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The Bank that Failed the World
Arghya Sarkar, 10012311
Introduction
On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and
$619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far
surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the
fourth-largest U.S. investment bank at the time of its collapse. Lehman's demise also made it
the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through
global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified
the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization
from global equity markets in October 2008, the biggest monthly decline on record at the time.
Building an Empire
In 1850, Henry, Emanuel and Mayer Lehman, Bavarian immigrants to Alabama, began
bartering for cotton as payment from customers at their store, and within a few years these
original Lehman Brothers were full-blown commodities traders. Subsequent generations of
Lehman would take the firm into investment banking, backing America's great retail
enterprises, from Woolworth's to Macy's, and then funding the first television manufacturers
and broadcasters in the Thirties.
It operated at a wholesale level, dealing with governments, companies and other financial
institutions, employing 25,000 people worldwide, including 5,000 in the UK. Its core business
included buying and selling shares and fixed income assets, trading and research, investment
banking, investment management and private equity.
Capitalising on Market Trend
The Prime Culprit
In 2003 and 2004, with the U.S. housing bubble well under way, Lehman acquired five
mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which
specialized in Alt-A loans (made to borrowers without full documentation). Lehman's
acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses
enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of
growth than other businesses in investment banking or asset management. The firm securitized
$146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits
every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion
on revenue of $19.3 billion.
Lehman's Colossal Miscalculation
In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization
of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing
market were already becoming apparent as defaults on subprime mortgages rose to a seven-
year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years
on concerns that rising defaults would affect Lehman's profitability, the firm reported record
revenues and profit for its fiscal first quarter. In the post-earnings conference call, Lehman's
chief financial officer (CFO) said that the risks posed by rising home delinquencies were well
contained and would have little impact on the firm's earnings. He also said that he did not
foresee problems in the subprime market spreading to the rest of the housing market or
hurting the U.S. economy.
Sub-Prime Mortgage Crisis Explained
Following the tech bubble and the events of September 11, the Federal Reserve stimulated a
struggling economy by cutting interest rates to historically low levels. As a result, a housing
bull market was created. People with poor credit got in on the action when mortgage lenders
created non-traditional mortgages: interest-only loans, payment-option ARMs and mortgages
with extended amortization periods. Eventually, interest rates climbed back up and many
subprime borrowers defaulted when their mortgages were reset at much higher monthly
payments. This left mortgage lenders with property that was worth less than the loan value due
to a weakening housing market. Defaults increased; the problem snowballed, and several
lenders went bankrupt.
Investors and hedge funds also suffered because lenders sold mortgages they originated into
the secondary market. Here the mortgages were bundled together and sold to investors as
collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). When
the higher risk underlying mortgages started to default, investors were left with properties that
were quickly losing value. In the wake of the meltdown, central banks released liquidity into
the market place, which allowed struggling lenders and hedge funds to continue operations and
make the necessary payments on their obligations.
Exposure to the mortgage market
Lehman borrowed significant amounts to fund its investing in the years leading to its
bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this
investing was in housing-related assets, making it vulnerable to a downturn in that market. One
measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners’
equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating
tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in
the value of its assets would entirely eliminate its book value of equity. Investment banks such
as Lehman were not subject to the same regulations applied to depository banks to restrict their
risk-taking.
The Beginning of the End
As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds,
Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-
related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender
Aurora in three states. Even as the correction in the U.S. housing market gained momentum,
Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote
more mortgage-backed securities than any other firm, accumulating an $85-billion portfolio,
or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded,
as global equity markets reached new highs and prices for fixed-income assets staged a
temporary rebound. However, the firm did not take the opportunity to trim its massive
mortgage portfolio, which in retrospect, would turn out to be its last chance.
Lehman's final months
In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200
positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction
in goodwill. The firm said that poor market conditions in the mortgage space “necessitated a
substantial reduction in its resources and capacity in the subprime space”.
In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis.
Lehman's loss was apparently a result of having held on to large positions in subprime and
other lower-rated mortgage tranches when securitizing the underlying mortgages. Whether
Lehman did this because it was simply unable to sell the lower-rated bonds, or made a
conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated
mortgage-backed securities throughout 2008. In the second fiscal quarter, Lehman reported
losses of $2.8 billion and decided to raise $6 billion in additional capital. In the first half of
2008 alone, Lehman stock lost 73% of its value as the credit market continued to tighten. In
August 2008, Lehman reported that it intended to release 6% of its work force, 1,500 people,
just ahead of its third-quarter-reporting deadline in September.
On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the
state-controlled Korea Development Bank was considering buying Lehman. Most of those
gains were quickly eroded as news emerged that Korea Development Bank was “facing
difficulties pleasing regulators and attracting partners for the deal.” It culminated on September
9, 2008, when Lehman's shares plunged 45% to $7.79, after it was reported that the state-run
South Korean firm had put talks on hold.
Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed
the S&P 500 down 3.4% on September 9, 2008. The Dow Jones lost nearly 300 points the same
day on investors' concerns about the security of the bank. The U.S. government did not
announce any plans to assist with any possible financial crisis that emerged at Lehman.
On September 10, 2008, Lehman announced a loss of $3.9 billion and their intent to sell off a
majority stake in their investment-management business, which included Neuberger Berman.
The stock slid 7% that day.
On September 13, 2008, Timothy F. Geithner, then president of the Federal Reserve Bank of
New York called a meeting on the future of Lehman, which included the possibility of an
emergency liquidation of its assets. Lehman reported that it had been in talks with Bank of
America and Barclays for the company's possible sale. The New York Times reported on
September 14, 2008, that Barclays had ended its bid to purchase all or part of Lehman and a
deal to rescue the bank from liquidation collapsed. It emerged subsequently that a deal had
been vetoed by the Bank of England and the UK's Financial Services Authority. Leaders of
major Wall Street banks continued to meet late that day to prevent the bank's rapid failure.
Bank of America's rumoured involvement also appeared to end as federal regulators resisted
its request for government involvement in Lehman's sale.
Allowing Lehman Fail
Lehman Brothers was the fourth-largest investment bank in the United States. It was considered
one of Wall Street's biggest dealers in fixed-interest trading and was heavily invested in
securities linked to the US sub-prime mortgage market. With these investments now shunned
as high risk, analysts say it was inevitable that confidence in Lehman Brothers would likely be
hit - particularly after the collapse of Bear Stearns earlier this year.
In its June to August period in 2007, the bank said it would make write downs of $700m as it
adjusted the value of its investments in residential mortgages and commercial property. One
year on this figure soared to $7.8bn, which in the last week before crash resulted in Lehman
reporting the largest net loss in its history. The bank also admitted that it still had $54bn of
exposure to hard-to-value mortgage-backed securities. As a result, Lehman saw its share price
plummet more than 95%. Despite having access to cash reserves, worried investors pummelled
the firm's shares in the eventful last week after talks to raise billions of dollars from outside
investors ran into a brick wall.
This significant improvement sealed the bank’s fate. But still, nobody expected it to spin so
much wayward. People expected the US Federal reserve to intervene, chairman Hank Paulson
to devise some strategic plan to get Lehman out of this misery. When none of this panned out,
people went into shock.
"It's unconscionable what they did – or more accurately what they didn't do," says Joseph Stiglitz,
Nobel prize-winning economist and professor at Columbia University. "They didn't do their homework. People were talking about the failure of Lehman Brothers from the moment of the
failure of Bear Stearns in March, or before, and they didn't do a thing. If they knew there was systemic risk, why didn't they do anything about it?"
Paulson had been pushing Lehman to find a solution to its problems, to sell itself or to raise
cash. He had not been preparing a government-sponsored contingency plan. There was none.
That weekend, everyone was flying blind.
When Bear Stearns ran into trouble, the US Treasury made the terms favourable for JP Morgan
Chase to buy it. And just in the previous week, the US government effectively nationalised
Fannie Mae and Freddie Mac, which between them own or guarantee about half of the $12
trillion US mortgage market. So already the US tax payer has been put at risk of shouldering
the burden of billions of dollars of losses, and it is becoming politically less acceptable for the
government to keep bailing out private companies. Plus also the moral hazard problem comes
into the fore. If govt. keeps bailing out failing companies, what prevents others from taking
extra risks to maximize revenue? The govt. had to draw a line somewhere, send a message to
the financial institutions and they chose Lehman Brothers.
By not giving UK bank Barclays a guarantee for Lehman's trading obligations as part of a deal
to buy the business, analysts say the US Treasury had put a line under its willingness to use
public money to rescue banks which have made wrong decisions. Instead, government officials
have focused on supporting the financial system in other ways, announcing measures to ease
access to emergency credit for struggling financial companies.
Dire Consequences Globally
Nobody had a Lehman Brothers cheque book or current account. The company was an
investment bank that specialises in big and complex deals and investments. Despite this,
Lehman's collapse and the troubles of other financial institutions was felt by millions of people
around the world - at least indirectly.
Most of our banks and pension funds had dealings with Lehman, or with firms like hedge funds
that traded extensively with Lehman. Unwinding Lehman's complex deals took months if not
years. During that time the global financial system was snarled up. Many banks dint even know
for sure how much they are exposed to Lehman, and went through extreme difficulty freeing
up the money in those deals.
This in turn intensified the credit crunch, with dire consequences for businesses and consumers.
And the dramatic collapse of Lehman Brothers had also shaken the financial markets, with
share prices slumping around the world.
--- Other Financial Institutions
Merrill Lynch was “THE” topic of discussion when it emerged that Lehman would go
bankrupt. US authorities and many bankers feared that after Lehman's demise the attention of
investors and speculators would have moved to Merrill. They were also in a similar position
like Lehman and in the time of disaster, moved fast to secure their own future. Taking
advantage of the fact that US treasury did not issue any guarantee for Lehman’s assets, Merrill
CEO John Thain thrashed out a deal with the anticipated buyer of Lehman, namely Bank of
America. The bank hopes to find safety under the roof of this banking giant. Bank of America
also wanted to spread their domain to investment banking and was more than happy to
capitalize on the deal.
The biggest worry, though, was insurance giant AIG. The company was running out of cash to
cover its losses and had asked the government for an emergency bridging loan, reportedly to
the tune of $40bn. AIG’s trouble would directly affect millions of consumers and companies
around the world. It would also hurt the whole financial system, because AIG is in the centre
of a web of complex financial deals. And compared with AIG, the crisis surrounding Lehman
is small beer. Keeping this bitter truths in mind, and in retrospect of Lehman Brothers’ fall,
Federal Reserve ultimately rolled out $85bn to save AIG.
What Now? – Principal Lessons Learned
1 – Bank executives lie…they also got paid huge amounts, weren’t as smart as they thought they were
and those that ended up at the top tended to be deeply flawed individuals…
On Sept 10 in a conference call with investors, days before Lehman collapsed, Dick Fuld
clearly stated to his shareholders that “no new capital was needed” and that “real estate and
investments were properly valued”. Yet only five days later, Lehman filed for bankruptcy.
At a congressional Committee just a few weeks later, he was defiant. He stood by his “no new
capital was needed” statement: “no sir, we did not mislead investors”. And he added that “we
(made) disclosures that we believed were accurate”. If no new capital was needed why did
Lehman go bust five days later? And if he didn’t know the financial position of Lehman what
was he doing as CEO?
As part of the Congressional Committee hearings, Dick Fuld was allowed to make a
presentation before he was questioned. These are his exact words as to the cause of Lehman’s
demise:
“Naked short sellers targeted financial institutions and spread rumours and false information. The impact
of this market manipulation became self-fulfilling as short sellers drove down the stock prices of financial
firms. The ratings agencies lowered their ratings because lower stock prices made it harder to raise capital
and (it) reduced financial flexibility. The downgrades in turn caused lenders and counter parties to reduce
credit lines and then demand more collateral which increased liquidity pressures. At Lehman Bros the
crisis in confidence that permeated the markets lead to an extraordinary run on the bank. In the end
despite all of our efforts we were overwhelmed.”
There are two facts about this statement that should be intensely scrutinised. Firstly the
downfall of Lehman, according to him, is due to the naked short sellers spreading false rumour
and misinformation. It is not that it was too highly leveraged, too risky and that he had missed
the speculative property bubble completely. And secondly Lehman was “hoisted with its own
petard” – it was injured by the device (short selling) that it had used frequently and very
profitably to injure others. Investment banks have made fortunes from shorting financial
instruments – bonds of indebted governments, shares of troubled companies etc. But then short
selling was used against the very financial firms that had so championed and defended its use.
A delicious irony.
Despite Fuld’s best attempts to obscure his compensation, the Congressional Committee
calculated he was paid at least $480mn in the period from 2000 to when Lehman went bust in
2008. Even for the credit boom times, he was getting massive sums. Such high levels of
compensation reinforced his sense of his own financial genius and infallibility. And that
explains why he found the demise of Lehman so difficult – it challenged his view of his own
brilliance. It’s also why he blames others and not his own shortcomings. Some of his statements
defy belief and confirm he was living in a different reality. He stated that “(past) decisions were
both prudent and appropriate”. That is an extraordinary level of arrogance and conceit for a
man presiding over the largest bankruptcy in America’s corporate history.
2 – Regulatory capture is not a theoretical concept…
The Nobel Prize winning economist George Stigler first came up with the term. It describes a
regulator that is supposed to act in the public’s interest but ends up acting in ways that benefit
the industry that it is supposed to be controlling. Or in laymen’s terms, these regulators are
“captured” by their industries – the gamekeeper turns to poaching if you want to say.
In retrospect just the lack of limits to leverage and the low capital requirements created a
disaster waiting to happen. And that is without all the slicing and dicing allowed, credit rating
agency failures etc. Financial firms had so much money and power, they persuaded politicians
and regulators to leave them alone. Such regulatory capture is not unusual but in the financial
industry it caused global devastation.
Weak regulation was highly beneficial to the banks short term but it has come at great economic
cost to the countries those banks are supposed to serve. Also the failure of weak regulation of
the past now ensures much stricter regulation in the future. Short term view, the banks and
executives benefitted but in the long term the operating environment will be a lot tougher.
3 – Allowing Lehman fail was the wrong decision…
Was Hank Paulson’s decision to let Lehman go bust justified? It’s difficult to comment upon,
but the devastation in the credit markets was truly terrible and Mr Paulson had no idea it would
be that bad. However he acted firmly against creating moral hazard – if bank executives know
the government will always bail them out, then they will take massive risks. Tails I win, heads
you lose, is not a great way for the banking and financial industries to be run.
However what needs to be done now is to create a way for banks to fail without destroying the
system. And the new concept of a bank’s “living will” attempts to do so. Regulators are trying
to make banks safer for the future, restricting “too big to fail” and splitting investment and
traditional banking apart.
However any criticism of Paulson has to be tempered by the remembrance of the environment
– September 2008 was a crazy time. Just one week before the collapse of Lehman, Freddie
Mac and Fannie Mae were effectively nationalised and bailed out by the state. On 16th
September, the day after Lehman’s bankruptcy, the Federal Reserve had to lend $85bn to AIG.
To try and understand what was happening and the implications of it was extremely difficult
at the time. But overall, the decision has not yielded good results and intensified the credit
crunch and subsequent global recession.
4 – We never learn the lessons of the past…
In 1931, the Austrian bank Creditanstalt – the oldest and largest in the country – went bust
because it used short term borrowings to fund long term loans. It faced a liquidity crisis when
foreigners stopped lending to it. At the same time Lazards was the first British bank to fall after
a “rogue trader” made a large and unauthorised bet which went wrong. The failure of banks in
the current crisis is remarkably similar. The funding and liquidity crisis at RBS and JPMorgan’s
$6bn whale like loss mirror the situations above. And these are not the only parallels. History
gives us hundreds of examples of the same behaviour repeated time and time again in the
financial industry. It is a deeply depressing thought that the human race (or at least the part of
it that works in banking) cannot learn any lessons from history.
Asset price bubbles, credit booms, banking collapses. It’s all been seen so many times before.
And so why were we not better prepared? And despite all the current regulatory reform to
ensure this never happens again, I’ve got to bet that it will.
Acknowledgements
www.forexlive.com/blog/2013/09/14/top-ten-lessons-from-the-lehman-brothers-collapse/
http://newsvote.bbc.co.uk/mpapps/pagetools/print/news.bbc.co.uk/2/hi/business/7615974.stm
www.lehman.com
http://home.howstuffworks.com/real-estate/subprime-mortgage2.htm/printable
http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
https://www.youtube.com/watch?v=oqOBnULi124
http://www.theguardian.com/business/2013/sep/13/lehman-brothers-collapse-five-years-
later-shiver-spine
http://www.ibtimes.com/death-lehman-brothers-what-went-wrong-who-paid-price-who-
remained-unscathed-through-eyes-former-vice
http://www.cnbc.com/id/26638883
http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers
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Brothers.html
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