Question
Lehman Brothers Case Lehman Brothersfiled for bankruptcy on September 15, 2008.Hundreds of employees, mostly dressed in business suits, left the bank's offices one by one
Lehman Brothers Case
Lehman Brothersfiled for bankruptcy on September 15, 2008.Hundreds of employees, mostly dressed in business suits, left the bank's offices one by one with boxes in their hands. It was a somber reminder that nothing is forevereven in the richness of the financial and investment world.
At the time of its collapse, Lehman was the fourth-largest investment bank in the United States with 25,000 employees worldwide. It had $639 billion in assets and $613 billion in liabilities. The bank became a symbol of the excesses of the 2007-08 financial crisis engulfed by thesubprime meltdownthat swept through financial markets and cost an estimated $10 trillion in lost economic output.1
In this article, we examine the events that led to the collapse Lehman Brothers.
KEY TAKEAWAYS
- Lehman Brothers had humble beginnings as a dry-goods store, but eventually branched off into commodities trading and brokerage services.
- The firm survived many challenges but was eventually brought down by the collapse of the subprime mortgage market.
- Lehman first got into mortgage-backed securities in the early 2000s before acquiring five mortgage lenders.
- The firm posted multiple, consecutive losses and its share price dropped.
- Lehman filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt.
Lehman Brothers History
Lehman Brothers had humble origins, tracing its roots to a general store founded by German brothers Henry, Emanuel and Mayer Lehman in Montgomery, Alabama, in 1844. Farmers paid for their goods with cotton, which led the company into the cotton trade. After Henry died, the other Lehman brothers expanded the scope of the business into commoditiestrading and brokerage services.
The firm prospered over the following decades as the U.S. economy grew into an international powerhouse. But Lehman face plenty of challenges over the years. The company survived the railroad bankruptcies of the 1800s, theGreat Depression, two world wars, a capital shortage when it was spun off by American Express (AXP) in 1994 in an initial public offering, and theLong Term Capital Managementcollapse and Russian debt defaultof 1998.
Despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman to its knees, as its headlong rush into thesubprime mortgagemarket proved to be a disastrous step.
The Prime Culprit
The company, along with many other financial firms, branched intomortgage-backed securitiesandcollateral debt obligations. In 2003 and 2004, with the U.S. housing bubblewell under way, Lehman acquired five mortgage lenders along with BNC Mortgage and Aurora Loan Services, which specialized inAlt-Aloans. These loans were made to borrowers without full documentation.
At first, Lehman's acquisitions seemed prescient. Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006. The firm securitized $146 billion of mortgages in 2006a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, it announced $4.2 billion innet incomeon $19.3 billion in revenue.4
The Colossal Miscalculation
In February 2007, Lehman's stock price reached a record $86.18 per share, giving it amarket capitalizationof nearly $60 billion.But by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent. Defaults on subprime mortgages began to rise to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. Following the earnings report, Lehman said the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings.6
The Beginning of the End
Lehman's stock fell sharply as thecredit crisiserupted in August 2007 with the failure of twoBear Stearnshedge funds. During that month, the company eliminated 1,200 mortgage-related jobs and shut down its BNC unit. It also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market.
In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, or four times itsshareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporaryrebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.
Hurling Toward Failure
In 2007, Lehman's high degree ofleveragewas 31, while its large mortgage securities portfolio made it highly susceptible to the deteriorating market conditions. On March 17, 2008, due to concerns that Lehman would be the next Wall Street firm to fail following Bear Stearns' near collapse, its shares plummeted nearly 48%.
By April, after an issue ofpreferred stockwhich was convertible into Lehman shares at a 32% premium to its concurrent priceyielded $4 billion, confidence in the firm returned somewhat.However, the stock resumed its decline ashedge fund managersbegan to question thevaluationof Lehman's mortgage portfolio.
On June 7, 2008, Lehman announced a second-quarter loss of $2.8 billion, its first loss since it was spun off by American Express, and reported that it raised another $6 billion from investors by June 12.According to David P. Belmont, "The firm also said it boosted itsliquiditypool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25.
Too Little, Too Late
These measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questionedCEORichard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning offcommercial real estateassets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold.
The devastating news led to a 45% drop in Lehman's stock, along with the firm's debt suffering a 66% increase incredit-default swaps. Hedge fund clients began abandoning the company, with short-termcreditorsfollowing suit. Lehman's fragile financial position was best emphasized by the pitiful results of its September 10 fiscal third-quarter report.
Facing a $3.9 billion loss, which included a $5.6 billionwrite-down, the firm announced an extensive strategic corporate restructuring effort. Moody's Investor Service also announced that it was reviewing Lehman'scredit ratings, and it found that the only way for Lehman to avoid a ratingdowngradewould be to sell a majority stake to a strategic partner. By September 11, the stock had suffered another massive plunge (42%) due to these developments.7
With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Over the weekend of September 13, Lehman, Barclays, and Bank of America made a last-ditch effort to facilitate atakeoverof the former, but they were ultimately unsuccessful.On Monday, September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from itsprevious closeon September 12.
Lehman stock plunged 93% between the close of trading on September 12, 2008, and the day it declared bankruptcy.
Where are They Now?
Former chairman and CEO Richard Fuld runs Matrix Private Capital Group, which he founded in 2016. The company manages assets for high-net worth individuals, family offices and institutions.9He reportedly sold an apartment in New York City for $25.9 million as well as a collection of drawings for $13.5 million.
In years following the collapse, Fuld acknowledged the mistakes the bank made though he remained critical of the government for mandating that Lehman Brothers file for bankruptcy whilebailing outothers. In 2010, he told the Financial Crisis Inquiry Commission the bank had adequate capital reserves and a solid business at the time of its bankruptcy.
Erin Callan (now Erin Montella) becamechief financial officerat the age of 41 and resigned in June 2008 following suspicions she had leaked information to the press.Her LinkedIN profile lists her as an advisor at Matrix Investment Holdings. Other stints include six months serving as head ofhedge fundcoverage for Credit Suisse and co-founding a non-profit that provides paid maternity leave to mothers.In 2016, Montella published an autobiography,Full Circle: A Memoir of Leaning in Too Far and the Journey Back, about her experiences in the financial world.
The Bottom Line
Lehman's collapse roiled global financial markets for weeks, given its size and status in the U.S. and globally. At its peak, Lehman had abottom lineof nearly $46 billion, which was wiped out in the months leading up to its bankruptcy.
Many questioned the decision to allow Lehman to fail, compared with the government's tacit support for Bear Stearns, which was acquired by JPMorgan Chase in March 2008. Bank of America had been in talks to buy Lehman but backed away after the government refused to help with Lehman's most troubled assets. Instead,Bank of America announced it would buy Merrill Lynchon the same day Lehman filed for bankruptcy.
Please find the questions for the attached case. Please submit them in the drop box for evaluation.
Q-1 Explain the reasons of downfall of the company. 5 marks
Q-2 What would your suggestions be for Lehman Brothers to avoid the collapse of their business. 5 marks
Q-3 Summarize the case as per your understanding in 150 words. 5 marks
All the best!
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