The reasons that caused Lehman Brothers to collapse

The bankruptcy of Lehman Brothers was a result of the investment bank’s exposure to the 2007-2010 financial crisis. In fact, the demise of the investment bank would come to symbolize the crisis. Therefore, in order to understand the Lehman Brothers’ bankruptcy, a consummate understanding of the 2007-2010 financial crisis is requisite. As such, an examination of crisis will serve as introductory.

Several factors contributed to the fall of Lehman Brothers. Perhaps most important, however, was the period of deregulation that preceded the crisis.

Arguably, the period of deregulation started during the Reagan Era. Reaganomics, the lassiez faireeconomic policies advocated by the former president, may have served as the starting point for the deregulatory climate that ensued for the following two decades. Either way, the following two decades witnessed an overriding belief in the virtues of deregulation.

In 1999, President Clinton signed the Gramm-Leach-Bliley Financial Services Modernization Act into law. The act repealed portions of the Glass-Steagall Act (Banking Act of 1933). The Glass-Steagall Act prohibited universal banking. “Universal banking is defined as a single institution acting as an investment bank, a commercial bank, and an insurance company”(Investopedia). The repeal of Glass-Steagall allowed for harmful activity on the part of several financial intermediaries, including Lehman Brothers. For example, “commercial banks played a crucial role as buyers and sellers of mortgage-backed securities, credit-default swaps and other explosive financial derivatives. Without the watering down and ultimate repeal of Glass-Steagall, the banks would have been barred from most of these activities” (Demos 3).

Several other factors contributed to the financial crisis, including:subprime lending, credit conditions, financial instruments, and an increase in home prices. Many subprime mortgages were predatory in nature. Often, the borrower had little chance of repayment. As mortgages were often bundled and sold, lenders were less concerned with a borrower’s ability to repay the mortgage. In addition, over “80% of subprime mortgages were adjustable-rate mortgages (ARMs)”(Lee).A combination of declining home prices and higher reset rates for ARMs caused delinquencies to increase dramatically.

Subprime lending was fueled by low interest rates. After September 11, 2001, the Fed lowered rates. In periods of low interest rates, lending becomes more profitable. As such, banks were pressured to increase subprime lending. By 2006, “subprime loans accounted for 20 percent of all mortgage loans” (Kratz).

The use of financial innovation to create complex financial instruments (derivatives) played a significant role in both subprime lending and the financial crisis. For example, banks sold mortgages, through the securitization process, to investors, in order to finance subprime lending. Asset-backed securities (ABSs) were a common securitization arrangement. “A portfolio of income-producing assets (loans) is sold by the originating banks to a special purpose vehicle and the cash flows from the assets are then allocated to tranches” (Hull 190). The securitized loan is then sold to investors as an ABS. The process is depicted below.

ABS

CDS

In addition, another derivative, a credit default swap (CDS), was designed to provide insurance to protect against default. CDSs allowed investors to synthetically bet against the asset-backed securities. The process is akin to “multiple people buying insurance on the same house” (Demos). As such, when mortgages began to default, causing the value of ABSs to decline, the losses to insurance agencies were magnified.

The combination of all three of the aforementioned factors caused a remarkable increase in home prices. Low interest rates encouraged borrowing. In addition, many subprime borrowers believed home prices would continue to appreciate in perpetuity. As such, subprime borrowers acquired ARMs. ARMs were a product of the financial innovation mentioned earlier. “Between 1997 and 2006, the amalgamation of these factors resulted in a 124 percent increase in home prices” (S&P/Case-Shiller).

Market Making

In order to better understand the collapse of Lehman Brothers, it is necessary to examine the functions and practices of an investment bank. The sales and trading desks at investment banks had primarily acted as market makers. Market makers are a “broker-dealer firms that accept the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security” (Investopedia). In other words, market makers provide liquidity to markets by quoting both bid and offer prices. In contrast,investment banks eventually began proprietary trading. Proprietary trading involves taking positions in assets, as opposed to profiting from the bid-offer spread (market making). Lehman Brothers, through proprietary trading, had large levered positions in both subprime mortgages and mortgage-backed securities. When the value of these assets began to decline, the firm’s equity was wiped out and the bank became insolvent.

Proprietary Trading

Collapse

On September 15, 2008, Lehman Brothers filed for chapter 11 bankruptcy. This was the largest bankruptcy filing in U.S. history. The bank declared a debt of $613 billion, bond debt of $155 billion and $639 billion worth of assets. The demise of Lehman Brothers was caused by a combination of the rejection of bailout from the government, lack of a willing buyer, and the mortgage crisis.

The reasons behind the government rejection of a Lehman Brothers bailout are hotly contested. Prior to Lehman’s bankruptcy, the government had saved both American Insurance Group (AIG) and Bear Sterns from a similar fate. According to Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, the government failed to bailout Lehman Brothers for two reasons. First, the government lacked legal authority to intervene. Second, Lehman had insufficient capital. “The Federal Reserve could only make a loan, Bernanke explained, if collateral supported it…Giving Lehman a loan then would be lending into a run, Bernanke felt… “The assessment was that if there was a run, which there would be . . . all we would have accomplished would be to make counterparties whole and not succeed in preventing the collapse of the company” (dailyfinance.com).Many theorize that the government didn’t save Lehman Brothers in order to teach market participants a lesson. However, Bernanke refutes, “I speak for myself, and I think I can speak for others, that at no time did we say, ‘We could save Lehman, but we won’t.’ Our concern was about the financial system, and we knew the implications for the greater financial system would be catastrophic, and it was” (dailyfinance.com).

Lehman Brothers’had potential buyers in bothBank of America and Barclays Capital. However, without government assistance,both Bank of America and Barclays Capital walked. Lehman was forced into liquidation.

September 16, 2008, the day following Lehman Brothers file for bankruptcy, Barclays signed a definitive agreement to acquire certain parts of Lehman as well as their New York headquarters building. The deal was revised days later for Barclays to acquire the core business of Lehman Brothers including their $960 million Midtown Manhattan office skyscraper and 10,000 employees for $1.35 billion. With few other options, Lehman had little choice but to acquiesce. On September 22, 2008, Nomura Holdings Inc. acquired Lehman Brothers’ franchise in the Asia Pacific region including multiple locations and 3,000 employees.

The mortgage crisis played a significant role in the collapse of Lehman Brothers. Lehman was a major player in subprime lending. Lehman was a leader in both mortgage lending and loans securitization of mortgages. Subprime lending and securitization represented an increasing large portion of Lehman’s revenues. As such, the firm was irrevocably linked to the mortgage market.

When mortgage default rates began to rise, demand for MBSs decreased. Lehman was stuck with billions of dollars of “toxic” assets on its balance sheet. Lehman would eventually close its mortgage lending operations. The following year, due to holding on to large positions in subprime and other lower-rated mortgage tranches, Lehman faced significant losses. By 2007, Lehman’s leverage ratio (measurement of risk) also increased tremendously to 31:1 putting them in a very vulnerable position because they were too thinly capitalized for the leverage used.

This was allowed because they were not subject to the same regulations as depository banks. Deregulation allowed for Lehman to take those increasingly risky positions.

Market Effects

Lehman Brothers’ bankruptcy filing on September 15, 2008 caused the DJIA to drop over 500 points (-4.4%). September 15, 2008 marked the biggest one day drop since the markets reopened following September 11, 2001. The DJIA would eventually lose an additional 43% of its value, erasing more than US$ 1 T in market capitalization. World stock market indices suffered a similar fate. The FTSE All-World Index would eventually lose 2400 points (44% of its value).

The prospect of Lehman liquidating $4.3 billion in mortgage securities sparked a selloff in the commercial mortgage-backed security (MBS) market. Several money and institutional funds had significant exposure to Lehman. BNY Mellon’s institutional cash fund and the primary reserve fund (an MMMF) both fell below $1 per share due to exposure to Lehman. The Net Asset Value (NAV) of MMMFs “normally stays constant at $1 because investment products usually do not produce capital gains or losses” (Investopedia). This event was referred to as the “breaking of the buck.”

Overall systematic risk increased drastically as a result of the bankruptcy filing. Due to the increase in systemic risk, there was a US$ 737 B decline in collateral outstanding in the securities lending market. In addition, the TED Spread, the spread between U.S. treasury rates and LIBOR rates, increased almost 400 basis points. Essentially, the dramatic increase in the TED spread was due to overwhelming uncertainty. LIBOR rates incorporate a “small” amount of credit risk; U.S. Treasury rates are seen as virtually risk-free. The uncertainty caused the rate differential between a “small” amount of credit risk and risk-free to widen.

After the Lehman Brothers’ bankruptcy filing, in order to address the escalating crisis, the government created the Troubles Assets Relief Program (TARP). TARP was designed to purchase both assets and equity from financial intermediaries (FIs). The purpose of its design was threefold. First, by purchasing assets, the government hoped to remove “toxic” assets from the banks’ balance sheets. Second, by increasing equity positions, TARP recapitalized the troubled banks. Third, TARP was also implemented to encourage inter-bank lending.

Opinion

The bankruptcy of Lehman Brothers was preventable. The preventability of the Lehman Brothers’ bankruptcy is primarily due to three factors. First, corporate culture is dictated by upper-level management (this is especially true in top-down hierarchical organizations). At Lehman Brothers, CEO Richard Fuld created a culture of risk taking. A corporate culture that reflected conservatism could have prevented the bank’s demise. Second, as a corollary, tougher risk management policies could have prevented risk taking behavior. For example, by historical measures, Lehman had a tremendous used a tremendous amount of leverage. As mentioned, a 3 percent decline in asset prices would wipe out the firm’s equity. A leverage cap could have been used to prevent the overuse of leverage. Third, the weak economic climate was disastrous for Lehman. Lehman had large positions in the mortgage market. When the market began to decline, those positions went against the investment bank.

To prevent the three factors, the firm should have hired a CEO that advocated a less risky business strategy. In addition, reduce employees compensation based on profit generation. The firm could have also employed a more market neutral trading strategy. In doing so, Lehman would have avoided insolvency.

As mentioned, several ways exist to prevent the failure of the investment bank. However,all the above approaches Lehman CEO Richard Fuld

are tailored to Lehman Brothers’ unique situation.

They may or may not, however, be industry-wide or socially beneficial.To prevent another financial crisis and, therefore, the failure of financial institutions, we must align the self-interests of those institutions with societal interests. The following are recommendations for aligning the above interests:

â-Long-term Incentive Structure

â-Fiduciary Responsibility

â-Promote Financial Education

â-Prevent the Manipulation of Social Interests

We need to develop a long-term incentive structure to prevent executives trying to capture profit upfront at expense of the company and/or society’s long-term interests. We could design a longer-term incentive structure that employees will be compensated for their performance over longer periods of times other than the currently yearly compensation. Also we could design compensation program make the compensations based on certain activities callable in the future, if the loss of the company is deemed directly related to the those activities that the compensations are based on.

Fiduciary responsibility should be mandatory and financial institutions should be held legally accountable. We need to require full disclosure of conflict of interest, not only in the event that two parties have a direct interest conflict, but also full disclosure when companies providing a financial service have different opinions than the clients’ current position. In addition, we should expand the concept of full disclosure. We propose making academic researchers disclose the benefit they are getting from financial institutions, including board positions and monetary compensation.

Promote education of the general public. Specifically, implement finance classes in public high schools, ensuring all students are aware of market basics. In addition, make firms provide optional education on specific products to clients.

Lastly, we must reduce or eliminate attempts to make social interests subservient to self-interests. This concept could apply to all industries. We could limit the funding of lobbyists a firm could hire, and highly restrict the political donations from large firms.We must also eliminate the links between government regulators and market participants, eliminating the conflict of interest between corporations and society. In general, the aforementioned actions are attempts to align self-interest with the social interest. Self-interest, the “invisible hand” in the successful free market system, must be made to serve the interest of the society.

Conclusion

This report has examined the following: the Lehman Brothers’ bankruptcy, the bankruptcy’s causes, the culpable parties, market effects of the bankruptcy, and risk management errors relating to the bankruptcy. In addition, the opinion section of the paper answers the question, “Was the bankruptcy preventable?”

In summary, on September 15, 2008, the Lehman Brothers filed for bankruptcy. It was the largest bankruptcy filing in U.S. history. Several causes forced Lehman into bankruptcy. Of primary importance, however, was the investment bank’s exposure to the subprime mortgage market. Deregulation and risk management errors allowed Lehman to increase that exposure. Lehman’s CEO Richard Fuld, Treasury Secretary Henry Paulson, and Fed Chairman Ben Bernanke are each culpable. Mr. Fuld is responsible because he created a culture of risk taking and pay based on short-term performance. Henry Paulson and Mr. Bernanke could have saved the bank and chose to do otherwise.

We believe this event was entirely preventable. As mentioned, the bank’s exposure to the subprime mortgage market was, ultimately, its downfall. If more stringent risk management policies had been in place and Lehman’s corporate culture had been more conservative, the bank’s exposure to the crisis would have been reduced. Reduced exposure would have undoubtedly increased Lehman’s chances for survival.

A singular theme continuously appeared while we conducted our research and, consequently, appeared throughout this report. That theme is greed. Greed is defined as excessive or rapacious desire, especially for wealth or possessions. Unquestionably, human greed contributed to the 2007-2010 financial crisis. Both financial intermediaries and individuals erred. For example, AIG reported record profits in 2007. Unfortunately, the insurer earned those profits by taking on enormous amounts of Off-Balance-Sheet risk. These OBS liabilities (contingent liabilities) resulted in an $85 B government bailout of the firm. Individuals speculated on home prices by refinancing mortgages. Often times, these loans were secured by home equity. When home prices declined, the mortgages went “underwater.”Mortgage defaults soared. In both cases, greed blinded the market participants.

Lehman Brothers wasn’t impervious to the “rapacious desire” either. Leverage is the use of either borrowed money and/or derivatives to multiply gains and losses. The multiplication of gains and losses (greater volatility) implies an increase in risk. Recklessly increasing risk demonstrates an excessive desire for wealth.Therefore, leverage metrics (ratios) can be used tomeasure greed. Prior to the crisis, Lehman’s leverage ratios soared.

Viewing a single financial product, event, action, or asset bubble as the sole cause of the crisis is overly simplistic. Greed served as a catalyst for each. By ignoring this fact, we are doomed to repeat our mistakes.