Lehman Brothers (NYSE: LEH) caused some commotion on the street Monday after issuing $4 billion in preferred stock. The move was intended to quench rumors of a capital shortage, but instead confirmed to many that the bank is facing problems. Meanwhile, existing shareholders aren't too happy about having their stakes diluted by up to five percent. The stock jumped 10 percent this morning, however, after investors digested the news overnight. So, what is the real story?

Short interest in Lehman Brothers has increased five-fold since early 2007 as shares fell more than 40 percent. These short sellers bet that the stock will decline by borrowing and selling shares with the hope that the stock price falls before the borrowed shares have to be purchased and replaced. So far, these investors have made money as fear continues to grip the market and force the financial sector downwards.

Lehman Brothers has vehemently denied rumors of a capital crunch, saying that it has $31 billion in liquid assets along with $65 billion in other assets that it could easily borrow against. However, investors are still a little leary given the rapid demise of rival Bear Stearns (NYSE: BSC) that came as a result of similar rumors. More, Lehman Brothers in many ways has a similar risk profile to Bear Stearns.

Lehman Brothers currently holds $31.8 billion in residential mortgage loans and $13.5 billion in Alt-A loans. So far, the firm has been forced to write down this portfolio by more than $3 billion. However, Lehman insists that the remainder of this portfolio is well-hedged and and future losses will be offset by gains in other areas.

The greater concern is its $31 billion commercial real estate portfolio that continues to face pressure. Many commercial real estate projects, like its Archstone-Smith Trust investment, are falling through amid the poor economic climate. Fewer corporations are expanding while more are laying off significant portions of their workforce. The result is fewer tenants and lower rental prices as a result of consistent supply.

The move upward today comes after foreign markets rallied on the news. This likely spooked short-sellers who then took action to repurchase their shares before the stock rallied. These repurchases combined with existing demand is likely what sent shares soaring higher. How much of the demand for shares was actually driven by confidence as opposed to shorts covering remains to be seen. 

In the end, Lehman Brothers has some significant exposure remaining that could put the firm at risk. However, it looks like its $31 billion in liquid assets should be enough to cover at least for the near term. The fact that it was able to easily raise $4 billion also illustrates confidence by Wall Street. The problem is that it came at the expense of existing shareholders and further spooked the market in general as things still aren't getting better.

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