Reasons Behind Lehman Brothers Bankruptcy

Undoubtedly, the complexity and unpredictability of the external environment-market forces/stakeholders influenced the way and manner Lehman’s CEO, Mr Richard Fuld behaved. He involved himself and his organization into unethical practices due to so many expectations on them. The market competition was getting very fierce, so he had to “bend the rules” in order to keep his organization profitable.

Market complacency, weak financial regulations, lack of transparency and poor internal financial control policy led to the demise of Lehman Brothers. Mr Fuld adopted the omnipotent view of management but told the U.S House of Representatives’ Committee on Oversight and Government Reform that the collapse of his firm was totally out of his control-i.e. symbolic approach. This indicated a weak moral culture/development at the preconditional level. His ethical inclination indicated a utilitarian approach which involves decision making based on favorable anticipated outcomes.

Clearly, the fall of Lehman Brothers was a preventable man-made disaster. He enshrined a very poor risk management culture in the organization by offering highly leveraged Mortgage Backed Securities. Even if Mr. Fuld felt the economic tides were beyond his control as he proclaims, he should have at least sold the company early enough the way Merrill Lynch’s CEO smartly did. But his ego as well as poor management insight took a better part of him.

Lehman never engaged in “real” Corporate Social Responsibility, rather what they did was philanthropy with ulterior motives in mind. They never issued a CSR report of any kind depicting lack of transparency and accountability.

There is no denying the hard and bitter truth that we are experiencing a global financial recession with many a nation counting their losses. We are in fact going through possibly the worst global credit crisis since the Great Depression. Given that the world is flatter and with advancing technology, global financial markets are now integrated thus making an otherwise national financial market a global phenomenon. By a simple click of a button, billions of dollars can seamlessly traverse national boundaries at the speed of light.

Sadly, this global financial meltdown originated in USA due to the widespread subprime mortgage defaults, economic recession is affecting all the major players of world economy.

By September 2008, the credit crunch, which started around 2006, had alarmingly ballooned into Wall Street’s biggest crisis since the Great Depression as hundreds of billions in mortgage-related investments went sour; mighty investment banks that once ruled high finance firmament crashed.

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In the midst of this conundrum, accusing fingers are been pointed at different quarters; some blame the regulatory authorities over complacency and “blind-faith”, while some blame the private and investment banks over greed, poor corporate governance/practises and investment decisions. The worst hit directly were the insurance companies, investment banks, Hedge Fund operators, Large Mortgage Lenders such as Lehman Brothers, Merrill Lynch, Bear Stearns, Fannie Mae, and Freddie Mac etc.

The United States government has been battling to starve off what has surely snowballed into a global economic recession by acquiring national mortgage giants: Fannie Mae, Freddie Mac, AIG as well as midwiving Bear Stearns Cos Inc’s sale to JPMorgan Chase. Bank of America took over Merrill Lynch. While these bailouts were going-on, a blind eye was turned on the struggling fourth largest investment giant- Lehman Brothers.

Consequently, the Lehman brothers filed for bankruptcy on September 15, 2008 as a result of the Fed refusing to bailout them out or at least backstop their toxic assets.

1.1 CASE ISSUES

The case issues discussed are:

The Internal and External Environment

We shall evaluate how these environments interacted with Lehman Brothers.

Managerial Ethics

Reactions are bound to be elicited as organizations continue to interact with their environments. Hence we shall attempt to assess how Lehman Brothers behaved and reacted in accordance with ethical theories and standards.

Corporate Social Responsibility

Lehman Brother’s Social Responsibilities as well as their attendant consequences shall be evaluated.

PART A

2.0 THE INTERNAL AND EXTERNAL ENVIRONMENT OF LEHMAN BROTHERS

2.1 The External Environment:

Organizations do not operate in a vacuum because they derive their ultimate existence from the environment. Environmental factors whether specific or broad-based, influences an organization’s strategy for survival and profitability. Lehman’s external environment consists of its stakeholders such as Mortgage financiers, Hedge Funds, Pension Funds, Government Regulators, Commercial Banks, Investors, Credit Rating Agencies, employees, Home Owners, Small and Large companies, etc. See figure below for a schematic diagram of Lehman’s overall environment. Figure 1

GLOBAL ECONOMICS

DEMOGRAPHICS POLITICAL/

LEGAL

TECHNOLOGICAL SOCIOCULTURAL

Suppliers

Pressure Groups

LEHMAN BROTHERS

Customers

Competitors

How uncertain and complex is Lehman Brothers’ environment?

Below is the Uncertainty matrix used to evaluate how the external environment affected Lehman Brothers. Figure 2

ENVIRONMENTAL UNCERTAINTY MATRIX

Source: Robbins, Bergman, Coulter, Management 4e, 2006, Pearson Education, Australia

Due to the type and nature of business, Lehman Brothers falls within the cell block 4: which connotes a dynamic and unpredictable environment characterised with many components and a high need for knowledge. Hence, Lehman stands the chance of been influenced by the external environment which may reduce the influence of its managerial decisions and interventions.

Lehman Brothers’ broader environment as it affected their activities, behaviour and outcomes are discussed under the following sub-headings using the Political/Legal, Economical, Socio-cultural and Technological changes, PEST analysis:

Political/Legal:

Lehman Brothers which was formed some 158 years ago was initially involved in assisting large corporate firms such as Sears, Roebuck and F.W. Woolworth, etc raise capital to expand their businesses. During the 1930s, the Lehman Brothers diversified into strictly Securities business when the U. S government forced all financial institutions to choose between commercial banking and Securities.

Lehman’s portfolio deepened following the repeal of the Glass-Steagall Act in 1999, during the Clinton administration. The act prohibited banks from investing on Wall Street, thus shielding consumers from riskier transactions. Once that protection was abolished, Lehman was able to gamble; and it became among the largest issuers of Mortgage-Backed Securities making its share price to climb from its 1994 price of $5 to $86 in 2007.

As a result of Lehman’s desperate attempts to compete fiercely with its core rival, Morgan Stanley for market share, it employed several under-arm tactics that exposed it to several bitter brushes with the law amounting to multiple litigations (See appendix 1). This further hurt its corporate image by brewing fear, panic, distrust amongst its stakeholders resulting in it been abandoned during its time of need.

Lehman would have been saved just as Fannie Mae, Freddie Mac, Bear Stearns and AIG under the current political climate, but there were outstanding issues involved e.g. the Federal Reserve picked out big holes created by the toxic assets in Lehman’s balance sheet coupled with their refusal to come out clean to the public. Instead, Treasury and Federal Reserve bosses, Messrs Henry Paulson and Ben Bernanke respectively, preferred to save others because they felt that allowing these (Fannie Mae, Freddie Mac, Bear Stearns and AIG) to fail would have resulted in a cataclysmic cascade of events that will consume not only in the U. S economy but the World’s. Moreover, Mr Paulson never believed it was right to use taxpayers’ money to save Lehman. Whether this was a right decision remains to be seen as the Lehman’s bankruptcy has inevitably crippled global financial markets worldwide.

Economic:

The Macro and Micro-economic environment which Lehman Brothers operated played a vital role in its demise. Indeed, what basically happened to Lehman was typically a simple economic case of supply outstripping demand.

After the terrorist attacks of September 11, 2001, the Fed greatly lowered interest rates in other to stimulate economic growth and prevent deep recession. Expectedly, the largest Wall Street firms began reacting to this Federal Reserve policy of extremely low rates at which money was borrowed by purchasing billions of dollars of subprime mortgage loans. These were most likely bought from nonbank mortgage companies, which borrowed money from companies like Lehman in order to make loans and quickly resell them to Wall Street.

Bear Stearns and Lehman Brothers almost monopolised this market as other players like Merrill Lynch were late arrivals to the highly leveraged/risky subprime lending and securitizing business. Lehman offered bulk loans to nonbank lenders, also purchasing mortgage products and then turning them into Asset Backed Securities (ABS), and then selling these bonds to end investors basically made up of the insurance companies, Hedge Funds, Pension Funds, Local Governments and foreign banks.

The Securities and Exchange Commission escalated the already worsening economic situation in 2004 by encouraging these investment banks through the relaxation of the pre-existing limits on leverage. Expectedly, the leverage ratios of the five largest independent investments banks hit the rooftop (Labaton, 2008). Lehman’s greedy internal financial policy did not help matters at all, as it offered potentially dangerous leverage ratios as much as 30:1, asset-to-equity ratio (Table 6, see appendix 2). Given this scenario, any 3% drop in value of assets completely blows out the entire value of equity thus rendering the company bankrupt. Nevertheless, Lehman grew rapidly, playing a dominant role in the securitisation market and the leveraged lending businesses posting quarter after quarter of record earnings from 2004 to 2007.

Even after the economy had recovered, the U.S Fed notoriously kept interest rates low which made mortgage payments even cheaper and affordable thus greatly reducing the likelihood of defaults to barest minimum. Therefore, demand for homes began to escalate, sending prices up. In addition, millions of homeowners seized the opportunity of rate drops to refinance their existing mortgages. As the industry became saturated (as virtually everybody now owned a home), coupled with the never-ending competitive rivalry among lenders, the quality of the mortgages went down resulting in the erosion of underwriting standards.

For the fear of inflation due to excess liquidity in the markets, Fed started increasing interest rates which eventually made mortgages already owned, worth less than the amount for which they were initially purchased due to higher payments. This sent widespread panic across all stakeholders which to loss of confidence and trust in financial markets leading to mortgage defaults and subsequent foreclosures. With this ugly scenario playing out, coupled with the Lehman’s increasing inability of meeting its debt obligations, investors lost confidence in its stocks resulting to bankruptcy with about $613 billion in debt.

Socio-cultural:

These are factors such as behaviours, beliefs, values, demographic trends as they affect organization. A majority of Lehman’s workforce belong to the generation Y. Generation Y are generally lifestyle oriented, tech-savvy, ambitious, impatient, etc. Because they generally flock to “where the money is”, Lehman’s top management continued to do everything in its power to retain its best brains. With the continuous availability of low interest funds, change in consumer taste became the norm. An individual who otherwise wouldn’t have been able to afford a house now had access to owning more than one house. This made the public adopt the culture tending towards investment rather than consumerism which affected other real sectors of the economy. This change in consumer taste favoured Lehman initially because of increase in mortgage demands. Soon Lehman had no borrowers for its mortgage products because everybody now had a house; and with the increase in interest rates, foreclosures became apparent because the real weak financial status of its borrowers became obvious.

Technological:

Advancement in technology played a very “double-edged sword” role at Lehman Brothers. It brought about drastic reduction in the cost of creating mortgages. The growth of the internet coupled with easier availability of information about potential borrowers by the simple click of the mouse button, encouraged it to rely more heavily on convenient sources of information, such as credit scores and ratings, rather than on the more labour intensive time tested methods. It also made searching for a new set of borrowers easier and less costly, mortgage offerings using bulk email sending tools.

On the other hand, these innovations created what economists call an “agency problem”. Since the mortgage originator was no longer going to hold the mortgage to maturity, but rather was going to immediately sell it to a securities firm and collect its fees upfront, it did not have a strong inclination to conduct a thorough appraisal of the loan.

2.2 The Internal Environment

The internal environment of any organization basically symbolizes its culture, personality, commonly shared values and beliefs (Robbins S., et al, 2006). Companies will react to same circumstances differently due to the differing cultures that distinguish them. Furthermore, an organization’s internal strengths and weaknesses as well as opportunities and threat, SWOT can play a vital role in its success or failure.

2.2.1 Lehman’s Culture

Lehman’s CEO, Mr Richard Fuld in my opinion is viewed as an omnipotent leader because he “single-handedly” turned the fortunes of the company around when he assumed office in 1994. He ran the organization like a warfront where he enshrined a very strong culture amongst his subjects.

His colleagues even nicknamed him “Gorilla” because of his imposing stature on the firm as nobody not even “outsiders” dared challenge his ideas, policies and decisions. This behaviour was not unexpected because Lehman has had a long history of hostilities, in-fighting and “coup de tat” within its ranks which had cost it its independence in 1984.

Since we already know that the internal environment of an organisation is all about its culture, behaviour and reaction as to how it sees the external environment. For the scope of this report, we may not dwell so much on the positive culture of Lehman rather we shall take a critical look at how its culture might have played a role directly or indirectly in its demise using the seven dimensions of culture.

Usually, attention to details is very much of required skill financial institutions must possess. But due to the competitive landscape and greed on the part of senior management, ethical details were ignored regarding the type of mortgage loans that were issued. Background checks weren’t performed to determine the credit worthiness of its mortgage borrowers

Innovation and Risk tolerance

X

High innovation/High risk tolerance culture as evidenced in their highly leveraged mortgage securities offering which came through several complex financial innovative packages

Outcome orientation

X

-Outcomes/result-oriented culture that focuses more on results rather than “how” they were achieved. This attitude made it lose sight on the illiquidity of the market during the impending crisis because of blind greed

– Short term performance reward culture throughout the firm not minding if these loans would survive in the long term or not

Stability

X

Very strong/stable culture of “let’s maintain the status quo” which resulted in their inability to adapt to the current financial situations.

People orientation

X

-Poor and ineffective communication culture from top management to the bottom. Senior execs never took feedbacks from employees in the “field” seriously

– While senior management compensated themselves with cash bonuses, other employees were issued bonuses mainly in stock options and bonds.

– Lack of recognition for outstanding performance especially if it came from a “lower” employee

– A culture of lack of transparency among the senior executives. They never communicated the true nature of their liquidity to their employees and other stakeholders

Aggressiveness

X

Overly aggressive culture in which they tried to bully, manipulate and outsmart the market but got their fingers burnt.

Team orientation

X

Non collaborative competitions which dampened employee morale. The atmosphere was like that of a collegiate, people formed cliques and cartels. There was teamwork, but competition was basically on a personal level because of rewards that may accrue from individual performance

The above listed cultural adoptions by Lehman went a long way in tarnishing their image before its global stakeholders which made it difficult for it to be trusted and rescued when its state of insolvency became apparent. Table 2.0

2.2.2 SWOT Analysis of Lehman Brothers

SWOT

DESCRIPTION

Strengths

-Lehman has a robust financial base with liquidity in excess of $42 billion as at Aug., 2008 which is capable of withstanding severe financial stresses (Scott S., Tanya A., 2008). It also has a strong franchise across its core investment banking, trading, and investment management businesses.

– Cutting-edge IT infrastructure is one of Lehman’s strengths which it exploited maximally in the acquisition of customers more efficiently (see PEST analysis).

– Strong knowledgeable and skilled workforce

– Strong culture which is one of team-work, collaboration and knowledge sharing as evidenced by the rotation of workers around departments at least every two years

Weaknesses

-Poor managerial decisions which led to the inability or otherwise outright refusal to see the financial dangers coming. -Poor risk management and internal controls which led to its finances being exposed to risk of been wiped out within days. – Strong culture which resulted in sluggish adaptability to the changing financial situations within and without the organization.

Opportunities

-The U.S Federal Treasury kept interest rates low for prolonged periods which made mortgage acquisition/repayments even cheaper and affordable which increased the patronage that accrued to investment banks, Lehman Brothers inclusive. – Securities and Exchange Commission relaxed limits of financial leverage which gifted Lehman with the opportunity to offer more highly leveraged mortgage backed securities to its investors. But these seeming “good” opportunities turned out to be a “curse” in disguise.

Threats

– Stiff competition coming from Morgan Stanley, Goldman Sachs, and Merrill Lynch in the “hunt” for new mortgage clients leading to the drastic reduction in the quality of mortgage instruments issued. More and more leverage was issued in other to remain competitive and remain “profitable”. The worst threat came from the Federal government backed Fannie Mae and Freddie Mac which had exclusive access to government subsidy (very low interest rate loans) making them issue the lowest rate mortgages thereby dominating the mortgage market. This then forced other players to issue even lower rates in order to stay in business. -Short selling of its stocks by brokers on the floor of the exchange which made the value fall freely thereby escalating investor anxiety resulting in loss of confidence. Negative market sentiments concerning its likely collapse due the earlier collapse of Bear Stearns, bailouts of Freddie Mac and Fannie Mae.

Summary of the SWOT Analysis

No doubt, Lehman is an indeed very large bank. With its robust financial war chest, experienced/diverse workforce and cutting-edge IT/IS at its disposal, it still went under. Lehman failed to utilize its strengths/opportunities to strategic advantage. Stiff competition, financial regulation laxity as well as poor management made it issue highly leveraged risky Mortgage Backed Securities, MBS which eventually wiped out its liquidity due to massive defaults in mortgage repayments which came as a result of increased interest rates to checkmate rising inflation.

PART B

3.0 MANAGERIAL ETHICS

These are laid down standards of conducts or moral judgements used in the discharge of business. More importantly, it refers to the rules and principles that define right and wrong conduct. It is the ultimate duty of the manager to effectively communicate and implement ethical issues within an organization.

Lehman Brothers adopted the utilitarian view of ethics, in which decisions were made based on outcomes and/or consequences. They concerned themselves with making enough profits to satisfy the greedy yearnings of the top few at the top hierarchy of management not minding if their activities were detrimental to the welfare of others. This was clearly seen in the way mind boggling bonuses was dished out to the CEO, Mr. Fuld and other top management executives. According to Mr. Fuld’s report to the Federal Committee on Oversight and Government Reform, over $30 million was paid to him as bonuses. He also claimed that during the fruitful years, 2004-2007, an astonishing $16 billion was disbursed as bonuses out of which he alone grossed over $260 million.

Below is a table showing a list of variables as they affect Lehman’s ability to behave the way it did.

Table 3.0

3.1 Factors affecting Lehman’s ethical behaviour

Factors affecting Managerial Ethics

Comments

State of moral development (manager’s)

Since the ethical behaviour of managers is the single most vital factor that influences employee decisions (Robbins S., et al, 2006), we shall focus on the state of moral development of Lehman’s CEO, Mr Fuld R. He operated at the preconventional level since his actions (selling highly leveraged Mortgage Backed Securities at all cost) were hugely inclined to the rewards and bonuses he and his cronies would get.

Personality/Values (ego strength/locus of control)

Values which represent personal convictions of what is right and wrong (Robbins S., et al, 2006) go a long way in influencing ethical behaviour. Mr Fuld has a very strong personality (ego strength) always believing that whatever he does is the right thing. Even at the collapse of Lehman, he never accepted responsibility for his actions and/or inactions. When he was alerted about what financial crisis they were in, by an insider, he waved it off. He also believes he has the ultimate power to control both his destiny as well as that of others (internal locus of control)

Organizational Culture/Design

-For the fact that Mr. Fuld took Lehman from “rag to riches”, he was seen as a demigod who was above the law. Hence, he was not subject to the organization’s code of ethics and conduct.

– The organizational design/structure adopted a Top-Bottom management style of leadership. It enshrined a strong master-subordinate relationship which stifled information and knowledge sharing as no employee dare alert top management on their wrongly adopted strategies

– Lehman’s culture is such that encouraged risk taking and constant innovation which later proved to be its undoing.

– The emphasis on individual achievement above group/team achievement encouraged employees as well as management to go extra lengths even if it’s unethical to “perform” e.g. the more mortgage clients you get, the more your bonus and recognition which was further boosted by its culture of short-term performance appraisals.

Issue Intensity

– Greatness of harm: Lehman brothers never believed their actions (highly leveraged MBS) would have deleterious effects on its overall stakeholders after all, it believed its investors had being hedged against dangers through the Credit Default Swaps, CDS being issued by American Insurance Group, AIG

-Consensus of wrong: Nobody dared oppose Mr. Fuld’s decisions, the very few that did were summarily sacked. So there was no basis for consensus of wrong here.

-Probability of harm: Lehman believed the probability of foreclosures was minimal because of the seemingly prolonged low interests rates which created a lot of liquidity in the economy

Immediacy of consequences: Mr. Fuld in his opinion believed that even if there’s an eventuality of foreclosures, economic downturn and/or write downs, it would be ” for a short while” because ” historically” crises does occur every few years and the markets would always ” heal itself”

-Proximity to victims: Lehman “pushed” its mortgage customers far off using its “distanced” subsidiary, Aurora Loan Services as the issuer of its mortgages. This, it used to distance itself from its customers. By so doing, most people never knew the subprime mortgages were being offered by Lehman in order to maintain a clean public image and avoid responsibility for any untoward adverse effects of its unethical actions

-Concentration of effect: Lehman ignored how concentrated the effect of foreclosures that would arise from its subprime mortgage sales would have on the national as well as global economy. They failed to see the broader picture of a likely global economic downturn. That necessitated their continuous unethical/risky financial actions.

Conclusion

Mr. Fuld of Lehman Brothers acted unethically in most of his decisions

From the complex interplay of several factors that affected Lehman’s unethical behaviour in the table above, we shall take a closer look at some of the ethical issues faced at Lehman Brothers below with a view to comparing opposing views on their conducts.

Table 4.0 Opposing arguments concerning Lehman’s managerial ethical decisions.

Ethical issues

Arguments for

Arguments against

Sale of risky/highly leveraged Mortgage Backed Securities

Small percentage appreciation in value can translate to explosive profits for its balance sheet and investors alike

Little decrease in value potentially wipes out the entire credit of the company rendering it insolvent. It is unethical to use investors’ hard earned monies to venture into greedy and risky ventures under whatsoever guise.

Constant financial products reengineering and “innovation”

This creates potential attraction for new customers as well as retaining the existing ones

Causes confusion as to the understanding of the potential risks these products- offers portends.

Unscrupulous “bulking or bundling” of mortgages

This otherwise smart strategy helps to dilute the “toxic” effect of under-performing mortgage securities by lumping them with the good ones thereby creating a positive appearance leading to AAA ratings by rating agencies

This strategy deceived many investors by underplaying the actual value and safety of their stock holdings leading them to be taking by surprise when their stocks became worthless

Generating mortgage demands; packaging them, and then reselling them back to Wall Street and the investing public for large profits when in reality, there weren’t “real” buyers for them

This was a way to create profits out of nothing

This is an unethical attempt to manipulate the natural forces of demand and supply. Hiding behind their phony subsidiary, Aurora Loan Services to propagate falsehood contributed to the housing market bubble burst when it became evident there was no more demand for these mortgages

Underwriting loans to questionable lenders e.g. FAMCO, Delta Funding Corp., etc and assisting them in cheating borrowers thereby violating consumer protection laws (Graham R., 2008, see bibliography)

NA

This led to widespread erosion of global investor and public confidence in the company which further contributed in its bankruptcy.

Mr Fuld’s non-equity incentives were astronomical exceeding the 85th percentile. Furthermore, his bonuses grossly exceeded the normal industry average of bonus= base salary x Two. Mr. Fuld’s bonuses were five times his base salary (Nell M., 2008, see bibliography)

NA

This compensation practice doesn’t align in favour of shareholder interests

PART C

4.0 CORPORATE SOCIAL RESPONSIBILTY

This is a broad term which is used to describe an organization’s business activities as it affects the well-being of its stakeholders- customers, investors, employees, communities and the environment within which it operates. It is the justifiable ethical standard for which all of an organization’s operational activities are measured (Davidson, P. & Griffin, R, 2005). Achieving financial success in a manner that honours ethical values and respect people, communities, and the local environment is what defines CSR.

An effective CSR program is one that is not mainly based on philanthropy or “goodwill” but rather on creating productive relationships with stakeholders who represent various social, financial and environmental concerns.

Lehman Brothers adopted the hand of management approach to CSR in which it strongly believes in the advancement of its corporate economic interests as well as the protection and enhancement of the quality of life of its stakeholders. The conscience and practise of an organization’s management is often a subject of frequent debate globally. Is it compulsory that an organisation must protect and improve the welfare of its specific and remote stakeholders? Well, the scope of this report is not to argue in favour of or against this motion but to analyse where Lehman got it wrong as regards to CSR.

Lehman engaged in several philanthropic (socially responsive) activities all over the world where they had their businesses. Lehman’s CSR spanned through the economic and legal levels terminating at the ethical level. Lehman used its philanthropy to avoid legal actions both from the government and its stakeholders while making sure its activities stayed within the ambit of the law. It engaged in philanthropy (in a socially responsive way) in my opinion because it did what it did just to create more global awareness (Public Relations for financial gains) (economic CSR) as well as to fulfil the general expectations society members place on corporations (ethical CSR). See Bibliography (URL link) for comprehensive details of their charity works.

Corporate Social Responsibility goes beyond just philanthropy. CSR means accountability towards a firm’s various stakeholders e.g.: shareholders, employees, customers, local and international communities, etc. Unfortunately, Lehman and Bear Stearns produced no CSR report of any s