Devastation of US Banking Industry in 2008 Financial Crisis

In year 2008, financial crisis had caused the collapse of numerous banks in United States. Lehman Brothers was one of the banks that had filed its insolvency on 15 September 2008. It was the most significant personal bankruptcy in the history and it still is for now. Being the 4th largest investment bank in United States that had actually been established for 158 years, its failure had actually brought a huge effect to the world financial markets. The failure of this large financial investment bank had activated people worldwide.

After the failure of Lehman Brothers in 2008, there are a variety of experts and scientists that had attempted to find out the root of such event, the reasons for the collapse, the effects of the failure and some lessons that might be learned from the failure of Lehman Brothers All these papers and analysis have their own perspective. Therefore, there are a couple of goals that I wish to concentrate on. In this paper, we will first concentrate on "What triggered its failure?" Everything that occurred will have its own factors and causes.

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Next we are going to focus on "what is the effect of its failure?" Another goal that we are focusing on is the lessons that we acquired from this failure. It is very important to study the story of Lehman Brothers who was a legend because it was established in 1850 up until 2008 and they had endured through the world monetary crisis.

1.0 History of Lehman Brothers.

Lehman Brothers was very first established by a brand-new German immigrant Henry Lehman in Montgomery, Alabama in year 1844.

He started up a shop named 'H. Lehman', which sells groceries and dry items to some regional cotton farmers. In 1847, his bro Emanuel Lehman showed up, and they alter the name once again to 'H. Lehman and Bro'. In 1850, their youngest brother Mayer Lehman arrived in Montgomery and as soon as again they changed its name and 'Lehman Brothers' established already.

During that time, cotton was one of the important crops thus they have a high market value. The three Lehman brothers started to accept raw cotton from their customers as a source of payment for merchandise. Within a few years, the trading of cotton had become their most important part of their operation. In 1855, Henry Lehman passed away at the age of 33 from yellow fever. After Henry’s death, Mayer and Emanuel continued their business on commodities trading. They have their own policy, only their family members-sons, brothers, and cousins-that were permitted to be their partners. This policy carries on until 1920s.

Their business grow and they formed a partnership with a cotton merchant John Wesley Durr to build their own storage warehouse. They used this warehouse to store their mass amount of cotton to enable them to support larger sales and trades. Their business continued to expand and they set up an office in New York in year 1858. However, Lehman Brothers faced hardship during the period of Civil War but they managed to rebuild their business after the war, and focusing their operations based in the New York office. Lehman Brothers expand to include sales and trading of other goods. Besides forming the New York Cotton Exchange, they were involved in establishing the Coffee Exchange and Petroleum Exchange. In 1867, Lehman Brothers became the agent of the Alabama government in selling the state’s bonds.

In 1906, under the leadership of Philip Lehman, son of Emanuel, he partnered with Goldman Sachs, together they brought the General Cigar Co. to market followed by Sears, Roebuck and Company. There were around one hundred new issues that were underwritten by Lehman Brothers in conjunction with Goldman. Philip Lehman retired in 1925, and the company was taken over by his son, Robert Lehman. Under Robert’s leading, the company survived through the Great Depression, and they carry on their operation focusing on venture capital. In 1930s, they underwrote the Initial Public Offering (IPO) of the first television manufacturer, DuMont. They also helped to finance companies like Halliburton and Kerr-McKee.

In 1969, Robert Lehman passed away and he was the last member of Lehman family to lead the company. Robert’s death had led to problems that brought hard times to the firm. In 1973, an important person, Pete Peterson was brought in to save the firm from its difficulties. He as the Chairman and CEO had led the firm from operating losses to record profits in five consecutive years. Lehman Brothers merged with Kuhn, Loeb Inc., and formed the country’s fourth largest investment bank preceded by Salomon Brothers, Goldman and First Boston. In 1984, American Express acquired Lehman Brothers to merge with retail brokerage Shearson to form Shearson Lehman Brothers.

However, a few years later in 1993, the firm spun off and became known solely as Lehman Brothers. In 2001, the World Trade Center offices were destroyed by terrorist attack therefore their headquarters was moved to Manhattan in 2002. The firm continue to shine until 2008, it had recorded a high profit in 2007 but in less than a year’s time they was entangled in the subprime mortgage lending crisis. On September 15 2008, they filed a Chapter 11 bankruptcy in federal court.

2.0 Causes of its Failure

The collapse of Lehman Brothers was a huge impact because everyone was thinking that it is impossible for such a large bank to collapse. Lehman Brothers had just reported a large profit in 2007, in less than a year time they filed for their bankruptcy. After the failure of Lehman Brothers, there were many people discussing about the causes that led to the failure of this large investment bank. Although they managed to pass through the past economic downturn with their business strategies but they could not survive the collapse of the housing market of United States of America. Until today, the causes of its failure were still being discussed among people around the world. Some would say that the poor management of the firm itself was the key to the collapse of the bank.

The top management of Lehman Brothers failed to detect the problem that might occur with their balance sheet and their Chief Executive Officer (CEO), Richard J. Fuld had miscalculated the severity of the market upheaval. Lehman began to emerge into home mortgages in 2005 without bothering the early warning that the housing market in United States is being overheated and it will burst anytime. In 2007, two hedge funds sponsored by Bear Sterns collapsed and the market’s attention had focused on the value of subprime mortgages. The firm has confidence with itself because they consider itself as an expert in the financing real estate. Lehman Brothers did not manage to detect the alarm yet because their balance sheet was heavily weighted in commercial real estate which had nothing to do with the residential housing sector. Although the lower management might have detected the danger earlier but the news could not reach until the top management.

The firm failed to realize that it was actually a ticking time bomb that might explode anytime. It is a norm that the top management was the last one to know whenever there is a danger because the employees would try to cover up. That is why the top management could not react to save the firm at an earlier stage. Some would argue that the CEO, Fuld was to blame because of his overconfidence and failure to recognize that Lehman faced a crucial crisis. Besides, Lehman paid an extremely high salaries and bonuses for their employees which total up more than half of the company earned in pre-tax profit. In addition, the accounting system of Lehman itself was a big flop. They used “Repo 105 transactions” that was described by their own accounting personnel as an “accounting gimmick”. First of all, some would question what does “repo” means.

“Repo” means repurchase agreements, transaction which banks use it to borrow cash for short term. It involves raising cash by lending out high-quality assets for a short period of time. The banks will agree to repurchase their collateral in a few days or weeks. This way of recording their accounts created a false portrayal of their true financial status. Even the external auditor, Ernst & Young did not take further action to investigate the “repo”. According to Stern Stewart (2002), he said that accounting is no longer counting what counts and those in charge have not been wise enough or strong enough to resist their ploys to make the auditors’ definition of earning into a reliable measure of value. Accounting fraud and accounting manipulation are the major reasons to companies’ failure and financial crises. They intend to keep this matter and hide it from the shareholders and the public. In this case, the external auditors did not do what they are supposed to do.

They failed to give any warning to the shareholders about the non-disclosure of their financial statements. According to the Public Company Accounting Oversight Board, “an external auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud” Lehman Brothers’ reckless way of lending made the firm into more liabilities. The subprime mortgages were to meet the needs of Americans who could not be qualified for long-term mortgages. Subprime mortgages were targeted on credit unworthy person but also had low interest rates on long term basis. Therefore, subprime mortgages were loans that are high in risk but low in return compared to the property to be purchased. Meanwhile, Lehman also encourages the “ninja (no income, no job, and no assets) or better known as liar loans”. These loans were banned in United Kingdom because “ninja loans” are loans offered to public without any form of collateral. Anyone could loan from the bank even he is without a job, without stable income and without any assets in hand.

These loans are another key for the failure of Lehman. Such loans are the breeding ground of unethical behaviour in the financial market. These loans encourage the moral hazard to happen because the borrowers had nothing to lose as they have no assets to be held as collateral. Following the incident of the failure of Lehman, there are people questioning the decision of the Fed for not bailing out Lehman. Federal Reserve does not bail out Lehman because Lehman could not prove that they have the ability to repay the loan from Fed. There is a theory in the economics called the “Big Bank Theory” which means that governments will not allow a large bank like Lehman to collapse because it will bring a huge impact to the economic. This theory does works when American International Group (AIG) and Bear Sterns were being helped by Fed to prevent it from falling. Everyone thought the same fate will happen to Lehman as well because of the theory “too big to fail”.

However, Lehman Brothers could not escape from the bankruptcy fate. Fed had conducted assessments and it showed that the failure of Lehman would not bring such a big impact to the whole world compared to AIG or Bear Sterns. Federal Reserve chose to bailout Bear Sterns but not Lehman Brothers because when the Fed bailed out Bear Stern in March 2008, it claimed that the bailout was an “extraordinary event”, thus it is impossible for Fed to save another troubled financial firm because it is not possible for “extraordinary events” to occur that often. Competitions are very common in each and every sector including banking and finance sector. Banks will compete among themselves on both assets and liabilities.

According to Bolt and Tieman (2004), to survive the competition for loans and remain profitable, banks undertake measures that will drive the loan volumes and enhance profitability but ultimately compromise their asset quality and increase the probability of collapsing. Bank therefore started to increase the risk in their portfolio by lowering the criteria or terms and condition for a loan. Wilmarth (2009) agreed that competition impacts negatively on lending standards, based on events leading to the global financial crisis in 2007. Banks compete blindly with each other neglecting the possible danger that might arise and harmful towards the banks. They keep on offering subprime mortgages with low payments in order to attract more customers. When the housing prices collapsed in 2007, the borrowers could not refinance their mortgages and defaults happen eventually lead to the subprime financial crisis.

3.0 Effects of Its Failure

In March 2010, it emerged that the bankruptcy was not just the largest ever to be experienced in the American financial system, but it was also one of the largest accounting scandals ever (Connerty, 2010). The failure of Lehman Brothers is similar to that Enron experienced earlier in 2001. Such failure and the present case of Lehman show how an investment bank had successfully fool all the investors and financial analysts. The investors of Lehman Brothers were badly affected because they could not escape from the financial crisis impact. In many countries, the investors were badly affected because most of them are holding the bonds issued by Lehman before it collapses. In Hong Kong, there are 43,000 individuals who had bought the so-called mini bonds up to a total of $ 1.8 billion. Pension funds, such as the New York State Teachers' retirement plan had also incurred losses due to the collapse of Lehman (Bryan-Low, 2009, cited in Swedberg, 2010).

Once Lehman declared its bankruptcy on September 2008, investors lose their money and some investors are even senior citizens. Although some investors do suffer a huge loss, but most of the world's leading investment banks made big profits again in 2009. Investment banks have always been a very volatile business and it will still continue on to have its ups and downs. The failure of investment banks does not affect the long run of the business because it is a very profitable business. The consequences of the collapse of Lehman are not that long because some banks started to record profit within a year. However, United States of America’s economy was seriously affected and the US government needs to prop up the markets in order to avoid any further catastrophe and to avoid the history of the Great Depression 1930s to happen once again.

4.0 Lessons Learned after the Collapse

Caplan et al., (2010) mention that in 2006, Lehman made a deliberate decision in pursuing a higher-growth business strategy. To achieve their goal they switched from a low-risk brokerage model to capital-intensive banking model that required them to buy assets and store them as opposed to acquiring assets to primarily moving them to a third party. This strategy at the time also brought a higher risk because most of the assets were long term and they were highly illiquid. As the subprime crisis happened, Lehman had to act quickly to liquidate its illiquid assets in housing mortgages. The crisis caused the assets to be bought at lower price due to the negative perception in the public. Lehman should have forgone its high-growth strategy because its cost had outweighed the benefits. Holding on with the strategy kept dragging Lehman into deeper danger because they should have sacrifice part of the profits to protect themselves from massive loss.

Besides that, the top managers should have eliminated dubious accounting practices by holding to a high ethical standard. Lehman used Repo 105 was only one of the way of many wrongful action used by Lehman to show that their financial statements are still stable and at a healthy state. Lehman practiced the Repo 105 in an unethical way in order to acquire new loans by displaying a healthier situation compared to the actual situation. A standard accounting system open the way for unethical managers to take advantage of it.

They practice the standard according to their own unethical behaviour in order to achieve or to display a healthy situation to the public. Therefore, the accounting standards must be modified to avoid any of the unethical behaviour that could affect the benefits of the public. The financial statements must meet the necessary accounting standard and the external auditors should point out the mismatch of the balance sheet and investigate for any problem occurred. In this way, it is easier to trace the problem earlier and the management could not have the chance to hide the true condition of their firm. Caplan et al., (2010) suggest that substance must be taken into consideration over form, in which the fairness and the health of the organization must be judged based on the substance of the statements and not simply the ratios inferred from them.

Basically, expanding safety nets involves providing all-embracing guarantees to both creditors and depositors of both commercial and investment banks (Rochet, 2010). Expanding the safety nets is to maintain funding especially during the economic downturn times and to rebuild the investor confidence after such a major economic crisis. The strategy to stabilize the economic is very important and it needs to be carrying on a long term basis in order to prevent future failures. All these strategies should be carried out by investment banks themselves as they were one of the factors that caused the Lehman Brothers to collapse.

In addition, we should have come out with strategies that were directed at dealing with the problem assets and implement the strategies in advance before the financial system failure occurs. It is better to prepare earlier rather than waiting for the failure to occur by its own. These strategies are basically of two types; they can either be in terms of government guarantees on specific high value loans but still keeping the loans on the failing firm’s balance sheet or acquisition of some or all structures securities and loan assortments (Stephanou, 2009). Although dealing with those problematic assets does not really reduce the firm’s vulnerability to such exposures but at least these strategies could tackle the liquidity problems and improve their creditworthiness. Government plays an important role to motivate the private investors to acquire the problematic assets or government can co-finance the acquisition of these assets.

There is need for the industry regulators to enforce more stringent measures to ensure that investment banks do not bite more than they can chew. The regulators should have regular monitoring done on all the investment banks to ensure that they are on the right path and did not take up too much risky investment. From the collapse of Lehman Brothers, we could see that most of the investment banks faced financial crisis with insufficient capital bases and inadequate liquidities. The regulatory measure must be able to ensure that banks have the ability and quantity capital bases that could buffer the financial institutions from massive losses and to be strong enough to withstand any failures in the future. Banks need to have a good number of liquid assets all the time so that the assets could easily be transformed into cash to face any panics. To conclude, it is very important to enforce standards on the capital, leverage and liquidity of every investment banks to prevent financial crisis in the future.

5.0 Conclusions

The recent competition in the banking industry has led to most of this banks engaging in risky exposures (Raghavan, 2003). This is very clear in the collapse of Lehman Brothers. We should learn up from the mistakes and ensure that we do not repeat it in the future. In the collapse of Lehman we could see that corporate governance plays an important role in every firm. The management must be clear with the firm’s condition and to make the right decision for the firm and to be alert towards any kind of possible danger. The Board and regulator could have intervened if Lehman practiced sound corporate practices and had not withheld information regarding the risk levels of the firm. Besides, the external auditors are also a part in this failure because they failed to detect the malpractices in their financial statements.

According to Greenfield (2010), the main indicators of fraud could be detected in the financial statement apparently; the external auditors could not discover this activity. Looking forward, there is no crystal ball. However what is known is that the international financial system is a complex web of dealings, relationships and dependencies. It must however be noted that the demise of Lehman had not impacted on the US economy alone but the world as a whole. Lastly, never assumes too big to fail. Even the most sophisticated financial tools, cannot predict or time the market properly. No one and nothing guarantees you that having past successes, you can be granted the same in the future.