August 18, 2008 – 3:58 pm

The game of cat and mouse between Lehman Brothers and the bears continues to heat up as the bears close in. This is not the first time Lehman has heard footsteps coming closer, nor is it the first time the bank has felt the sting of a claw ripping away chunks of shareholder value. In the past year alone, the bank has seen its share price decline by 75 percent.

Lehman Brothers CEO Richard Fuld sits on the board of directors for the New York Federal Reserve Bank, so even after deflating by 75 percent, Lehman is no easy mouse to catch. In the second quarter, Lehman actually broke away from the bears and briefly ran free with the help of smoke and mirror accounting and a Pravda-style propaganda campaign.

 During the second quarter press conference, management brought in its favorite gunslinger, Erin Callahan, to fend off David Einhorn, the King of Bears leading the hedge funds that want part of the action. For a while, it looked as though it might work, and Einhorn had to steady his troops and hit the CNBC financial media shows. Callahan was demoted as the cats caught up and shares fell again.

Friends at the FED temporarily de-clawed the beasts when the SEC announced a ban on naked short selling of Lehman and 18 other Privileged Ones. The action stripped bears of their most fearsome weapon — save for the greediness of Lehman — and they had to back off again.

Now as the third quarter rolls a little closer, Lehman Brothers is becoming exposed once more.

As the end of the third-quarter approaches, the speculation has begun about the level of losses at various Wall Street firms. Lehman Brothers, of course, is at the center of the talk. This morning a report in the Wall Street Journal suggests that Lehman may face a fiscal third-quarter loss of $1.8 billion. That would take Lehman’s losses since March up to $4.5 billion, or more than it made in profits for all of 2007.

Losses of this size could force Lehman to follow Merrill Lynch’s lead by selling off a huge amount of its assets at once, most likely at a steep discount. The ongoing losses coupled with reassurances about the strength of the balance sheet has badly damaged Lehman’s credibility. Further capital raising will be difficult for Lehman in an atmosphere of distrust and shareholders already angered over dilution from earlier rounds of capital raising.

So, the battle rages with both sides wounded. Lehman can still strike back, and another rally in the stock along with an extension of a ban on “naked short selling” will put tremendous pressure on the shorts to cover once again.

For its part, Lehman better pick up the pace if it can. As for the shorts, they had better keep in mind that Lehman Brothers is no WaMu.

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