Prelude
The world is at a financial and economic cross road with an air of uncertainty looming over most private and public expenditures. All this can be attributed to the failure of self-discipline, over-indulgence and short sightedness. Of course with hindsight all can appear simply but there’s a fine line between being innovative and cautious. In this report we will analyze some of the factors behind the collapse of the Wall Street giant Lehman Brothers which in turn served as a signal to one of the greatest economic downturns in the century.
The Financial Boom
The intermediate years between 2002 and 2008 saw the global economy enjoying massive growth and financial innovations accompanied with easy money policies, speculation, excessive leverage and ingenious financial instruments. Worldwide, governments, financial, non-financial institutions and individuals engaged in risky strategies, bets and investments to expand their wealth or fund their operations. Most had relatively very easy access to financing from the money and capital markets. Globalization produced an interlinked financial system and as a result, all the market participants were engaging in very similar tactics for the creation of wealth and edging competitors in the market. New complex financial derivatives and securities as well as real estate investments became the new source of abnormal profits for banks and individuals operating in Wall Street and elsewhere. The year 2002 and the period afterwards saw an upsurge in borrowing owing to the prevailing cheap financing stream in the markets. Cheap credit fuelled the rapid rise of US house prices. As the financial sector was growing and becoming powerful, financial executives and corporations came to influence some public policies via their lobbying and to ensure that regulators acted more as cheerleaders than as regulators on the assumption that financial markets are efficient and self-regulating. Capitalism and the fundamental theories of the free markets seemed to be perfect at that time. The existing conditions permitted banks, governments and corporations to ‘overindulge’ and lose sight of their level of debt in relation to their assets. Focusing on banks, their balance accounts expanded as they allowed themselves to become too over borrowed and leveraged leaving them with massive external debt (N.Ferguson, 2009). Regulators failed to prevent banks, hedge funds and other such entities from exceeding prudential lending limits. Some prevailing conditions in the environment enabled certain practices to fester and by so doing caused the economic downturn (appendix 1).
Lehman Brothers – “The bank that burst the global economy”
It is often said ‘when America sneezes, the world catches a cold’. The global recession of 2007-09 was triggered by the decline of real estate prices, the bursting of the subprime-mortgage bubble and the collapse of Lehman Brothers, all originating in the United States. These factors combined resulted in the collapse and decline of credit markets and asset prices worldwide along with the sharp deterioration of the fiscal accounts of most developed economies and corporations. Investors in the credit markets responded to the situation by driving up credit spreads. Credit froze, inter-banking lending (commercial paper) also stagnated and banks were reluctant in lending to companies or individuals or even to huge corporations such as Microsoft, IBM, General Electric and General Motors. The global financial system was unable to provide liquidity for the real economy and itself. Initially, the US government decided against saving Lehman from collapse to serve as a warning against the prevailing assumption that some institutions were ‘too big to fail’. However the consequences of Lehman’s failure brought about a change of view. As a result, Henry Paulson, the United States Treasury Secretary, stepped up to bail out the whole financial system via the Trouble Asset Relief Program in order to clear banks balance sheets from toxic assets (asset backed securities, subprime liabilities etc.). They provided huge funds from taxpayers to Wall Street giants such as Goldman Sachs, JP Morgan and other financial institutions. They nationalized Citigroup, Freddie Mac, Fannie May, American Insurance Group and General Motors. Other governments in the world followed suit such as the United Kingdom where Gordon Brown nationalized Royal Bank of Scotland and Northern Rock, the biggest mortgage lenders in UK. The Governor of the Bank of England, Mervyn King captured the severity of the rescue effort when he noted ‘Never has so much money been owed by so few to so many’ (Guardian, 2008).
With regards to the financial sector, economists and researchers are well aware that significant "market failure" issues arise in the context of banking. In a world of imperfect and asymmetric information, the banking system is prone to failures of monitoring by depositors (who face a free-rider problem1) and excessive risk-taking ("moral hazard"2) by bankers. Bank runs are an ever-present risk in a context of uncertainty about the true value of bank assets and the inability of depositors to co-ordinate their actions. The implications are that solvent banks with liquidity problems may be forced into bankruptcy and that a scramble for liquidity may entail meltdown risks for the financial system (Nicholas Crafts, 2008). The economic theory suggests that short-term borrowing cannot finance long-term investments. The above status quo could summarize the theoretical reason behind the colossal failure of one of the biggest investment banks, in this case Lehman Brothers.
Lehman Brothers Holdings
History
Lehman Brothers Holdings Inc. (former NYSE ticker symbol LEH) was a global financial services firm and the fourth-largest investment bank in Wall Street until its collapse, with 25000 employees worldwide. Its primary subsidiaries included Lehman Brothers Inc., Neuberger Berman Inc., Aurora Loan Services Inc., SIB Mortgage Corporation, Lehman Brothers Bank, FSB, Eagle Energy Partners, and the Crossroads Group. The firm's worldwide headquarters was in New York City with regional headquarters in London and Tokyo, as well as offices located throughout the world (Lehman, 2010).
The corporation traces its roots back to 1840s when Henry, Emanuel and Mayer Lehman established a trading and dry company for goods, specializing in cotton which was one of the most valuable commodities back then. After the Civil War, in 1968 Lehman’s moved to Manhattan and joined in the postwar expansion of trading and bonds. They were selling bonds in order to raise capital for their devastated home state, Alabama, desperately trying to build textiles mills and railroads. In 1887 the firm became listed on the New York Stock Exchange, marking the evolution of Lehman Brothers from a commodities business to a merchant-banking firm. The New York office provided the presence to build a securities trading business, and Lehman Brothers aggressively pursued this arena (Columbia University, 2009). Lehman’s made its breakthrough into the old Wall Street families by helping to build major banks and companies such as The Mercantile Bank and General Cigar Company. The grandson of Emanuel, Bobbie, like his father Philip, focused the firm on venture capital and as a result he led the firm into an undeniable golden age. They raised capital and invested their own wealth for the creation of famous corporations such as Gimbel Brothers, Woolworth, American airlines, National and Pan-American airlines. They backed Hollywood film studios, Paramount, the 20th Century Fox, plus the TransCanada pipeline, the Murphy Oil and Halliburton (Harvard Business School, 2010).
The firm was involved in financial advisory, which provided the foundation for developing the underwriting business in the early 1900s. Lehman Brothers expanded through numerous mergers and acquisitions such as American Express and Shearson. It increased its global presence as well, opening offices in Europe and Asia. In 2000, Lehman celebrated its 150th anniversary (Columbia University, 2009). The business was built on integrity and trust. For almost a 100 years Lehman represented a business aristocracy and served as a New York corporation which was admired and emulated by other investment banks.
Reasons behind the collapse
Asset-backed securities and Collateral debt obligations
Credit derivatives trace their roots in the markets back in the 1980s; however they were rapidly replicated by many players in the financial services industry between 1998 and 2006. These instruments were mainly securitized derivatives with bundles of many financial assets and their values were mainly derived from the credit risk of these assets. Credit derivatives included the now infamous Asset-backed securities (ABS); ABS is a security created from the cash flows of financial assets such as loans, credit card receivables, mortgages, auto-loans, leases, student loans and equipment loans (V.Acharya, 2010).
It became a new form of banking and a profitable business for financial institutions and individuals. Collateral debt obligations (CDOs) and ABS full of mortgages were the new era of banking in the global financial system. In the last couple of decades, issuance of Mortgage-backed securities grew to 2 trillion a year from 250 billion and other asset backed securities from 43 billion to 753 billion (appendix 3). Investment banks such as Lehman Brothers saw the potential to make enormous profits trading these securities masked with artificially high credit ratings. CDOs and ABSs were insured through credit default swaps (CDS) to protect the investors in a bad credit event. The market failed to question if these CDS had adequate capital behind them (V.Acharya, 2010). The demand for securitized derivatives from Wall Street investment banks was increasing and as a result the demand for mortgages also increased in order to construct more ABSs deals. As a result they were creating subsidiary mortgage lenders and financing them in order to collect, repackage, trade and resell bundles of different mortgages amongst themselves as well as investing in them. Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in subprime loans. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005 and invested in a $56billion portfolio (Lehman, 2006). In 2007, Lehman underwrote more mortgage-backed securities than any other firm accumulating an $85 billion portfolio, four times its shareholders' equity (Lehman, 2007).
Subprime boom
Globalization and low interest rates brought endless cheap money in the financial sector. For banks, it was very easy to borrow money and as a result, they started lending to everyone in order to obtain higher returns. The flood of cheap money, the exposure of highly lucrative financial products and a light touch regulatory system led to a new generation of lending methods. Banks were encouraged to take on otherwise intolerable risk in the form of bad loans and relax their lending standards as well as risk management practices (M.Scholes, 2010).
After 2000, most commercial banks started targeting homeowners with bad credit ratings who could be charged with high interest rates termed subprime borrowers. Risky lending practices became commonplace across the industry. Lenders were eager to provide mortgages for houses considering the fact that they could sell or drain those mortgages to other financial institutions. They weren’t concerned about the risks or the credit worthiness of the customers. It turned out that mortgage salesmen from commercial banks were following orders of providing floating mortgages to anyone without doing the proper credit analysis or considering the creditworthiness of their clients. Ninja and Non-Doc loans became common across the industry. Lehman via its subprime lenders was obtaining massive portfolio of sublime loans to securitize them. Risky customers without income verification, jobs or a source of income could easily qualify for a mortgage and they were simply charged with a higher floating interest rate .The problem was that the borrowers couldn’t understand these complex loans. They often had to pay a low interest rate but it was dramatically increased after a couple of years. If they couldn’t afford to meet their obligations afterwards, they could easily refinance their mortgage using their house capital appreciation as collateral (L. McDonald, 2009). The whole financial system had faith in real estate price appreciation and as a result, every home owner could use his home as collateral in order to obtain loans for anything ranging from cars, holidays to equipments.
Graph1
Graph 1 above illustrates the subprime mortgage component of home ownership in the last decade. Subprime mortgages reached the 20% mark of total mortgages in 2006 and regulators never questioned the dangers and the risks behind such inappropriate lending practices (N.Ferguson, 2009).. Banks started repackaging and trading credit derivatives with bundles of subprime mortgages and many investors were oblivious of the content because these securities were masked with high ratings from Credit Rating Agencies. Many of those bundles were insured by unregulated CDS. The risks attached to these lending practices and credit derivatives were hugely underestimated by the banks. Many investment banks and financial institutions such as Lehman Brothers in particular, Citigroup, Merrill Lynch, Bank of America and Bear Stearns were leveraging (the ratio of total debt to shareholders equity and assets) (see appendix 4) in response to the ‘cheap money in the markets’ and were investing in ABSs apart from repackaging and selling them. This in turn was leaving them with a huge exposure to potential subprime defaults. By 2007, Lehman was one of the biggest underwriters of real estate loans in America (BBC Love of Money, 2009).
The Real Estate Bubble
The last two decades saw both U.S presidents Bill Clinton and George Bush championing homeownership and encouraging banks to provide mortgages to families. American house prices were rising steadily since the Second World War but they rocketed after September, 2001. The reason was the slash of interest rates by the Fed as a response to boosting the economy, spending and borrowing. The aftermath of the attack on the World Trade Center had a negative impact on the U.S stock market, exports, employment as well as many domestic companies.
Graph 2
| Interest % |
The graph above shows clearly the movement of the official interest rate (Fed funds) over the last two decades. Alan Greenspan was the head of the Fed and was quasi-responsible for U.S economic policies as well as the setting of interest rates. Evidence proved that he had a great deal of responsibility over the bubble because his decisions boosted home prices and resulted in endless lending (L. McDonald, 2009). In 2000, he started decreasing the rates in order to improve the economy and overcome the shocks of the dot.com bubble and the attacks of 9/11. By 2004, interest rates had reached a historical low of 1%. The combination of low interest rates and the eagerness of politicians with respect to homeownership led mortgage lenders to relax the lending standards in 2000 and led to the rise of the subprime market. Demand for credit derivatives and mortgage lending practices fueled the bubble in the U.S real estate.
Graph3 3aph
Source: S&P/Case-Shiller composite
The chart above illustrates the index for house prices in the U.S between 1987 and 2010. In 2000, house prices started to rise much faster than they had in the previous decade. As long as house prices were rising, most market agents thought that bundles of subprime mortgages were absolutely safe and as a result they were trading them based on the bubble. Wall Street backed everyone to adopt the securitization business. When Wall Street bankers saw the potential problems, the investment banking segment was making huge revenues that made it difficult for them to shut down the securitization business. In addition, they were taking on so much risk and were leveraging up to 20-35% of their equity capital (appendix 4) in order to invest in securitized products using debt capital. The Fed, Treasury, Financial Service Authority (FSA) and regulators didn’t question the risks behind the bubble, the high leveraging level and the financial innovations as they were mesmerized by the global property boom and the cheap money in the economy. Until 2007, economists, bankers and governments thought that this was a blessing for the global economy and in particular the U.S.A (BBC Love of money, 2009).
Lehman had bets on the property boom, heavily invested on property developments, hotels, shopping centers and corporations from different industries such as energy and tobacco using leveraged buyouts. The bank’s commercial property investment was around $60 billion; they spent another $45 billion on Texas Energy Corporation and $20 billion stakes in several other corporations (Lehman, 2007). In 2003 and 2004, with the U.S. housing boom well under way, Lehman's acquisitions at first seemed ideal; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge up to 56% from 2004 to 2006, a faster rate of growth than any other businesses in investment banking or asset management. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of record $4.2 billion on revenue of $19.3 billion (appendix 5).
Lehman & the Collapse of the Financial System
The problems started in 2006 when China was thriving to complete the Olympics facilities and as a result they increased their global demand for commodities which led prices to skyrocket after 2006. In addition, speculative flows of money from housing and other investments into commodities and numerous long term positions taken from emerging economies led to a commodity boom. The Fed responded to this by increasing the official rate from 1% to 5% (see graph 2) in order to avoid inflation. As a result, interest rates for mortgages increased and subprime mortgage holders couldn’t keep up with their mortgage payments. Countless defaults and foreclosures followed and as a result, a huge number of houses came into the market for sale. The huge supply of real estate combined with the low demand for them brought a decline in housing prices. In addition, many prime customers with non-risky mortgages made an optimal decision to default on their entire outstanding principal on their mortgages because the decline of housing prices brought a negative equity to them. The aftermath saw investors and banks in possession of bundles of defaulting prime and subprime mortgages trying to sell such repossessed houses, adding further downward pressure on the house prices (BBC Love of Money, 2009).
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. ABS and CDOs made from different types of bundles of loans to the tune of millions were sold all over the world. As a result, Lehman along with other CDO and ABS holders didn’t know which of these assets they held were still valuable or worthless. Following many defaults in 2007, credit rating agencies downgraded many securitized products and as a result Lehman and other holders couldn’t sell them because they were considered as being junk or risky; the entire market was collapsing (L. McDonald, 2009).
At the end of summer 2007, confidence evaporated in the credit markets and as a result the money market started freezing. Banks didn’t want to lend to each other. The liquidity crisis directly hit every financial institution which was in possession of CDOs and especially Lehman Brothers at that. Lehman's high degree of leverage was 31% in 2007 (see appendix 4) and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions (L. McDonald, 2009). In August 2007, the firm shut down its subsidiary subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations and incurred a loss of $25 million (Lehman, 2007). Lehman’s board stated that market conditions in the mortgage space "necessitated a substantial reduction in its resources and capacity in the subprime space (The Street, 2007). In 2008, Lehman faced an unprecedented loss to the continuing subprime mortgage crisis. Lehman's loss was a result of being exposed to gigantic positions of ABS and CDOs. In the second fiscal quarter (2007), Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets (The New York Times, 2008). With regards to their gigantic real estate portfolio, their excessive leverage strategy was multiplying profits when real estate prices were escalating. However, it was also multiplying losses when prices were depreciating after 2006.
Following the near-collapse of Bear Stearns, the second-largest underwriter of mortgage-backed securities, Lehman shares fell as much as 48% with concern it would be the next Wall Street firm to fail. Crisis of confidence and naked short-selling attacks followed by rumors contributed to the collapse of Lehman Brothers share price (appendix 2). As interbank lending froze and Moody’s (credit rating agency) downgraded Lehman’s ratings, the bank wasn’t capable of borrowing anymore and its liquidity problems became severe and obvious. They couldn’t finance their short-term operations. In the summer of 2008, the state-controlled Korea Development Bank was considering buying a huge stake in Lehman but they were "facing difficulties pleasing regulators and attracting partners for the deal." (New York Times, 2008). Richard Fuld, the CEO of Lehman rejected an offer of $18 per share from the Korea Development Bank as late as August 2008 which later turned out to be a generous offer. The news was a deathblow to Lehman, leading to a 45% plunge in its stock (appendix 2) and a 66% spike in credit-default swaps on the company's debt. The company's hedge fund clients began pulling out, while its short-term creditors cut credit lines. Investor confidence continued to erode as Lehman's stock lost roughly half of its value and pushed the S&P 500 down by 3.4% on September 9, 2008 (see appendix 2). Afterwards, Lehman pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position. The firm reported a loss of $3.9 billion including a write-down of $5.6 billion in real estate assets, and also announced a sweeping strategic restructuring of its businesses (Lehman, 2008).
Last-ditch efforts were made over the weekend of September 13 between Lehman, Barclays PLC and Bank of America aimed at facilitating a takeover of Lehman. They were unsuccessful because its property portfolio value depreciated from $50 billion to $25 billion due to the property crash, leaving them with a huge hole in their balance sheet. In addition, a deal with Barclays failed because the Federal Reserve and the British government were not prepared to allow the transaction and provide the collateral for the massive debts of the bank (FT, 2008). Hank Paulson stated that no government money would be made available to facilitate a rescue takeover of Lehman in a similar form to the Bear Stearns deal. He refused to offer guarantees against losses on Lehman’s trading positions or its troubled portfolio of real estate assets to help bridge a deal (FT, 2008). In 2008, the government and the Fed had to step in and bailout Bear Stearns and Merrill Lynch as well as provide liquidity to the whole financial system but they left Lehman out of the game - moral hazard at its peak but not for Lehman. At their peak, Lehman’s shares were worth $85(each) but a day before the collapse they were valued at 0.03cents. Lehman Brothers became entangled in the subprime mortgage lending crisis which in turn led to its demise in 2008. On September 15, 2008, the firm filed for Chapter 113 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock and devaluation of its assets by credit rating agencies (BBC Love of Money, 2009). The filing marked the largest bankruptcy in U.S. history, ten times bigger than Enron with a total debt of $600 billion. The company's valuable assets were subsequently sold to several other firms including Barclays PLC and Nomura Holdings, Inc. It is important to mention that as of March 2010 reports by the court-appointed examiner indicated that Lehman executives regularly used creative-accounting methods at the end of each quarter to make its finances appear attractive and avoid loss of shareholder confidence. This practice was a type of repurchase agreement that temporarily removed securities from the company's balance sheet; this method was creating "a materially misleading picture of the firm’s financial condition in late 2007 and 2008 (Bloomberg, 2010).
The End of an Era
After 158 years of existence, the collapse of Lehman Brothers shattered assumptions built over decades that modern finance eliminates risk, asset prices would always appreciate and that free markets operate perfectly and efficiently. The 1929 lessons have been ignored by successive governments over the past 25 years and the event has been repeated when many didn’t expect it. Mervyn King said: ‘people who think that the world has changed, I am afraid they have not read history’ (BBC Love of Money, 2009). L. McDonald in his book (The Inside Story of the Collapse of Lehman Brothers, 2009) asserts that Richard S. Fuld, the CEO’s strategies and endless envy to compete with Goldman Sachs led to its catastrophic demise.
However one could observe that, the origins of the crisis lay in the ‘age of risk’. The world economy showed two decades of globalization, deregulation and misplaced confidence. Regulators should have imposed fierce ‘banking controls and regulation on different activities and not encourage the perception that investment banks were ‘too Big to Fail’. Lehman’s bankruptcy left a huge lesson and one could hope that in the future, governments, regulators, economists and central bankers would not repeat the same mistakes. It was the biggest and the most catastrophic bankruptcy in the world and led to one of the worst global recessions in human history. Allowing Lehman to fail was a tremendous mistake; it was the catalyst for the crash of 2008. The exposure to the subprime crisis sunk banks around the world; financial institutions lost billions of dollars, businesses went bankrupt, unemployment rose and houses were repossessed. That crisis is long-lasting and taking place globally; Europe is facing the consequences of the credit markets decline and their poor supervision over the last decade. Greece, Ireland, Spain and other heavily indebted Euro area countries are struggling to remain in the zone and are desperately fighting to avoid being ‘The Lehman Brothers’ of Europe. Basic economics theory suggests that long-term investments should not be financed with short-term debt and excessive leveraging; that’s a bankruptcy business model. But Wall Street lost all of its fear and risk wasn’t a factor anymore because greed took over. It was greed and hubris that led to the fall. The bank had soared so high for so long, they thought they were invincible, but they were flying too close to the sun (Paul Mitchell, BBC documentary, 2009). Lehman’s bankruptcy brought down the whole financial system; it never should have happened.
Appendices
Appendix 1
Market Analysis –PESTL Model of the Investment Banking Industry Pre Crash of Lehman Brothers
| Factor | Often Comprised Of |
| Political | - The repeal of the Glass-Steagall Act by the Clinton administration. -Extensive deregulation of banking statutes e.g. the loosening of accounting practices (mark-to-market) – Arthur Andersen’s collapse in the Enron debacle. - Some elements of the Basel Accord provided the avenue for global financial over-exuberance. (Stiglitz, 2004) |
| Economic | -US GDP had been falling from 2003 to the period that preceded the crisis however consumer expenditure was relatively high. This could be associated with the easy availability of credit. - Financial innovation in the form of complex financial instruments and strategies. These innovations tended to be ‘black boxes/swans’ which market agents couldn’t fully comprehend their operation (N.Ferguson, 2009).. -Financial globalization meant that markets across the world were interlinked via their activities. This in turn meant that the propensity of contagion was increased. |
| Sociological | - Greed and hubris. Unfortunately some segments of the financial system believe this to be true. This is marked by short term gains and the negligence of long term consequences. -The notion of ‘too big to fail’ is entrenched in the psyche of financial institutions with the knowledge that the government will always be in the wings to save it (Moral Hazard). |
| Technological | -Computer based technology meant that information was readily fast and available. - Improvements in asymmetry of information resulted in a ‘herd mentality,’ which in turn worsened the position of financial institutions which found themselves in distress (V.Acharya, 2010). -Financial instruments owing to technology and globalization could be easily acquired and sold internationally (N.Ferguson, 2009).. |
| Legal | -In establishing a fine balancing act between over-regulation and deregulation, the latter exceeded the former with implications being an over indulgence in risk(V.Acharya, 2010). -With the gift of hindsight, it came to light that regulatory bodies should have been empowered in their enforcement of financial laws (V.Acharya, 2010) -The pursuant of a global accord in policing financial deals across borders. Example: the German chancellor, Angela Merkel, hosting the G8 Summit in a bid to harmonize global financial practices while maintaining individual national competitive edge. |
Appendix 2
Source: Financial Times
Appendix 3
Appendix 4
Appendix 5
| Annual income data, in millions | FY2003 | FY2004 | FY2005 | FY2006 | FY2007 | 6M2008 |
| Total Revenue | $17,287 | $21,250 | $32,420 | $46,709 | $59,003 | $18,610 |
| Interest Expense | $8,640 | $9,674 | $17,790 | $29,126 | $39,746 | $15,771 |
| Net Revenue | $8,647 | $11,576 | $14,630 | $17,583 | $19,257 | $2,839 |
| Operating Expenses | $6,111 | $8,058 | $9,801 | $11,678 | $13,244 | $6,263 |
| Operating Income | $2,536 | $3,518 | $4,829 | $5,905 | $6,013 | -$3,434 |
| Net Income | $1,771 | $2,393 | $3,260 | $4,007 | $4,192 | -$2,408 |
Source: Lehman Brothers Annual Report, 4Q2007 Earnings Release
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