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Before its collapse, Lehman Brothers was the fourth largest investment bank in the US. Founded by three German immigrants in 1850, the investment bank experienced heady growth over its 158-year history, culminating in its record performance in 2007 when it recorded its highest ever profits, its share price hit an unprecedented value of $86, its market capitalization breached the $60 billion mark. This was not to be long-lived however, as the firm, overburdened by debts amounting to $619 billion, filed for Chapter 11 bankruptcy protection on Sep 15 2008 (Economic Times, 2010).
This paper takes the position that while the sub prime mortgage crisis contributed in large part to the collapse of this once venerable bank, it is its financial policies (defined by a very aggressive leverage and excessive financing of debt by short-term borrowing) that delivered the ultimate death blow.
It traces the origin and growth of the bank, evaluates its position relative to other players in the US and global markets before its collapse, and analyses its financial policy and the role such policies played in the bank's collapse. Finally, it evaluates the impact of the bank's collapse and makes recommendations which can help forestall the recurrence of such events in future.
a) History and Rise:
Lehman Brothers traced its roots to a dry goods store started by Henry Lehman, a German immigrant in 1844. In 1850, Henry was joined by his two brothers Emanuel and Mayer, with whom they founded Lehman Brothers (Investopedia, 2010).
Initially, Lehman Brothers traded in cotton, a major cash crop at the time, accepting it for the settlement of accounts from farmers. Buoyed by the transition of the American economy from an agrarian economy to an industrial one and the rapid expansion of the American economy in the latter half of the 19th century, the firm would venture into the purchase and sale of securities, merchant banking, and into financial advisory. In 1887, Lehman Brothers became members of the New York Stock Exchange, having shifted base to New York in 1858 (Economic Times, 2010).
With time, Lehman Brothers expanded internationally to meet the needs of an increasingly global clientele. It opened an office in Paris in 1960, in London in 1972, and in Tokyo in 1973. It enhanced its international footprint by merging with Kuhn Loeb. In 1975, it acquired Abraham and Co, but was itself acquired by Amex in 1984 and became part of Shearson. In the nineties, American Express would divest from Shearson, and the firm would once again become known as Lehman Brothers (Economic Times, 2010).
It would become an independent company in 1994 through an initial public offer, and its shares would begin trading on the New York Stock Exchange and the Pacific Stock Exchange. Lehman Brothers would open additional offices in Tel Aviv and Mumbai. It joined the S&P Index and became a member of the Amsterdam Stock Exchange. Other acquisitions which the firm undertook include Lincoln Capital Management's fixed income business and Neumann Burger (Economic Times, 2010).
As Lehman Brothers' history illustrates, its growth has been through a combination of organic and M&A strategies. The organic growth has been made possible through an accurate assessment of the growth potential of the industries financed (railroad industry in the latter half of the 19th centuries, TV and radio in the 1930's, the computer industry, and the biotech industry). Additionally, the firm's growth has been underscored by innovation of financial solutions (such as private placements in the wake of the credit crunch following immediately after the stock market crash of 1929 and the underwriting of corporate debt over the internet). This innovative streak is perhaps what inspired Lehman Brothers to get heavily involved in securitization and become a leader in the sub-prime mortgage financing market, eventually leading to its collapse on September 15th 2008 (Swedberg, 2009).
a) Position in the home and international markets:
Before it filed for bankruptcy protection on 15th September 2008, Lehman Brothers was the fourth largest investment bank in the US, behind Merrill Lynch, Goldman Sachs, and Morgan Stanley (CNN Money 2008a, 2008b, 2008c).
Among other accolades, Lehman Brothers had been ranked first in Barron's 500 annual survey in corporate performance for the leading firms in the US and Canada. It had also been named the "Most Admired Securities Firm" by Fortune in 2007, and the "Best Investment Bank" by Euromoney in 2005. Lehman Brothers also boasted of the distinction of having handled the largest ever M&A transaction (the $98 billion acquisition of ABN AMRO by a consortium led by the Royal Bank of Scotland) (Economic Times, 2010, p.1).
With some 25,000 employees just before its collapse, it was ranked eleventh among the top fifty investment banks in the world in a 2000 Euromoney Poll of Polls. The top investment banks in the world, as per that survey, are shown in the table below:
b) Milestones (share price):
The firm's share price rose steadily from the time the bank was listed in 1994 to reach its peak in of $86.18 in February 2007, before plunging downwards to just $0.22 as Lehman Brothers began its descent downwards (Yahoo Finance, 2010). The movement in the firm's share price since its listing in 1994 is depicted in the graph below:
c) Financial Policies:
Before its collapse, Lehman maintained a very high leverage (asset to equity ratio). It also placed a very strong reliance on short term borrowing to finance debts. The firm's financial statements in the period leading up to its demise, from which its leverage and short term borrowing positions can be ascertained, are shown below:
d) Causes of Lehman's Collapse:
The collapse of Lehman Brothers has been attributed to the sub prime mortgage crisis, of which it was the market leader in 2005 and 2006. The subprime mortgage crisis resulted when banks and other financial institutions, spurred on by a protracted low-interest regime and rising house prices made out loans to the sub prime segment of the market. Zingales (2008, p.3) writes that for example, "From March 1997 to June 2006 the Case and Shiller national index of real estate prices increased every month, except for two. During the same period the average increase in real estate prices was 12.4% per year." This increase was driven by a sustained upward tempo in the price of real estate. Correspondingly, the average T-bill rate between 2002 and 2004 stood at just 1.3%, a stark contrast to the 6.1% average for the preceding forty years. These are depicted in the graphs below:
This environment of rising house prices and low interest rates created the illusion among many prospective and actual home owners that the upward rise in home prices would continue for a long time to come. With innovative financing tools such as interest-only amortization, negative amortization and mortgage options, many sub prime mortgage borrowers were encouraged to take up loans which they were ill equipped to pay (Zingales, 2008).
The borrowers expected that with rising home values and low interest rates, they would be able to refinance their home purchases at low rates and take out their equity for use in other purchases. When the real estate bubble burst, against all expectations, Lehman Brothers was left holding billions of assets in the form of bad debts (Zingales, 2008).
However, while the sub prime mortgage crisis played a very instrumental role in the collapse of Lehman Brothers, Lehman Brothers' own financial policies accelerated its demise. As shown in the financial statements, Lehman Brothers maintained a very aggressive leverage (which hovered at around 30:1 in 2007). Einhorn (2008) estimated the firm's leverage to be 44:1. What this basically means is that for every $100 it held as loans, it had only $3.3 as equity. Therefore, if the value of its assets declined by just 3.3%, its entire equity would be wiped out and Lehman would become technically bankrupt. Indeed, by the time Lehman Brothers was filing for bankruptcy, it had debts worth $619 billion, and assets worth only $639 billion, making it the largest bankruptcy filing in the history of the US (Investopedia, 2010).
Looked at against the background of the sub prime mortgage crisis where the value of the securitized assets was declining, this policy subjected the bank to a lot of instability. The problem was however made much worse by the bank's excessive use of short term debt to finance its assets. As illustrated above, more than 50% of the bank's assets were financed by short term debt. While this can work very well for the firm in a low-interest rate regime, it exposes the firm to a very high risk of experiencing runs on its deposits. Should the market lose confidence in the bank (due to for example rumors about the bank's solvency), many short term lenders would refuse to renew their lending and many of them would rush to withdraw their funds, further worsening the liquidity problem (Zingales, 2008).
This was the case with Lehman Brothers, where its stocks plunged downwards as investors became jittery about its prospects, massive credit-default swaps on its debts took place, hedge fund clients withdrew, and short-term creditors cut their credit lines. By the last week leading to its folding up, the bank had only $1 billion cash left (Investopedia, 2010).
At first, Fuld (Lehman's CEO) was indifferent to suggestions that he get a buyer for the troubled investment bank (rejecting for example offers from Warren Buffet, among others) (Story and White, 2008), and believing that by investing in commercial real estate and assets outside the US rather than in the declining housing market Lehman would be able to shore up its financial position. This worsened rather than helped Lehman's position and as 2008 progressed, the bank's financial condition worsened. When the gravity of the situation sunk and Fuld began approaching prospective suitors with a view of either raising additional capital or getting a buyer (Citigroup, Korea Development Bank, and Barclays), the potential suitors chickened out after taking a look as the bank's books.
e) Effects of Lehman's Collapse:
The collapse of Lehman Brothers had a huge impact:
- It caused a rise in the cost of insuring cash invested in junk bonds (from $4.50 to over $6 for every $100 invested) (Zingales, 2008).
- It brought about a lot of uncertainty in the money markets and triggered a dramatic loss of confidence in the financial sector (Zingales, 2008) as evidenced by the 500 point drop (a 4.4% drop) of the Dow Jones, and the dramatic drop in the value of the share prices of other investment banks. As a result of the loss in confidence, jittery investors withdrew close to $400 billion. The confidence crisis also affected interbank borrowing (evidenced by the hike in the LIBER-OIS spread), and froze the corporate paper and repo markets, while occasioning a credit crunch that paralyzed the consumer and industrial borrowing (Swedberg, 2009).
- It caused massive losses in investor funds around the world. For example, Japanese banks and insurance firms with close ties to the fallen bank announced losses worth $2.4 billion while the Royal Bank of Scotland announced losses of up $1.8 billion. Pension funds and local governments in the US lost close to $1.7bn, while the Sachsen Bank in Germany lost up to half a billion euros (Swedberg, 2009).
- It occasioned a dramatic hike in the price of CDS's (Swedberg, 2009) as shown in the graph below:
- It has led to massive consolidation in the investment banking sector. Consequently, the remaining few investment banks are likely to wield enormous power over other players such as credit rating agencies to the further detriment of the financial sector and the consumer (Swedberg, 2009).
The collapse of Lehman Brothers triggered a massive loss of confidence in the US financial industry, caused a loss of billions of dollars of investor funds, a rise in the cost of insuring cash invested in junk bonds, rising CDSs prices, and widespread loss of employment for Lehman staff. It also hit hard the repo and corporate paper markets, and led to a crippling credit crunch.
While the subprime mortgage crisis played a role in the collapse of Lehman Brothers, Lehman Brothers' financial policy of maintaining an aggressive leverage and of excessive use of short term borrowing to finance debts accelerated the firm's descent into bankruptcy.
To avert similar occurrences, several things need to be done:
- Proper oversight of the investment banks needs to be carried out. For example, while banks are not allowed to have a leverage ratio of more than 15:1, Lehman's leverage stood at 30:1, thanks to the SEC relaxing pre-existing leverage limits for the big five investment banks in 2004 and which resulted in increased liquidity among the banks and worsened Lehman's position. This rule needs to be revised.
- Increased vigilance by the oversight authorities would also help avert a situation, such as the one that prevailed, when lending rules were relaxed in order to accommodate sub prime borrowers, and where deceptive practices such as the use of teaser rates were used.
- The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which compelled Fannie Mae and Freddie Mac to create inflated demand for securitization and fuelled the sub prime mortgage crisis needs to be revised.
- Changes to the fair value accounting method which allow for easier valuation of mortgage-backed securities using the approaches provided for under FAS 157 need to be made.
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