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AhmedMouneimneh

ThefallofLehmanBrothers

Subject:Commercial&InvestmentBanking

SMCUniversity

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TableofContents

Abstract.........................................................................................................................................................3

Introduction................................................................................................................................................3ThecausesofLehman’sfailure.............................................................................................................5

TheMortgagemarket...............................................................................................................................8

CreditratingofMBS...............................................................................................................................11Repo105....................................................................................................................................................11

Riskmanagement...................................................................................................................................13Corporategovernance..........................................................................................................................14

Financialdistress...................................................................................................................................16

CouldLehman’sfailurebeaverted?.................................................................................................17Recommendationgoingforward......................................................................................................18

Conclusion.................................................................................................................................................19

References................................................................................................................................................20

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Abstract

ThefilingofbankruptcybyLehmanBrothersinSeptember2008hadexacerbatedtheconditionof

thefinancialcrisisstemmingfromthecollapseoftherealestatemarket inwhichLehmanwasa

majorparticipant.Itsseniormanagementtooktoomuchriskexceedingitsinternalguidelines,and

deceptivelyusedRepo105inordertohideitsfinancialdistressduringthethreeyearspreceding

itsbankruptcy.Moreover, its largeholdingsofderivativesoff-balancesheetpositionspresented

governance challenges. Thus, Lehman’s financial condition was beyond the cadre of rescuers

including the US Government. The lesson of Lehman shows that there seem to be a conflict

betweenaccounting,andlegalrules,whichrequireanupgradebytheregulatorsinordertokeep

upwithcomplexityoffinancialinnovations.

Introduction

Much of the wealth of the United States owed its beginnings to the dazzling brilliance of

financiers,allnamedLehman,whomhadplotted,andschemedonbehalfoftheirfirm.Theroots

oftheplacestretchedbacktothe1840s,tothefieldsofMontgomery,Alabama,whencottonwas

king;where the three Lehmanbrothersmerchants,had settled fromBavaria. Theymoved their

business to lower Manhattan in 1868 after the Civil War, where they founded the New York

CottonExchange,andjoinedthepostwarexpansionoftradingstocks,andbonds.Moreover,they

wereinheavycollaborationwithGoldmanSachsbytheturnofthecentury,raisingmoneytohelp

listingcompanies,andinvestedtheirownwealth(McDonald&Robinson,2010).

Themodernhistoryof LehmanBrothersHoldings, Inc. (Lehman)began in1994when its

stormy marriage to American Express ended in divorce. American Express had bought the

investment bank to create a financial supermarket, combining it with Shearson, a brokerage

business.Theunderlyingeconomicslookedgood,butmanyLehmanemployeescouldn’tadjustto

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Shearson-Lehmanandviceversa,asmanyleftthefirm.AmericanExpressspunLehmanofftothe

publicin1994,whereitsemployeesheldmorethanathirdofitsshares(WetFeet,2004).

Lehmanfiledforthelargestbankruptcyever,on15September2008,withlossesofbillions

ofdollars to investors,both small and large; includingpensionplan sponsors, suchasCalifornia

Public Employees’ Retirement System (Denbeaux, Dabek, Gregorek, Kennedy & Miller, 2011).

Lehman employees who were famously invested in their own firm when the company failed

learned this lesson with considerable pain. Roughly its 24,000 employees, and their losses on

thosesharesownedinthefirmtotaledaround$10billion(Bodie,Kane&Marcus,2011).

Lehman’s stockclosedunder$4ashareandonSeptember12,2008,adeclineofnearly

95%fromitsJanuary2008,whenthecompanyreportedrecordrevenuesofnearly$60billion,and

recordearningsinexcessof$4billionforitsfiscalyearendingNovember30,2007(Valukas,2010).

The bankruptcy of Lehman in 2008 was a critical event in the Global Financial Crisis,

exposingseriousfaultinessinthestructureofglobalfinancialmarketsandleadingtowidespread

economic disruption (McConnell, 2012).When Lehman failed, the liquidity in the creditmarket

disappeared.Tradingvolumeoftransactionsfellsharply,accompaniedbytherushtocash,which

normally occurs during high uncertainty in the financial market. In the meantime, financial

institutionswereinapositiontoextendcreditwereextremelyhesitanttodoso,forthewantto

increasetheirownliquidity,andholdingsofcash,whilefirmslikeLehman,whichreliedextensively

on borrowed short-term funds to finance their assets found it exceedingly difficult and

extraordinarilyexpensivetofinancetheirmaturingdebts(Kindleberger&Aliber,2011).

However,thebusinessofbankingissystematicallyexposedtomanagingbothsolvencyand

liquidity risks together, unlike other industries. Investor owned banks have an incentive of

leveraging their profitability with excess debt that increases liquidity risks. This creates a

fundamentalconflict formanagersseekingtomaximizeprofitswhileminimizingrisk (Turnbull&

Pirson,2012).

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While Lehman was hardly the sole cause of the financial crisis, but its failure was a

substantialeventcausinglossofconfidenceinthefinancialmarket,andthebankingsystems;such

thatitisconsideredsoimportantinthemindsofbusiness,andeconomicanalyststhattheterms

“Lehman-typeevent”isoftenusedinbusinesspress(Jones&Presley,2013).

ThecausesofLehman’sfailure

Many pundits believe repealing Glass-Steagall Act, was the beginning of the end for Lehman

Brothers. This landmark legislation from the Great Depression (GD) separated the interests of

commercial,andinvestmentbanks,preventingthemfromcompetingagainsteachother,including

protectingtheirbalancesheets.Asaresult,LehmanbecameakeyplayerintheUnitedStates(US)

housingboom.From2004to2006,LehmanBrothersexperienceda56percentsurgeinrevenues

fromrealestatebusinessesalone. Inthesameyear, itsstockreachedanall-timehighof$86.18

pershare,givingitamarketcapitalizationcloseto$60billion(Montgomery,2012).However,the

runsontheinvestmentbanksBearStearns,inFebruary2008,followedonLehmaninAugust,and

extendedonother financial institutionsworldwide,whichfrozethecreditmarket.Asaresult, it

prompted governments to step in and commit support to these institutions, and the whole

financialmarket,exceptLehman(Kindleberger&Aliber,2011).

The weekend preceding the bankruptcy, Secretary of the Treasury Henry Paulson

determinedthatLehmanBrothershadoneofthreeoptions:(1)apurchasebyanothercompany,

(2) a bailout (with no purchase) by other large investment and commercial banks, or (3)

bankruptcy.Oneofthethreehadtooccurbeforestocktradingcommencedthenextweek.The

governmentdetermined that it didnothave the legal authority tobail out an investmentbank

(Jones&Presley,2013).

The voluminous Examiner’s report of Lehman’s bankruptcy that explains in details the

agony of the events leading up to the demise of the firm, has clearly pointed to 2006 when

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Lehman’s management developed a new strategy, which was fully endorsed by the board,

althoughtherisksinherentinthestrategywerenotfullydisclosedtotheboard,andnotproperly

mitigatedbymanagement,withtheresultthattheflawedstrategyresultedinthebankruptcyof

Lehman(McConnell,2012).

Lehmanwasnotuniqueinthisrespect.PresidentObamaandtheUSCongresswiththeaim

ofexaminingthecauses,domestic,andglobal,ofthecurrentfinancialandeconomiccrisis,setup

the Financial Crisis Inquiry Commission (FCIC). One of its key conclusions was that dramatic

failuresofcorporategovernance,andriskmanagementatmanysystemically importantfinancial

institutionswere a key cause of this crisis. Illustratingwith examples from some of the largest

financial institutions in theworld, thecommission reported“ourexamination revealedstunning

instancesofgovernancebreakdownsandirresponsibility”(Valukas,2010).

TheWall Street Journal analysis of financial data from18 largebanks knownasprimary

dealers,amongwhichisLehman,showedthatasagroup,theyhaveconsistentlylowereddebtat

theendofeachofthepastsixquarters,reducingitonaverageby42%fromquarterlypeak.The

Wall Street Journal investigated the practice,which isn't illegal butmasks banks' true levels of

borrowingandrisk-taking.Thepracticesuggeststhebanksarecarryingmoreriskthanisapparent

totheir investors,andcustomers,whoonlyseethelevelsrecordedonthecompanies'quarterly

balancesheets(Rappaport,2010).

According to the Valukas (2010), Lehman was caught in a “perfect storm” after its

managementmadethedeliberatedecisiontoembarkuponanaggressivegrowthstrategy,totake

onsignificantlygreater risk,and tosubstantially increase leverageon itscapital. In2007,as the

sub-primeresidentialmortgagebusinessprogressedfromproblemtocrisis,Lehmanwasslowto

recognize the developing storm and its spillover effect upon commercial real estate, and other

businesslines.Butratherthanpullback,Lehmanmadetheconsciousdecisionto“doubledown,”

hopingtoprofitfromacounter-cyclicalstrategy.Asitdidso,Lehmansignificantly,andrepeatedly

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exceededitsowninternalrisklimitsandcontrols(Valukas,2010).

Theageofderivativessuchasmortgagebacksecurities (MBS),andAssetBackSecurities

(ABS),withCollateralizedDebtObligation(CDO)asthenumberoneproductthathaveproducea

breedofrashfinancialofficerswhoconjuredLehman’sbillionofdollarprofitsoutofoneof the

most complexmarkets ever to show its head aboveWall Street’s ramparts. Such products had

poweredoneofthemostrecklesshousingboomsinhistory(McDonald&Robinson,2010).

Lehman attempted to pledge illiquid, Lehman-structured instruments, such as certain

collateralized loanobligations, toCitigroupandJPMorgan, twoof itsprincipalsettlementbanks.

Citigroup rejected the assets proposed by Lehman, due to their illiquid characteristics and the

inabilitytoestablishreliablemarksforsuchassets.WhileJPMorganacceptedLehman’sstructured

instruments, that bank demanded additional cash collateral after conducting analyses showing

thatthecollateralappearedlessworththanparvaluesassignedbyLehman.JPMorgan’scollateral

call was one of the contributing factors to the liquidity problems that hastened Lehman’s

bankruptcy(Valukas,2010).

The proximate cause of the insolvency was that Lehman was overly exposed to the

commercialpropertymarket,andwassittingonalargewarehouseofsecurities,CDOs,thevalue

ofwhichwerefallingrapidlyasaresultofcreditratingagencydowngrades(Valukas,2010).Asthe

economydownturnbecamemorepronounced, Lehman inflated thevalueof its assets, thereby

further concealing the extent towhich Lehmanhad increased its risk and leverage. In the year

preceding its bankruptcy, Lehman grossly overstated its expected return on investments

(Denbeaux,etal.,2011).

The uncertainly as to the fair value of Lehman’s assets also played a role in the

negotiations between Bank of America (BOA) and Lehman regarding a potential acquisition of

Lehman by BOA. Chairman Lewis told the Examiner that BOA put together a diligence team at

some point around September 10 or 11, 2008, and it became quickly apparent to them that,

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without substantial government assistance, the deal would not be beneficial to BOA, for the

stickingpointwaswhatLewisdescribedasa“$66billionhole”inLehman’svaluationofitsassets

(Valukas,2010)

AcarefulreviewoftheExaminer’sReportrevealsthattherewerefindingsotherthanthe

well-citedRepo105transactionsthatrevealegregiousdecisionsthathadgreatconsequencesfor

Lehman,itsinvestors,andtheglobaleconomy.Further,notably,theExaminerdidnotinvestigate

allofLehman’s transactionsorbusinessdecisionsduetoa lackof timeandresources.His2200

pages to the Court is factual investigation in order to identify colorable claims. Thus, his

conclusionsarebasedontheanalysisofsmallsamplesofLehman’stotaltransactionsandbusiness

decisions(Denbeaux,etal.,2011).

The Mortgage market

Thehousingproblemwasbroadbased;withatotalUSmortgagemarketof$14trillion,including

the increase in subprime loans toborrowerswithpoor credit classifiedas subprime,whichhad

mushroomedto$2trillion.However,anumberofothercriticalfactors,suchasthefactthatthe

link between the housing market, and the financial system was further complicated by the

growing use of exotic derivatives. Securities whose income and value came from a pool of

residentialmortgageswerebeingcombined,slicedup,andreconfiguredagain,andsoonbecame

theunderpinningsofnewinvestmentproductsmarketedasCDOs(Sorkin,2009).

Byearly2005allthebigWallStreetinvestmentbanksweredeepintothesubprimegame;

theywereunderwritingthesesubprimebonds,withBearStearnsandLehmanweremoreexposed

to themortgagebondmarket than theother firms (Lewis,2010).Businesswas so sensationally

good, the investmentbanksdecided to cut out someof the severalmiddlemen involved in the

processofcreatingtheCDOs.Lehmanhadbeenpermittedtopurchasetwomortgageoutfits,BNC,

andAuroraLoanServices,withthousandsofsalesmenouttherepressuringold ladies into loans

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theydidn’tneed,andmightnotbeabletopayback.LehmanhadownedastakeinAurorasince

1997,whichwaswellbeforemostinvestmentbanksevendreamedofowningamortgagebroker.

They had bought a piece of BNC in 2000. But if anything ever did gowrong, Lehman Brothers

wouldsurelytaketheirshareoftheblame(McDonald&Robinson,2010).

Thefinancialinstitutionshadkeptasmallfractionofthesubprimeloanstheyoriginatedon

theirbooks, fortheymighthave learnedasimple lessonfromthemarket,nottomake loansto

peoplewho can't repay them. Or keep onmaking these loans; then sell them off to the fixed

incomedepartmentsof bigWall Street investmentbanks,whichwill in turnpackage them into

bonds and sell them to investors. Thus they adopted what was called the "originate and sell"

model.Thisprovedahit,suchthatWallStreetwouldbuytheloans.BNCmortgagewasfounded

todonothingbutoriginateandsell.LehmanBrothersthoughtthatwassuchagreatideathatthey

boughtBNC(Lewis,2010).

ThebankruptciesofthemortgagebrokersintheUSinlate2006,alongwithoversupplyof

housing,werethefirstsignsofadjustmentoftheextraordinaryriseinhousepricesthatstartedin

2002(Kindleberger&Aliber,2011).Thatfollowedbygrowingdefaultsonmortgages,andmadeit

difficultforfinancialinstitutionstodeterminethetruevalueofthemortgage-relatedassetsheld

ontheirbalancesheet.Themarkdownsinvaluationreducedthevalueofbankregulatorycapital,

forcing banks to raise additional capital, and creating uncertainty among investors about the

healthofthebanks(Harris&Kutasovic,2010).

Eric Dinallo, the insurance superintendent ofNew York State, stated that as themarket

begantoseizeup,andasthemarketfortheunderlyingobligationsbegantoperformpoorly;there

wasnomoneybehindthecommitments;toalargeextentwhathappenedtoBearSterns,Lehman

Brothers,andtheholdingcompanyofAIG.“It'slegalizedgambling.Itwasillegalgambling,andwe

madeitlegalwithnoregulatorycontrols”(Kroft,2008).

Mortgagebackedsecurities(MBS)originatedbyfinancialinstitutionssuchasCountrywide

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Financial,LehmanBrothers,andWachoviawereamainsourceoftheproblem.Poolsofsubprime

or ALT-A loans, which were subject to high default rates, backed these MBS. These privately

packagedMBSwere further securitized creating illiquid products such as CDOs, and structured

investment vehicles (SIV) were illiquid intensified the problem. Thus, accounting rules used to

determineassetvaluestookonacentralstageinthecrisis(Harris&Kutasovic,2010).

The increaseof supplyof credit available formortgageswas facilitatedby securitization,

whichbegunin1970andinitiallyinvolveddepositingmortgageswithsimilarattributesintermsof

maturity in a trust, essentially its own corporation, and then issuing new securities called

collateralized debt obligation (CMO) (Kindleberger& Aliber, 2011). However, the abundance of

credit accompanied by low interest had sprung numerousmortgage brokers,motivated by fast

profits, functioning as shadowbanks, particularly inCalifornia, Florida, andNevada; theywould

lend,finance,andprovidecapitalforhousepurchases,buttheyhadtoborrowthemoneyinthe

firstplacefromproperbanks,mainlybecausetheydidn’thavethemoneythemselves(McDonald

&Robinson,2010).

Minsky believed that increases in the supply of credit in good economic times and the

subsequent decline in the supply led to fragility in financial arrangements, and increased the

likelihood of a crisis. He focused on the variability in the supply of credit, and attached great

importancetothebehaviorofheavilyindebtedborrowers,particularlythosethatincreasedtheir

indebtednesstobuyrealestateinsearchforshort-termcapitalgains.Theirmotivewastheprofits

fromtheincreasesinthepricesoftheseassets,whichtheyanticipatedwouldgreatlyexceedthe

interestpaymentsontheborrowedmoney.Whentheeconomyslowed,manyoftheseborrowers

wouldbecomedistressedsellers, for thepricesof theseassetswouldbe falling (Kindleberger&

Aliber,2011).

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CreditratingofMBS

Lehmanhadthesamegoalasanymanufacturingbusiness,suchastopayaslittleaspossiblefor

rawmaterial(homeloans)andchargeasmuchaspossiblefortheirendproductMBS.Thepriceof

theendproductwasdrivenbytheratingsassignedtoitbythemodelsusedbyMoody'sandS&P.

ButeveryoneonWallStreetknewthatthepeoplewhoranthemodelswereripeforexploitation.

A company called theFair IsaacCorporation (FICO) claimed tomeasure the creditworthinessof

individualborrowerscreatedFICOscores,inthe1950s.ThehighestpossibleFICOscorewas850;

thelowestwas300;theUSmedianwas723.WallStreetbondtradingdesks,quicklyfiguredout,

Moody'sandS&Pdidn'tactuallyevaluatetheindividualhomeloans,orsomuchaslookatthem.

Therefore,scoreswereovershadowedbythewaytheyweremisusedbytheratingagencies;such

that Moody's and S&P asked the loan packagers not for a list of the FICO scores of all the

borrowers, but for the average FICO score of the pool, in order to meet the rating agencies'

standards to maximize the percentage of triple-A-rated bond, the average FICO score of the

borrowersinthepoolneededtobearound615.Therewasmorethanonewaytoarriveatthat

averagenumber.Andthereinlayahugeopportunity.Apoolofloanscomposedofborrowersallof

whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans

composedofborrowershalfofwhomhadFICOscoresof550andhalfofwhomhadFICOscoresof

680(Lewis,2010).

Repo105

Lehman did not disclose that it had been using an accounting maneuver called Repo 105 to

manageitsbalancesheet,suchthat,bytemporarilyremovingapproximately$50billionofassets

fromthebalancesheetattheendofthefirstandsecondquartersof2008.Inanordinaryrepo,

Lehmanraisedcashbysellingassetswithasimultaneousobligationtorepurchasethemthenext

day or several days later; such transactions were accounted for as financings, and the assets

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remained on Lehman’s balance sheet (Valukas, 2010). Linkleters, the law firm of Lehman in

Londonhadblessedthepractice,butitdidnotkeepmanyseniorofficersfrombeinguneasyabout

it(Sorkin,2009).

InaRepo105transaction,Lehmandidexactlythesamething,butbecausetheassetswere

105%ormoreofthecashreceived,accountingrulespermittedthetransactionstobetreatedas

salesratherthanfinancings,sothattheassetscouldberemovedfromthebalancesheet(Valukas,

2010).

MathewLee,aLehman’sseniorvicepresidentinthefinancedivisionsentalettertosenior

managementinwhichheclaimedtohaveuncoveredseveralaccountingproblems.Theletterwas

forwarded to Lehman’s auditors Ernst & Young too. Further, Lee raised a serious red flag as

accounting procedure called Repo 105 in his meeting with the same auditors. A repo 105

transactionsweredonetowardtheendofeachquarterinordertolowerLehman’sleverageratio,

andthenunwindfewdaysafterreleasingthequarterlyearningreport.Meanwhile,thefinancial

controllersbelievedRepo105was legal,butdidnot lookgoodwhendone.However,HungLee,

theco-headofglobal fixed incomesentanemail tohiscolleagueBartMcDadeaskinghim ifhe

wereawareofRepo105,hegotareply”Iamveryawareofit…Itisanotherdrugweron”(Sorkin,

2009).

Theexcessiveuseofrepo isariskychoiceconsideringDrysdale,aGovernmentsecurities

dealerfailedin1982.Itsmassiverepotransactionsballooneditsassets,andproducedprofitsuntil

shifts inmarketconditions,whichpromptedparticipants intherepoarrangementsto limittheir

activity,henceanothermajorcreditcrises(Kaufman,2009).

While Lehman Brothers' financial situation was desperate at the time of its bankruptcy

filing, later investigationsof itspracticesduring thebankruptcyshowedthat through theuseof

Repo105,thecompanywasabletoconcealasubstantiallyworsefinancialcondition.Throughthe

use of Repo 105,where Lehman had reduced the leverage ratio at the timewhen temporarily

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transferringinvestmentassetswithrepurchaseagreementsreportedquarterlyandyearlyfinancial

statements. Financial difficulties had been hidden from investors and regulators. Bank debt at

Lehman was $613 billion. Investors were aware of Lehman’s increasing financial difficulties.

However, use of financial statement "window-dressing" through off-balance sheet transactions,

suchasRepo105,disguisedtheextentofthefinancialdifficulties(Jones&Presley,2013).

Riskmanagement

WhenthemajorinvestmentbankssuchasLehmanBrotherswasapartnership,itwasmuchmore

conservativesincethepartnerswereriskingtheirownmoney.Onceitbecameapubliccompany,

they did notmind taking on huge amounts of risk since theywere no longer risking their own

wealth. Ineffect, theywereusingotherpeople’smoney tobecomesuperwealthy (Friedman&

Friedman,2009).

In 2006, Lehman made the deliberate decision to embark upon an aggressive growth

strategy,totakeonsignificantlygreaterrisk,andtosubstantiallyincreaseleverageonitscapital.

In 2007, as the sub-prime residential mortgage business progressed from problem to crisis,

Lehmanwasslowtorecognizethedevelopingstormanditsspillovereffectuponcommercialreal

estate andotherbusiness lines. Rather thanpull back, Lehmanmade the consciousdecision to

“doubledown,”hopingtoprofitfromacounter-cyclicalstrategy.Asitdidso,Lehmansignificantly,

andrepeatedlyexceededitsowninternalrisklimitsandcontrols(Valukas,2010).In2007Lehman

hadaleverageratioaround33thatis$1incapitalforevery$33infinancialpositionsthatitheld.

This translates toa3 to4percentdecline in thevalueof itsportfolio, and thenLehmanwould

havenegativeequityandwouldpotentiallyfacebankruptcy.The$85billionitheldinMBSinthat

year was nearly four times more than the underlying value of its capital, meaning that a 25

percent decline in their value would likely be enough to bankrupt the company (Silver, 2012).

Lehman, after recognizing the magnitude of the economic crisis, doubled down on its risk,

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dramatically increasing the amount it was prepared to lose $ 4 billion up from $2.3 billion,

meanwhile,disguisingthedecliningvalueofitsassets.Theseactswerenotinadvertent,butrather

were deliberate violations of internal risk limits, and conscious overvaluation of its assets

(Denbeaux,etal.,2011).

MadelynAntoncic,theheadofriskmanagementopposedmanyofthetransactions,size,

andleverage,asearlyasApril2007;shewarneduppermanagementthatLehman’sleveragedloan

exposurewasgettingtoolarge,andlimithadtobeimposed,butshewasreplacedbyChristopher

O’Meara on September 20, 2007. Severalmonths later, Antoncic reflected back on the general

consensusthatthemarketswereintrouble:“everyonesawthetrainwreckcoming.64kquestion

iswhydidn’tanyonegetoutoftheway”(Valukas,2010).

Lehman frequently exceeded its self-imposed risk limits. At the same time, Lehman

compounded its risk through inaccurate valuations of the assets upon which the inflated risk

rested.TheresultwasthatLehman’sleveragewasmuchhigherthanwasreportedtothepublic,

andtheartificiallyincreasedassetvaluescausedLehmantotakemoreriskthanwasunderstood

(Denbeaux,etal.,2011).

In response to an email about this issue of why Bear Stearns was saved and Lehman

Brothers let go intobankruptcy, LynnTurner, former SEC chief accountant, replied: “Bothwere

highly risky with very, very arrogant CEOs and chairmen. Neither has a great board but Bear

Stearnsmayhavehadbetter connectionson theirboardand in this instance, LehmanBrothers

being secondwas fatal. Both dependedway toomuch on very short term financing, including

overnightcommercialpaper,orrepo’s,averyilladvisedandhighlyriskystrategyforanycompany

withverylittlecapital(Grove&Clause,2011).

Corporate governance

Regulators mostly trusted in market actors to self regulate. As a result, some regulators were

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convinced that there never was a mortgage bubble, because markets operated efficiently

(Kaufman, 2009). On the contrary, Valukas (2010) provides evidence that Lehman middle

management, and auditors possessed knowledge of risks, but obscured it from the directors.

Further,regulatorswarnedtheCEOFuldontheexcessiveriskexposureofthefirmmonthsbefore

thefirmfailed,buthedidnothavethewilltoact(Turnbull&Pirson,2014).

CEOFulddidnotsharewiththedirectorstheinformationtoact.Eveniftheyhaditwould

bequestionableiftheyalsopossessedthewilltoactcontrarytothewishesoftheCEO,whilethe

executiveslikewisefollowedtheirCEO(Valukas,2010).

Fuld works closely with Lehman’s nine members executive committee, which guides

Lehman’s strategicdirection since2002,aswellasboardofdirectors.Theexecutivecommittee

composedofheadbankers,andtraders,whommanagethefirm’sday-to-dayoperations.Fuldhas

steadfastlymaintainedthatLehman isdedicatedtomanagementbycommittee, reiterating that

teamwork is a key ingredient of Lehman’s success, in spite of criticism from industry observers

(WetFeet, 2004). Fuld was a member of the board of the New York Federal Reserve in 2007,

essentially the federal government’s eyes and ears on Wall Street. He was one of the most

influential and respected men in the global financial market. He ran the fourth-largest U.S.

investmentbank,whichhehad largelybuilt.Hehadaccess toeveryone,andeverything (Sears,

2014).

The economics of the off-balance sheet transactions Lehman undertook prior to its

collapse,andhighlightsthecorporategovernancechallengesinsituationswherefirmsfacecapital

market pressure and market downturns. In particular, the financial accounting, auditing, and

internalmanagementcontrolpracticesaroundtheRepo105transactions,whichhadasignificant

effectontheleveragepositionofthecompany.Therolethatmanagement,externalauditors,and

theauditcommitteeplayedinwhatamountedtoasignificantcontrolfailure(Mikes,Hamel,&Yu,

2011).

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Valukas accuses Lehman executives of having deliberately manipulated information

disclosedinfinancialstatements.Healsoblamestheauditors,whomhesaidclosedtheireyesto

themanipulationsinquestion,whichdatebacktotheearly2000s.Lehmandidnotdiscloseitsuse,

orthesignificantmagnitudeofitsuseofRepo105totheGovernment,totheratingagencies,to

its investors,orto itsownBoardofDirectors.Lehman‘sauditors,Ernst&Young,wereawareof

butdidnotquestionLehman‘suseandnondisclosureoftheRepo105accountingtransactions(Le

Maux&Morin,2011).

InApril2008aNewYorkhedgefundmanagernamedDavidEinhornhadannouncedthat

hewasshortingLehman.Then,onMay21,atan investmentconference inNewYork,heraised

theante,questioning Lehman’saccountingof its troubledassets, includingmortgage securities.

He insisted that the Lehman had vastly overvalued these assets and had underreported its

problemsinthefirstquarter(Paulson,2013).

Financialdistress

TheLehmanbankruptcywarrantsarevisitthetechniquescurrentlyusedtopredictfirms’financial

distress,which shows that analysts failed to predict, point to shortcomings in existing financial

analysis techniques. Annual and interim financial statements produced by listed companies are

part of the information that all stakeholders can use to judge the performance and viability of

thesefirmsoverashort-termtimehorizon(LeMaux&Morin,2011).

Creditscoringsystemsrelyprimarilyonthecompanies’ financial statements toestimate

whichfirmsaremostlikelytobecomebankruptanddefaultontheirdebts;thussuchaccounting

data have impact on the security prices of publicly traded companies, and hence allowing the

stockholders,andcreditorstoexercisetheiroptiontodefaultifthemarketpricesofthesecurity

fallsbelowthepaymentsthatmustbemadeonthedebts.Anearly,andstillwidelyusedmodel,

the famousZ-scoremodeldevelopedbyEdwardAltmanthatusesmultiplediscriminantanalysis

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approach,which assigns a numericalweight to each category of a predictive variable and then

computesascoreforanewapplicantbyaddingallweightsoverthevariables(Brealey,Myers&

Allen,2011).

Altmanin1968foundthefollowingequationtobestseparatefailingandnon-failingfirms:

Z -scores below1.23 indicates vulnerability to bankruptcy, scores between 1.23 and 2.90 are a

grayarea,andscoresabove2.90areconsideredsafe(Bodie,Kane&Marcus,2011).

Applying the Altman’s model, one can observe that Lehman had been clearly sending

signalsoffinancialdistresssince2005.Lehman’sZ-scoreswerebelow1.23indicatingvulnerability

tobankruptcyforthethreeyearspreceding,Z-scores0.0823in2005,0.0965in2006,and0.0891

in 2007with an averageof 0.0897 these three years;where the2005-2007 statementsof cash

flowsisareliablepredictorofLehmanbankruptcy.Assuch,thefollowingsignsoffinancialdistress

were detectable in Lehman’s financial statements, which showed chronic inability to generate

cash from operating activities, due tomore intensive investments in financial instruments, and

systematicuseofmainlyexternallong-termdebtfinancingtooffsetoperatingdeficits,aswellas

steadydeteriorationofthecashsituationoverthreeconsecutiveyears(LeMaux&Morin,2011).

Could Lehman’s failure be averted?

MartinWolf,chiefeconomistoftheFinancialTimesaskedBenBernanke,theformerChairmanof

theFederalReserveBankoftheUSduringthe2008Lehman’sbankruptcy,ifLehmanfailurecould

= + + + +

= =Retained = and = Liabilities= = or

18

beavoided.HestatedfirmlythatthefailureofLehmancouldnothavebeenavoided.Hesaid,“It

wascompletelyunavoidable.Withoutabuyer,therewasnoonetoguaranteetheirliabilities.So

no one would lend to them. There was a complete run of all the creditors, all of the

counterparties,allofthecustomers.Andifwehadlentthemthemoneyandsomehowconjured

upsomefakecollateral,inviolationofthelaw,wewouldhaveendedupowningthefirm,andit

would have been a non-viable firm”(Wolf, 2015). Thought, Tim Geithner the president of the

FederalReserveBankofNewYork,andPaulsonhadrepeatedlytoldFuldthatthegovernmenthad

nolegalauthoritytoinjectcapitalinaninvestmentbank(Paulson,2013).

Thus by the weekend preceding the bankruptcy, Secretary of the Treasury Paulson

determined that Lehman had one of three options: (1) a purchase by another company, (2) a

bailout (withnopurchase)byother large investment and commercial banks, or (3) bankruptcy.

Oneofthethreehadtooccurbeforestocktradingcommencedthenextweek(Jones&Presley,

2013).

Paulson,privatelytoldFuldthatifLehmanwereforcedtoreportfurtherlossesinthethird

quarterwithouthavingabuyeroradefinitivesurvivalplaninplace,Lehman’sexistencewouldbe

injeopardy.AlthoughLehmanhadexploredoptionsoverthesummer,ithadnobuyerinplace;its

only announced survival plan was to spin off troubled assets into a separate entity. Secretary

Paulson’spredictionturnedouttoberight;itwasnotenough(Valukas,2010).

Recommendationgoingforward

Without understanding the need for radical changes in the currently accepted system of

governance regulators, andpolicyadvisersare leftwith the twoquestionableoptions,either to

seekever-greaterpowerswithever-tightercontrolstopreventacrisisthatweandcommentators

citedearlierbelievecannotbeeffective,ortotakeapalliativeapproachofbeingbetterprepared,

tocopewithacrisisbyrequiringbankstoreduceleverage,andincreaseliquidity,asproposedby

19

theBaselguidelines(Turnbull&Pirson,2014).

Topreventsimilarfailuresinfuture,thereisademonstrableneedforbankingregulators,

especially of “significantly important” banks, to address such critical deficiencies in corporate

governance and strategic risk management. The bankruptcy of Lehman had ramifications far

beyondthenarrowconfinesoftheeventitself.TheliquidationofLehmandidnotcausetheglobal

financial crisis but the firm’s failure exposed serious fault lines in the structure of the global

financialmarketswherea cat’s cradleofopaqueand complex interconnections collapsed likea

houseofcardswhenLehmanwasremoved(McConnell,2012).

The findings of Valukas (2010) on its face reveal that the legal system, which allowed

Lehman’stofailwillalsoallowotherstofailinthefuture,forLehman’sactionsdidnotviolatethe

law,inrespectwithfraud,dishonesty,incompetence,misconduct,mismanagement,orirregularity

(Denbeaux,etal.,2011).

Conclusion

Lehman’s failure proved that bankruptcy of a large investment bank could have harmful after-

effectsontheentirefinancialsphere,duetoitsbroadconnectionstotheentiremarket.Themain

points of the Court Examiner’s report shows that Lehman systematically, and continuously

breacheditsowninternalriskmanagementguidelines,thoughtdidnotgiverisetothecolorable

claims,whichwasthemainaimofMr.Valukas;however.However,theoverallpicturebasedon

the facts is rather disturbing, especially, when the uppermanagement of publicly traded firms

suchasLehmandeliberatelyexploitaccounting,andlegalloopholes,whichenabledthemtotake

excessiverisk,andhidefinancialstatementdistressinordertounjustlyenrichthemselvesatthe

costofthepublicshareholders,andhenceendupindyerfinancialconditionbeyondtherescueof

lenderoflastresort.

20

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