in this fight by the fact that the Fed is keeping the discount window open for primary dealers. If Bear Stearns had had this facility, it might never have gone down.

But its not enough help for Lehman. What Lehman needs is to stay afloat until the real estate market rebounds. That's more than a year away, and the only way to survive this year is by de-leveraging and raising capital again. After declaring a Q2 loss of $2.8 billion, Lehman raised about $6 billion by selling $2 billion of convertible preferred stock and $4 billion of common shares. Lehman has sold about $130 billion in assets since April, and is taking steps to further reduce its leverage by selling about $120 billion more in assets this year. All this would bring its leverage ratio down from 25 to 15. Bear Stearns went belly-up with a leverage ratio of 34.

All these steps, while helping the firm to stay afloat over the next year, will also result in more pain for shareholders in the form of losses from discounted asset sales and write-downs in the next quarter or two, and diluted earnings over an extended period. The share will keep dropping, at least until the year end, and possibly even beyond. And every time Lehman announces a downgrade, the rumors will fly. But Lehman is not going to be the next victim. They are not going to collapse. They won't be in need of a bailout. Its an orderly retreat.

References:
http://www.guardian.co.uk/business/feedarticle/7643997
http://blogs.wsj.com/marketbeat/2008/07/11/lehman-taking-a-beatingagain
http://www.nytimes.com/2008/06/10/business/10lehman.html
http://www.bloomberg.com/apps/news?pid=20601109&sid=awH4lSOm6eDk