The Collapse of Lehman Brothers A Case Study

The Collapse of Lehman Brothers A Case Study A little over a decade ago, something unexpected happened in the banking sector in the United States, sending out huge ripples that greatly shook the financial industry, both in the United States and across the globe.On September 15 2008, Lehman Brothers filed for bankruptcy protection, thereby shaking consumer confidence in the economy and sending out the message that no institution was too big to fail.The collapse of Lehman Brothers was significant for a number of reasons.At the time, Lehman Brothers was United States’ fourth largest investment bank and employed over 25,000 people across the globe.At the time of filing for bankruptcy, the bank had $639 billion in assets and $619 in debt, making this the largest bankruptcy filing ever, even surpassing the collapse of other giants such as Enron and WorldCom.The Lehman bankruptcy filing was more than one and half the size of Sweden’s GDP in the same year.The collapse also made Lehman Brothers the largest victim of the 2008 financi al crisis, which was induced by subprime mortgages, at least in the US.The collapse of Lehman Brothers intensified the financial crisis and contributed to the global equity markets losing close to $10 trillion in market capitalization in October 2008.At the time, this was the biggest ever monthly decline.What made Lehman Brother’s bankruptcy filing even more shocking was that it came less than a year after the bank had posted its biggest profits ever, and after repeated assurances by the bank’s chief executives that its leverage was manageable, that liquidity levels were high, and that the bank’s overall finances were looking good.Finally, owing to the bank’s global footprint and cross-border interdependencies, the aftershocks that followed its collapse were felt all across the globe and directly affected thousands of financial market participants.The bank’s bankruptcy filing led to more than 75 other distinct bankruptcy filings.In this case study, we are going to look at a brief history of Lehman Brothers and the errors that led to its massive collapse. HISTORY OF LEHMAN BROTHERSLike many other companies playing at the global stage, Lehman Brothers had quite a humble beginning.In the early 1840’s, a German immigrant named Henry Lehman opened up a general store that sold utensils, dry goods and groceries to cotton farmers in Montgomery, Alabama.A few years later, in 1850, Henry’s two brothers, Emanuel and Mayer, decided to join Henry in the business, and that is how Lehman Brothers was born.Soon after, the brothers realized that buying and selling cotton was more lucrative, and so they abandoned the general merchandising business in favor of trading in cotton.The brothers then opened an office in New York and were instrumental in setting up the commodities futures trading business in the US when they opened the New York Cotton Exchange. Lehman Brothers also helped establish the Petroleum and Coffee Exchange.In the early 1900s, Lehman Brothers sta rted intermediating funding for the industrial, retail and transportation giants that were emerging at the time, and their business shifted from dealing with commodities to merchant banking.In 1925, a grandson of Emanuel Lehman known as Robert Lehman took over the reins of the firm and led it until death.During his time at the helm, Robert Lehman turned Lehman Brothers into a well-known investment bank.It became an important asset on Wall Street, helping leading U.S and international companies in mergers and acquisitions, underwriting securities offerings and giving financial advice.Lehman remained privately owned and under the control of the Lehman family until Robert Lehman’s death in 1969.As the US economy grew and prospered, Lehman Brothers grew and prospered with it, though the growth was not without its challenges.In the 1800s, it was the railroad bankruptcies. In the 1930s, there was the Great Depression. Then there was the two world wars.In 1994, the bank was spun off by A merican Express, leading to a capital shortage. In 1998, there was the Russian debt default.Lehman Brothers survived all these challenges and potential disasters, and therefore it came as a surprise when the bank was finally brought down by the collapse of the U.S housing market.At the time of the Lehman Brothers’ collapse, the bank’s main business areas were typical investment banking, as well as capital markers, fixed income, equities, and investment management.The investment banking arm of the bank dealt with provision of financial services, such as underwritings, mergers and acquisitions, and issuance of securities.REPEALING OF THE GLASS-STEAGALL ACTMany financial experts believe that the first factor that contributed to the demise of Lehman Brothers was the repealing of the Glass-Steagall Act.The Glass-Steagall Act, passed in the wake of the Great Depression of the 1930s, separated the interests of investment and commercial banks.This, in essence, prevented competition betw een commercial and investment banks and protected their balance sheets by allowing each to focus on its strongest areas.Under this legislation, commercial banks typically handled capital intensive investments, such as corporate and real estate investments, while investment banks dealt with highly liquid, asset-light investments.Aside from separating the interests of investment and commercial banks, the Glass Steagall Act was a way of protecting the economy from mass collapse.In case one sector failed, this legislation ensured that the other would remain strong rather being dragged down as well, therefore preventing the entire economy from going down.In 1999, however, President Clinton signed into law the Gramm-Leach-Bliley Act, thereby making it possible for investment and commercial banks to once again compete directly with each other.The ensuing competition would turn out to be disastrous, not only for Lehman Brothers, but also for the global economy.With the Glass-Steagall Act re pealed, Lehman Brothers fervently went after the US housing market, which was experiencing a boom at the time.Between 2003 and 2004, the bank became a key player in the housing market and acquired give mortgage lenders, including Aurora Loan Services and BNC Mortgage, two subprime lenders who specialized in Alt-A loans.Initially, these acquisitions looked like wise decisions. Between 2004 and 2006, Lehman Brothers recorded a 56% growth in revenue from its real estate business alone.Starting from 2005, Lehman Brothers reported record profits, and in 2007, the bank posted revenues of $19.3 billion and a record net income of $4.2 billion.In February 2007, the firm’s stock price rose to an all-time high of $86.18 per share, giving Lehman Brothers a market cap of almost $60 billion.Despite the exceptional profits and the rise in Lehman Brothers’ stock price, it had started becoming apparent that the U.S housing market was approaching a bubble burst.By the first quarter of 2007, defau lts on subprime mortgages had reached their highest point in 7 years.On 13 March 2007, just a day before Lehman Brothers posted record revenues and profits for the first quarter of 2007, its stock experienced its biggest one-day drop in five years, due to growing worries that the increasing rate of defaults in the subprime mortgages markets would affect the bank’s profitability.The firm’s CFO, however, assured shareholders that the defaults were well contained, and that the delinquencies in the subprime market would not cross over to the rest of the housing market.TROUBLE STARTS BREWING FOR LEHMAN BROTHERSDespite the record profits posted by Lehman Brothers in the first quarter of 2007, that year would turn out to be a tumultuous year for firms in the housing market.In August 2007, two hedge funds operated by Bear Stearns failed completely.At the time, Bear Stearns was Lehman Brothers’ biggest rival in Wall Street. The failure of Bear Stearns two hedge funds eroded investor co nfidence in the market, and Lehman’s stock experienced a sharp decline.In the same month, Lehman Brothers shut down its BNC unit, did away with about 2500 mortgage related jobs and closed the offices of Alt-A lender Aurora in 3 states.Despite the market conditions not looking promising, Lehman Brothers did not slow down on its mortgage backed securities.That year, the firm was the biggest underwriter of mortgage backed securities, resulting in an $111 billion portfolio, which was about four times the firm’s shareholder’s equity.At the same time, the firm’s chief executives continually reassured the press and shareholders of the firm’s financial strength and downplayed the concerns that there was danger in the domestic and global economies.In the fourth quarter of 2007, there was a temporary rebound in the market.Prices for fixed income assets rebounded, global equity markets reached new highs, and Lehman’s stock experienced a rebound.This was the perfect time for the fir m to trim its portfolio of high-risk, illiquid assets.Unfortunately, the firm failed to do this, and looking back, this would turn out to be the firm’s last chance to reduce its massive mortgage portfolio.THE COLLAPSE OF LEHMAN BROTHERSIn March 2008, Bear Stearns, which was second to Lehman Brothers in underwriting of mortgage backed securities, almost collapsed and was only saved by financial injection from JP Morgan, backed by the Federal Reserve.The near-collapse of Bear Stearns created fear that Lehman Brothers would be the next Wall Street firm to fail, and its shares dropped by as much as 48%. In the second quarter of 2007, Lehman Brothers posted losses of $2.8 billion.Seeing its bleak outlook, Lehman Brothers issued preferred stock that could be converted into Lehman shares at 32% premium.By so doing, the firm raised about $6 billion, thereby helping to slightly raise investor confidence in the company, though the confidence was short lived.The conditions in the credit mark et continued deteriorating, and by the end of the first half of 2008, the stock price of Lehman Brothers had fallen by 73% compared to January the same year.In August 2008, as it approached its third quarter reporting deadline, the firm announced intentions to let go 1500 employees, about 6% of its workforce.On 22 August, 2008, there were reports that a deal was underway for the state-controlled Korea Development Bank to purchase Lehman Brothers. These reports led to a 5% increase in Lehman Shares.Unfortunately, these gains were quickly reversed when the Korea Development Bank announced that it was having trouble attracting partners for the deal and pleasing regulators.On September 9, Korea Development Bank announced that it had put the talks on hold, resulting in Lehman shares plunging to $7.79.Things continued going south for Lehman Brothers.When time came to release financial statements for the third fiscal quarter, the firm posted additional losses of $3.9 billion.The release of the third quarter financial statements resulted in the firm’s stock price plummeting to $3.64, representing a 94% decline from January the same year.Seeing that the firm was in a grave crisis, CEO Richard Fuld attempted to keep the firm afloat by announcing a plan to sell the firm’s real estate holdings. Unfortunately, there were no willing buyers.To make matters worse, the United States Treasury made it clear that it would not step in to bail out Lehman Brothers.Instead, the Treasury encouraged other financial institutions such as Bank of America and Barclays to acquire Lehman Brothers and save it from its impending collapse.None of the potential acquirors agreed to a deal, and eventually, on Sunday September 15, 2008, Lehman Brothers admitted defeat, and under advice from the United States Treasury, the firm filed for Chapter 11 Bankruptcy protection, before the markets opened on Monday.AFTERMATH OF THE LEHMAN BROTHERS COLLAPSEWhile there are other factors that contributed to the subsequent economic turmoil, the bankruptcy of Lehman Brothers seemed to be the one event that triggered the widespread economic recession that continued well into 2009.This was the biggest economic crisis ever since the Great Depression.Following the bankruptcy filing by Lehman Brothers on September 15 2008. The Dow Jones dropped by 504 points once the markets opened.On September 16, Barclays agreed to a deal to purchase Lehman Brothers’ US capital markets division at $1.75 billion.The resulting financial crisis also took insurance giant AIG to the brink of total collapse. The federal government was forced to step in and save the insurance giant with a financial bailout package worth $182 billion.Owing to its Lehman Brothers exposure, the stocks of the Primary Fund also experienced a very sharp decline, dropping to below $1 per share.Following the collapse of Lehman Brothers and subsequent financial crisis, over 6 million people lost their jobs and unemployment in the United States rose by 10%.It also led to the controversial passage of the Trouble Asset Relief Program on October 3 2008, which saw the US government step in with a $700 billion bailout package to rescue what remained of the country’s financial sector.The 2008 financial crisis also led to the passage of the Dodd-Frank Act, which was passed with the aim of increasing financial regulation.The effect of the collapse of Lehman Brothers was not restricted to the United States.Across the world, people confidence in the global banks and hedge funds dropped greatly and credit markets froze. The economies of countries like Lithuania, Hungary and Latvia were devastated.Even the European Union was majorly affected. Government officials in Iceland announced that the government had no funds to support the country’s major banks, while Pakistan was forced to seek a bailout from the International Monetary Fund (IMF).WHAT REALLY WENT WRONG?Ever since its foundation back in the early 1840s, Lehman Brot hers surmounted multiple tests and trials over a period of more than one and a half centuries.Therefore, it is unfathomable that one isolated incident was all it would take to make the Wall Street giant go belly up. So, what really went wrong?The collapse of Lehman Brothers can be attributed to a series of factors that, combined together, put it in a position it could not extract itself from.These factors are:Lies by its CEO Richard FuldWhen the housing market started showing cracks in 2007, Lehman Brothers was deeply involved in a highly aggressive and leveraged business model.However, many other Wall Street firms at the time employed the same model, so how did they survive while Lehman Brothers went belly up?The difference is that some of the firms had the foresight to recognize that the US housing market was facing a pending collapse, and they therefore took the time to evaluate what a high default rate would do to their business.Lehman’s CEO, Richard Fuld, on the other hand, d id not take the time to evaluate market conditions.When others firms started reducing their leverage, Lehman Brothers continued increasing their asset portfolio in mortgage-backed security investments, which were very risky given market conditions.That was not all.At some point, Fuld realized that his strategy was not working as he expected, and he had an opportunity to take responsibility and admit that he had made an error.Had Fuld spoken out truthfully about the firm’s financial health in time, there would have been time to come up with good solutions on how to prevent the firm continuing its headlong march towards its inevitable collapse.For instance, if they had been given a notice early enough, financial institutions such as Barclays and Bank of America would have had enough time to come up with a plan to save Lehman from its imminent collapse.Unfortunately, instead of being truthful, Fuld repeatedly assured shareholders and the press that the firm was financially healthy an d was not facing any foreseeable concerns.Speaking out would also have made the federal government aware of the situation Lehman Brothers was in and allowed it to take actionable measures to minimize losses and protect the firm from total collapse.By choosing to paint a rosy picture of the bank’s financial health, Fuld made it impossible for outsiders to know the actual situation the firm was in until it was too late.Complicity by CFO Erin CallanEven though Lehman CEO Richard Fuld chose to lie to the public that the firm was not facing any foreseeable concerns, the banks financial reports would have shown a different picture.To keep shareholders and other stakeholders fooled, CFO Callan gave approval of Lehman’s assets to be siphoned away into Hudson Castle, a phantom subsidiary of Lehman’s.By siphoning of Lehman’s assets into Hudson Castle misrepresented Lehman’s financial health and made sure its balance sheets did not show any sign of trouble.This misrepresentation of f inancial health was applied on two consecutive quarters.Following the collapse of Lehman Brothers, the investigations that followed confirmed that the siphoning of Lehman assets to Hudson Castle was not done for tax benefits, but to create the illusion that the illusion that Lehman Brothers was financial stable and secure.While this was not an illegal strategy, it intentionally kept shareholders from being aware of the bank’s dangerously high leverage, since awareness of the same would have eroded shareholder confidence in the firm’s operations.As with the CEO’s decision to lie, the firm would have been better off had the CFO not been complicit to the CEO’s lies by misrepresenting financial information.Negligence by Ernst YoungAt the time of Lehman’s impeding collapse, Ernst Young were the only outsiders who were aware of the actual situation at Lehman Brothers and the extensive steps the firm’s executive leadership was taking to conceal the firm’s financial woes.As a firm of certified public accountants, Ernst Young was expected to honor and uphold the industry’s code of ethics.However, Ernst Young choose to neglect its responsibility of honestly disclosing what was going on at Lehman Brothers.This was a highly unethical blunder that put Ernst Young’s highly respected reputation at risk.It is presumed that Ernst Young chose to turn a blind eye because Lehman Brothers was at the time one of their biggest and most lucrative clients.WRAPPING UPThe collapse of Lehman Brothers was a significant and unfortunate event in the history of the US financial industry.The collapse was significant because it killed the general public’s illusion that some institutions were too big to fail.At the same time, the collapse was unfortunate because it was essentially caused by the unethical behavior of the firm’s executive leaders and professional advisors.They consciously made the decision to deceive and manipulate the bank’s shareholders and the gen eral public, and the consequences for this deception proved too dire, not only for the firm, but also for the economy as a whole.The main lesson from the collapse of Lehman Brothers is that transparency and accountability are very important, regardless of how dire the circumstances mat seem.