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The following text introduces the topic at hand.
Lehman Brothers Holdings Inc., the fourth largest US investment bank, filed for chapter 11 bankruptcy on September 15, 2008. This was a result of the subprime mortgage crisis and set a record as the largest bankruptcy filing in history. Despite successfully navigating previous challenges such as railroad bankruptcies in the 1800s, the great depression in the 1930s, and the collapse of long-term capital management ten years prior to this crisis, Lehman Brothers could not withstand its impact.
With a history of operation spanning 158 years, we will now analyze how media coverage during this crisis unfolded and provide a timeline showcasing how it ultimately led to their bankruptcy.
2008
Lehman faced its first loss in 2008 due to the subprime mortgage crisis, which resulted in a significant decline in their stock value and staggering losses of $2.8 billion in the second quarter alone. To meet their debts, Lehman had to sell off assets worth $6 billion and announced a workforce reduction of 6% in August 2008. These events ultimately led to Lehman's collapse.
September 10th, 2008
Lehman Brothers' third-quarter results revealed their dire financial position.
The company incurred a loss of $3.9 billion, including a write-down of .6 billion.
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In order to raise capital, Lehman Brothers had to sell its asset management subsidiary, Neuberger Berman. Simultaneously, Moody's Investor Service announced the reassessment of Lehman Brothers' credit ratings and advised selling a majority stake to prevent a downgrade in ratings. Consequently, CEO Dick Fuld urgently sought potential buyers and devised plans for asset sales. Additionally, investors expressed concerns regarding whether the US government would offer assistance to Lehman Brothers, particularly following the bailout of major lenders Fannie Mae and Freddie Mac.
11th September 2008
The Korea Development Bank withdrew from the deal to buy Lehman Brothers due to challenges with regulators and partners.
This decision had a major impact on Lehman Brothers, causing its stock value to drop by 45% and credit-default swaps on its debt to increase by 66%. Furthermore, the bank's hedge fund clients started pulling out their investments and short-term creditors reduced their credit lines. As a result, there was an urgent search for buyers, raising concerns about the bank's ability to survive. Consequently, shares plunged by 42% to $4.44.
12th September 2008
Barclays is considering an offer to acquire Lehman Brothers in order to strengthen its presence in North America. However, despite this interest, the value of Lehman shares has decreased by 13.5 percent. The US government is in discussions with Wall Street bankers to find a solution for rescuing Lehman Brothers. Tim Geithner, the president of the New York Federal Reserve System (FRS), has proposed a strategy called the 'good bank, bad bank' approach. This plan would allow buyers to acquire Lehman Brother's desirable assets while Wall Street funds $80 billion worth of toxic debts.
September 14, 2008
Over 100 individuals from different sectors of Wall Street, such as bankers, regulators, and US Treasury officials, convened at the Federal New York building for a weekend conference to address potential solutions. Despite already granting $229 billion in bailouts to Bear Stearns, Fannie Mae, and Freddie Mac, the US Treasury showed hesitation towards further financial support from taxpayers.
On the 15th of September 2008,
Lehman Brothers filed for chapter 11 bankruptcy due to the failure of Wall Street and the US Treasury to find a solution, resulting in abandonment. This bankruptcy holds the record as the largest in US corporate history, with $639 billion worth of assets and $613 billion worth of debts. It is particularly significant because it marks the first major bank collapse since the credit crisis began one year earlier. The value of Lehman bonds and loans experienced a drastic drop, going from trading at 80-90 cents on the dollar just a week prior to slightly over 40 cents. Consequently, other institutions holding approximately $70 billion of Lehman Brother's debt had their debt eliminated, leaving them vulnerable to potential substantial losses.
After going through the process of bankruptcy
Lehman Brothers, which emerged from bankruptcy in September 2012, is currently operating as a typical investment bank. However, its main objective is to liquidate all assets and repay lenders in order to ultimately cease operations. The collapse of Lehman Brothers can be primarily attributed to the housing market boom in 2004, driven by low interest rates and easy financing. During this period, Lehman Brothers acquired mortgage lenders BNC Mortgage and Aurora Loan Services, leading to a significant increase in revenues from capital markets within its real estate business segment. However, the housing market began declining in 2007, resulting in a seven-year high in subprime mortgage defaults. While many financial institutions were impacted by the crisis, Lehman Brothers faced particular vulnerability. The following section will delve into the underlying causes of the challenges faced by Lehman during this time.
3.1 There is an excessive concentration in the mortgage market.
The primary cause of Lehman Brothers' collapse was its strong focus on the mortgage market. During the period from 2006 to mid-2007, Lehman aggressively expanded into various areas such as commercial real estate, private equity, and leveraged lending using its own capital (Latifi, 2009). It also underwrote a larger volume of mortgage-backed securities in 2007 and accumulated a portfolio worth $85 billion, which was four times greater than its shareholders' equity. Despite being aware of the risks associated with the mortgage market, instead of reducing its exposure, Lehman increased investments in illiquid assets from $87 billion in 2006 to $175 billion by the end of Q1 2008 with hopes of profiting from a counter-cyclical strategy (Saurav K. Dutta, 2010). This heavy reliance on the mortgage market left Lehman particularly vulnerable to a decline in housing prices. Consequently, when housing prices dropped significantly during H1 2008, Lehman's stock value decreased by 73% (Sourcewatch, 2012).
The leverage is 3.2, which is considered high.
The downfall of Lehman Brothers can be attributed to their excessively high financial leverage, as indicated by the ratio of total assets to shareholders equity. Neglecting risk management, Lehman Brother's leverage ratio increased from 24 in 2003 to 31 in 2008, surpassing the industry standard of 20 to 1 for Wall Street broker-dealers. Furthermore, Lehman heavily relied on short-term debt financing, which posed a significant insolvency risk if lenders cut credit lines. As the financial crisis unfolded, confidence in Lehman diminished and borrowers recalled their loans. Due to their high leverage, Lehman lacked funds to repay the loans and had no choice but to sell off assets. This resulted in fire-sale risk and liquidity problems since most of their assets were illiquid.
The primary subject of conversation revolves around the overvaluation of Collateralized Debt Obligations (CDOs).
The crisis at Lehman Brothers in 2007 and 2008 was worsened by the over-valuation of CDOs, resulting in liquidity issues and a significant impact on the company's balance sheet. This over-valuation was caused by three main factors. First, the product control group at Lehman lacked sufficient resources to thoroughly evaluate the prices of CDO positions, which were responsible for verifying the value of assets held by the trading desk. The employees in this unit did not have the same quantitative expertise as traders and relied on their models for asset valuation. Second, only 10% of the CDO portfolio underwent evaluation using third-party prices, which failed to accurately determine their value. Lastly, incorrect discount rates were used by Lehman Brothers during project valuation.
Lehman Brothers made an error in its largest CDO position, Ceago, by using a lower discount rate for the riskier subordinate tranches, which contradicts the usual practice of considering senior tranches as safer securities. According to reports, Lehman significantly overestimated certain tranches, with estimated prices being only about one-thirtieth of the reported price. This overvaluation resulted in heavy devaluation of CDO positions as the financial crisis unfolded and subprime mortgage defaults increased. Consequently, investors became worried about their exposure to these assets and stopped investing in Lehman Brother's commercial papers. The withdrawal of funds had a negative impact on Lehman Brothers' ability to renew or roll over its commercial papers, leading to liquidity problems and eventual insolvency.
The manipulation of accounting statements is what fraud in finance entails.
According to Adam (2010), Lehman Brothers experienced various factors that contributed to its downfall, including the manipulation of accounting statements. To temporarily remove up to $50 billion of assets from its balance sheet, the company utilized a tactic called Repo 10510. This involved classifying short-term loans as sales in order to deceive the public about Lehman's actual liquidity state and present a more favorable image on its published balance sheet (Agatha, 2011).
Shareholders expressed worries regarding the company's financial leverage and the increased risk associated with higher debt levels. Despite these concerns, Lehman failed to effectively address this situation and instead engaged in risky investments and activities.
Lehman Brother utilized Repo 105 transactions as a means to conceal its financial difficulties (Pranvera, 2010). These transactions were frequently amplified prior to quarterly reports in order to create the illusion of a strong financial position and high leverage for the company (Agatha, 2011). However, Lehman Brother failed to disclose any information regarding these transactions, leading others to believe that the company was financially secure. Ultimately, this deceitful practice resulted in bankruptcy and was deemed a significant act of fraud. Had Ernst & Young, Lehman Brother's external auditor, expressed concerns about Repo 105, it is conceivable that the bankruptcy could have been prevented.
The workforce consists of 3.5% Certified Public Accountants (CPAs).
According to allegations, Ernst & Young (E&Y) did not question or challenge inadequate or improper disclosure in Lehman Brother's financial statements. E&Y claimed that the financial statements were presented in accordance with Generally Accepted Accounting Principles, but the audit firm should have been concerned about the significant decrease of 0.9 in the gearing ratio12 for the second quarter of 2008 due to excessive use of Repo 105 (Steve, C). There were also allegations that E&Y simply approved the accounting treatment without considering its impact on the financial statements or why Repo 105 was being used (Karen, 2010). This lack of consideration for materiality and examination of Repo 105 transactions did not meet professional audit standards. Consequently, E&Y's inaction allowed Lehman Brothers to manipulate its accounting statements and ultimately led to its downfall.
The credit ratings assigned to mortgage-backed securities are 3.6.
The extensive investments of Lehman Brothers in subprime mortgage-backed securities led to its failure. These securities were rated highly by credit rating agencies such as Moody's, Standard and Poor, and Fitch, despite their failure to accurately assess the associated risk. This resulted in worsened market conditions due to underestimating the complexity of these financial instruments. The collapse of many subprime mortgages shortly after receiving high ratings caused significant impact on companies, including Lehman, that had invested in them. The accuracy of credit ratings was relied upon by the entire financial industry, making it suffer from these investments in subprime mortgages.
The government regulations account for the total, which is 3.7% in percentage.
The financial crisis of 2008 was a consequence of the deregulation of over-the-counter derivatives. This deregulation was brought about by the Commodity Futures Modernization Act of 2000, which prohibited the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) from regulating derivatives trading. Consequently, Lehman faced significant challenges as they participated in numerous OTC derivatives transactions without sufficient supervision from the SEC and with reliance on industry self-regulation. Ultimately, their failure to meet their derivative obligations resulted in their insolvency.
3.8 Negative Corporate Governance
The failure of Lehman Brothers can be attributed to its corporate structure, specifically the lack of financial market experience among the individuals comprising the Board of Directors. The CEO, Richard Fuld, had complete authority over risk management, strategies, goals, and objectives. However, the Board of Directors lacked effectiveness and control over the company. This was exacerbated by Richard Fuld's dual roles as chairman of the board and head of the risk committee, which posed risks related to self-interest and independence. Consequently, there was a delay in acknowledging the mortgage crisis due to Richard Fuld's autocratic leadership style that disregarded alternative perspectives.
Moreover, the company's autocratic corporate structure led to a lack of communication and shared understanding. Despite warnings from skilled researchers and managing directors about the considerable risks involved in mortgage transactions (Robyn Alman, 2009), their concerns were disregarded and they were dismissed. As a result, management did not promptly acknowledge the need for Lehman to raise capital and dispose of problematic assets, ultimately leading to liquidity problems. To address the root causes of Lehman Brothers' difficulties, we will explore possible measures that could have been implemented to prevent these issues.
Discover ways to prevent the issues
The study of history and the subsequent downfall of Lehman Brothers can provide valuable lessons on the errors they made and the steps that could have been taken to prevent such issues.
The concept of moral hazard is being discussed.
Increasing management's accountability towards shareholders could have mitigated the issue of moral hazard. The implementation of an equity pay structure for employees aims to instill a sense of ownership and responsibility, as their income becomes tied to the long-term value of the company. However, this approach had unintended consequences at Lehman Brothers. The equity pay structure actually encouraged employees to take excessive risks and focus solely on maximizing profits. Therefore, it is crucial for companies to manage the risk-reward ratio in their equity pay structure. While it remains important to reward employees with equities, it may be wise to reduce the percentage of equities awarded based on overall performance.
Diversification
During the subprime mortgage crisis, Lehman Brothers faced significant losses due to its heavy investments in the risky subprime mortgage market. While holding such assets can yield high returns during a housing market boom, it can lead to substantial losses when the housing market underperforms. As shown in Figure 3, Lehman Brothers was the largest underwriter for securities in 2006, with a value of over $51.8 billion. However, by September 2007, 20% of the subprime loans were in default. This crisis resulted in Lehman Brothers reporting a loss of $2.8 billion in the 2nd quarter of the 2008 financial year. Diversifying their portfolio could have helped offset this loss.
Less innovation
Source: http://angryfutureexpat.wordpress.com/
According to marketers, financial innovation can sometimes destroy value instead of increasing it, especially with the introduction of new financial securities such as credit default swaps (CDS), mortgage-backed securities (MBS), collateralized debt obligations, and derivatives of derivatives (CDO2) which were at the center of the crisis. Instead of offering traditional financial instruments like corporate or government bonds, equities, and others that customers could easily understand, Lehman Brothers and other investment banks introduced complex financial products to hedge funds, pension funds, and institutional investors, often with higher margins. The complexity of these derivatives required expertise from learned individuals to accurately value and price them.
Regulators and traders frequently lacked comprehension of derivatives and the true nature of the underlying assets, such as subprime mortgages. Consequently, the creative bundling of financial securities prevented them from fully grasping the inherent risks involved. Having a clearer understanding would have enabled them to recognize that they possessed high-risk subprime mortgages. This would have facilitated earlier detection of warning signs, such as homeowners defaulting on their loans, leading to banks halting the purchase of home mortgages and ultimately could have averted the crisis.
Regularly reviewing the ratings is performed by credit rating agencies.
Sprinzen and Azarchs (2008) argued that Lehman Brothers received a high credit rating of A+ from Standard and Poor's (S&P). They stated that the company's value was evaluated based on its past performance and as long as the ratings accurately reflected the market sentiment, a rating review would only occur if there was a change in market sentiment. Therefore, Credit Rating Agencies like S&P should constantly assess the creditworthiness of companies and re-rate them on a regular basis.
Managerial oversight and accounting standards
Claims from various sources suggested that it was necessary to establish a reliable system for monitoring the activities of the executive committee. This system would involve conducting thorough audits of the organization's financial records in order to determine the true state of the firm. For instance, a court-appointed examiner's report revealed that Lehman executives routinely utilized a practice known as Repo 105, particularly at the end of each quarter, as a way to artificially improve the appearance of the company's financial stability. If an effective system for accounting for repurchase transactions had been in place, such misleading information would have been exposed. As a result, Lehman Brothers may have faced pressure to reduce their leverage in order to meet market expectations and prevent a downgrade in their credit rating. Consequently, the International Accounting Standards Board (IASB), Financial Accounting Standards Board (FASB), and other influential organizations responsible for establishing accounting standards convened in April 2010 to reevaluate how such repo transactions should be accounted for.
Tightening of rules & Regulations
Lehman Brothers' rapid downfall can be attributed to its extensive reliance on leverage for financing its investments in the housing market.
Source: goldnews.bullionvault.com
In the period leading up to the crisis, as shown in the left graph, Lehman Brothers increased their leverage in an effort to take advantage of the booming housing market. Compared to other financial institutions, Lehman Brothers had a significantly higher leverage of 31 to 1. At that time, there were no specific regulations preventing Lehman Brothers from doing so. In other words, most of their investments had little cash backing them up. As depicted in the right bar graph, the troubled assets held by Lehman Brothers exceeded double its tangible equity. When the mortgage backed securities began to default, the bank discovered that its ability to handle losses was compromised due to its high leverage.
One potential solution to address risk in banks is by implementing regulations that require a maximum leverage ratio. For instance, banks could be limited to a leverage ratio of 25 to 1. This regulation would provide banks with additional funds to support their investments and allow them more time to handle any issues that arise. By having excess cash available, banks can invest in alternative income sources that still hold potential, mitigating the impact of defaults and losses. Ultimately, this regulation would help prevent banks from assuming excessive risk and provide them with the means to recover from difficult situations.
Government intervention
When Lehman Brothers filed for bankruptcy, it ceased paying its commercial paper, leading to a rush by individuals and corporate treasurers to withdraw their cash from money market funds. As a result, the funds had to urgently obtain cash by retrieving any available money from banks on both sides of the Atlantic, causing a freeze in lending across the board. This had significant ramifications in the financial world. Some officials maintain that they had no alternative but to let Lehman fail due to the absence of legal authority and funds. However, others argue that if policymakers had desired, they could have found a more innovative solution. Douglas Elliott, a former investment banker, states, "They could have found a way in that kind of emergency."13 (Francis, 2009)
The collapse had such a strong impact on the economy that some speculate whether the damage could have been reduced if the government had provided bailouts and assistance. Even if rescuing Lehman Brothers was not feasible, a gradual decline could have allowed for a smoother adjustment rather than an immediate crisis. While the actual consequences remain unknown, we believe the government could have implemented more effective measures to address the situation.
Shadow banking system
Shadow banks, which differ from traditional banks by not accepting deposits, are subject to less regulation. As a result, they can increase their investment rewards by leveraging up more compared to mainstream banks. However, this can lead to an accumulation of risks in the financial system. For example, Lehman Brothers conducted transactions that were not included in their conventional balance sheet accounting, making them invisible to regulators and unsophisticated investors. Consequently, unregulated shadow institutions serve as a means to bypass the tightly regulated mainstream banking system and evade measures aimed at preventing financial crises.
To regulate the shadow banking system effectively, it is crucial to introduce stricter credit and capital requirements. The Dodd-Frank Act, enacted in 2010, grants the Federal Reserve System the authority to regulate all systemic important institutions, including shadow banks. These regulations would enhance transparency and impose necessary requirements on the shadow banking system, potentially preventing the collapse of Lehman Brothers.
Bibliography: - Robyn Alman, R. C. (n.d.). Lehman Brothers: An Exercise in Risk Mismanagement. Retrieved 2013 йил 1-April from New England College of Business and Finance: http://www.necb.edu/resource_lehman-brothers-an-exercise-in-risk-management.cfm - Latifi, P. (n.d.). Lehman Brothers’ rise and fall: From hero to dust. Retrieved 2013 йил 1-April from lcbr-online.com: http://www.lcbr-online.com/index_files/proceedingssym12/12sym13.pdf - Saurav K. Dutta, D. C. (2010 йил August). Lehman’s Shell Game Poor Risk Management. Retrieved 2013 йил 1-April from imanet.org: http://www.imanet.org/PDFs/Public/SF/2010_08/8lawson.pdf - sourcewatch.(2012 йил 20-June). Lehman Brothers. Retrieved 2013 йил 1-April from Sourcewatch: http://www.sourcewatch.org/index.php?title=Lehman_Brothers - Carney, J. (2010 йил 17-March). Lehman Brothers Was Dramatically Over Valuing Its CDOs. Retrieved 2013 йил 28-March from Business Insider Clusterstock: http://articles.businessinsider.com/2010-03-17/wall_street/30061008_1_lehman-brother-lehman-report-valuations - Investopedia.(n.d.). Collateralized Debt Obligation - CDO. Retrieved 2013 йил 28-March from Investopedia: http://www.investopedia.com/terms/c/cdo.asp - Francis, T. (2009, September 13). Lehman's Fall: The What-Ifs Linger. Retrieved April 22, 2013, from http://www.businessweek.com/: http://www.businessweek.com/stories/2009-09-13/lehmans-fall-the-what-ifs-lingerbusinessweek-business-news-stock-market-and-financial-advice - angryfutureexpat.(2010, April 20).The text discusses two articles: "The Magnetar Trade" and "Lehman Bros. vs. Bear Stearns". The first article, titled "The Magnetar Trade - CDOs, Pricing Arbitrage, Vampire Squid, And Hand Jobs," can be found at http://angryfutureexpat.wordpress.com/2010/04/20/the-magnetar-trade-cdos-pricing-arbitrage-vampire-squid-and-hand-jobs/. The second article, titled "Lehman Bros. vs. Bear Stearns," can be found at http://goldnews.bullionvault.com/lehman_bear_stearns_fed_bonds_financial_052920082, and was written by Amoss on May 29, 2008.
The Fall of Lehman Brothers: A Media Timeline. (2016, Apr 28). Retrieved from https://studymoose.com/lehman-brothers-case-essay
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