A Fall from Lieu: Lehman Brothers
In February 2007, with a stock price of $86 a share, Lehman Brothers had a market capitalization of over $60 billion. The annual net profit for the corporation was above $4 billion, setting a new record. As of the beginning of 2008, Lehman Brothers ranked as the fourth biggest investment bank in the United States.
Lehman Brothers shares plunged by over half in March after the near-collapse of Bear Stearns, the second-largest holder of mortgage-backed securities. The corporation posted its first quarterly loss since being split off from American Express in 1994, a total of $2.8 billion in June. Lehman Brothers Holdings Inc., the biggest corporate bankruptcy filing in U.S. history (with $619 billion in debt), disappeared from investment banking by year's end of 2008.
Lehman Brothers' Early Years
The origins of Lehman Brothers may be traced back to the nineteenth century, namely, to 1844. A German immigrant named Henry Lehman founded the organisation in Montgomery, Alabama. Henry's brothers, Mayer and Emanuel, joined him in 1850 to form Lehman Brothers from their dry goods and general shop. In the 1850s, Lehman became a significant player in the cotton market and expanded into other commodities trading.
When it teamed with Goldman Sachs on an initial public offering in 1906, the business transitioned from commodities dealing to investment banking. Lehman underwrote approximately a hundred new stock offerings between 1906 and 1926, including those of household names like F.W. Woolworth, Studebaker, and Macy's.
Lehman Brothers' past reflects the evolution of investment banking in the American economy. The corporation persisted and even prospered despite terrible national disruptions like the Civil War, World Wars, the stock market collapse of 1929, and the subsequent Great Depression. The original firm started as a commodities brokerage but has since undergone several transformations to become one of the world's biggest investment banks.
The 1990s' Success
It was stated that Shearson/American Express paid $360 million to purchase Lehman Brothers in 1984. From 1984 to 1994, American Express was the sole owner of Lehman Brothers. At that time, the firm was "spun off" via an IPO that brought in over $3 billion. Lehman Brothers were allowed to grow rapidly after the repeal of the Glass-Steagall Act, which prohibited banks from engaging in investment and commercial banking activity simultaneously.
Despite the tragedy of September 11, 2001, Lehman Brothers recovered and regained its position as a market leader in investment banking. To the point that it was the fourth biggest investment bank in the United States in 2007, Lehman Brothers saw tremendous growth. Massive investments in mortgage-backed securities were crucial to its expansion and financial success (MBS). The company's demise may be traced back to its investments, which is ironic in retrospect.
How does Bankruptcy Affect You Now?
The failure of Lehman Brothers signalled the start of the 2008 financial crisis and subsequent recession. Because the millennial generation was just starting in their careers, they were particularly hard hit. Millennials were the hardest hit by rising unemployment rates, which rose from 9.9% in May 2007 to a record 19.5% in April 2010. Unemployment was 8.8% between the ages of 25 and 54 and 7.0% between 55 and older. Even though millennial unemployment had fallen to 8.9% by December 2017, the damage had already been done.
The reasons for Lehman's Failure
Lehman brothers' debt and bankruptcy had below mentioned major causes:
Risk: The bank had taken on too much risk without the ability to raise capital quickly. Technically, its $639 billion in assets exceeded its $613 billion in debt in 2008. However, selling the assets proved difficult. Lehman Brothers were unable to sell them to raise sufficient funds. It went bankrupt because of a cash flow problem.
Culture: Management encouraged taking unnecessary risks. According to Lehman's chief risk officer, upper management ignored many of her risk-management strategies. Top executives believed their company was too sophisticated to fail and wanted to stay ahead of competitors who used similar high-risk strategies.
Regulator's Inaction: The Securities and Exchange Commission and other authorities did nothing. Even though the SEC was aware that Lehman Brothers was taking on too much risk as early as 2007, it never demanded that Lehman take any action. 5 Furthermore, it did not openly notify rating agencies that the bank had exceeded its permitted level of risk.
Case Study
What were the consequences of the Lehman brothers' debt and bankruptcy? Streamline the timeline.
The failure of Lehman Brothers shook the financial markets. The Dow Jones Industrial Average fell 504.48 points, the most in seven years, to its lowest level in seven years. Losses continued until the Dow closed at 6,594.44 on March 5, 2009. It had fallen 53% since its peak of 14,164.53 on October 10, 2007. Investors flocked to the relative safety of US Treasury bonds, driving up prices.
Investors knew that the financial institutions that owned Lehman's bonds were in jeopardy due to the company's bankruptcy. On September 16, 2008, the Reserve Primary money market fund "broke the buck." This meant that its shares, normally worth at least $1, were worth $0.97. Investors lost faith in the money market fund after it disclosed losses of $785 million in Lehman's commercial paper.
On September 17, 2008, the collapse began to spread. Investors withdrew a record $196 billion from money market accounts. If the run had continued, businesses would have been unable to obtain funding for ongoing operations. Within a few weeks, the economy would have collapsed. Shippers, for example, would not have had the funds to deliver food to supermarkets.
On September 18, 2008, Paulson and Bernanke met with congressional leaders to warn them that a credit market crisis was only a few days away. The Treasury Department would be able to buy stock in troubled banks due to its $700 billion bailout request. This was the quickest way to defrost the frozen financial system by injecting capital.
On September 29, 2008, Congress rejected the proposal. As a result, the Dow fell 777.68 points, the most in a single day until 2018.
Relevant case details
The following are relevant facts (assumptions are labelled) about the case:
Repurchase Agreements were a standard method of financing for Lehman Brothers.
Leverage ratios rise when a financial firm uses repurchase agreements because they are a liability.
In some circumstances, buyback agreements may be removed from a company's balance sheet thanks to a loophole in financial accounting rules.
During reporting periods, Lehman Brothers would (legally) remove loans related to buyback agreements from its balance sheet to deceive investors by lowering leverage (assumption).
Lehman Brothers' buyback agreement tricks were a secret from investors. The company's stock price at Lehman Brothers may have been affected if investors had known (assumption).
This dishonest method was not used by any other banks (assumption).
Conclusion
The failure of Lehman Brothers played a significant role in the chain reaction of other financial disasters that eventually led to the 2008 Global Financial Crisis. Many in the industry are still perplexed as to why the American federal government did not save Lehman, as it did so many other banks, but instead allowed it to fail. One common argument is that Lehman's debt is simply too large for its assets to even begin to repay.
FAQs on Lessons from Lehman Brothers' Collapse
1. What was the main reason for the collapse of Lehman Brothers in 2008?
The primary reason for the collapse of Lehman Brothers was its deep involvement in the subprime mortgage market. The firm had accumulated vast amounts of risky mortgage-backed securities. When the U.S. housing market bubble burst, these assets lost significant value. This was worsened by extreme leverage, meaning the company had borrowed huge sums of money to finance its investments. When its assets became toxic, it couldn't cover its debts, leading to the largest bankruptcy filing in U.S. history on September 15, 2008.
2. What was the business of Lehman Brothers before its collapse?
Before its collapse, Lehman Brothers was a major global financial services firm with a history spanning over 150 years. Its primary business activities included:
- Investment Banking: Advising companies on mergers, acquisitions, and raising capital.
- Asset Management: Managing investments for individuals and institutions.
- Fixed-Income and Equity Trading: Buying and selling stocks, bonds, and other securities.
- Real Estate: Heavy investment and origination of commercial and residential mortgages, which ultimately led to its downfall.
3. How did the collapse of Lehman Brothers impact the global economy?
The collapse of Lehman Brothers triggered a massive shockwave across the global financial system, demonstrating the concept of systemic risk. Its failure caused a complete loss of confidence in the banking sector, leading to a severe credit crunch where banks stopped lending to each other. This resulted in a global stock market crash, the failure of other major institutions, and pushed the world into the Great Recession, the most severe economic downturn since the Great Depression.
4. What happened to Lehman Brothers' assets and stock after the company declared bankruptcy?
After declaring bankruptcy, Lehman Brothers' stock, which once traded at over $86 per share, became virtually worthless. The company was not sold as a single entity but was broken apart. Barclays purchased its North American investment banking and trading operations, including its New York headquarters. Nomura Holdings of Japan acquired its businesses in Asia and Europe. This dismantling marked the end of the financial giant.
5. What are the key lessons for students of Economics from the Lehman Brothers collapse?
The Lehman Brothers collapse offers several critical lessons in economics and finance:
- The Danger of Excessive Leverage: Borrowing too much amplifies both gains and losses, creating immense vulnerability.
- Understanding Systemic Risk: The failure of one large, interconnected firm can bring down the entire financial system.
- Importance of Regulation: It highlighted the need for stronger government oversight of financial institutions to prevent them from taking on too much risk.
- The Problem of Moral Hazard: The event sparked a global debate on whether to bail out failing companies and risk encouraging future recklessness.
6. Can you explain the Lehman Brothers crisis in simple terms?
Imagine a person who borrows a huge amount of money to buy houses, not to live in, but to sell for a quick profit. For a while, house prices go up, and they seem very rich. But then, house prices crash. Suddenly, the houses are worth less than the loans taken to buy them. The person can't pay back their debts and goes bankrupt. Lehman Brothers was like that person, but on a massive scale with complex financial products tied to housing loans. Its collapse caused everyone who had lent it money to panic, leading to a freeze in the entire global financial system.
7. Why was Lehman Brothers not bailed out by the U.S. government, unlike other banks?
The decision to let Lehman Brothers fail was a pivotal moment and was driven by several factors. Firstly, there was a strong concern about moral hazard—the fear that bailing out Lehman would send a message to other banks that they could take huge risks without consequence, as the government would always save them. Secondly, U.S. policymakers, particularly Treasury Secretary Henry Paulson, were politically hesitant to use more taxpayer money for bailouts. Finally, they misjudged the sheer scale of the interconnectedness of Lehman with the global financial system and underestimated the catastrophic domino effect its failure would cause.
8. How did corporate governance failures contribute to the fall of Lehman Brothers?
Poor corporate governance was a key internal factor in Lehman's collapse. The firm's leadership fostered an aggressive, risk-taking culture that prioritised short-term profits over long-term stability. Executive compensation was tied to these profits, incentivising managers to ignore the underlying risks of their investments in subprime mortgages. The Board of Directors failed in its duty to provide effective oversight and challenge the high-risk strategies being pursued by the CEO and top management, ultimately leading the firm to disaster.
9. What does the term 'too big to fail' mean, and was Lehman Brothers considered one?
The term 'too big to fail' describes a financial institution that is so large and deeply integrated into the economy that its failure would cause a catastrophic economic crisis. The assumption is that the government would have no choice but to bail it out to prevent this. Before its collapse, Lehman Brothers was widely considered to be 'too big to fail'. That is why the U.S. government's decision to let it go bankrupt was such a profound shock to global markets. It shattered the assumption that all major banks were protected, triggering widespread panic.
10. What is 'moral hazard' and how does it relate to the Lehman Brothers case?
Moral hazard is an economic concept where a party has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. In the context of the 2008 financial crisis, many large banks operated with an implicit belief that they were 'too big to fail' and would be bailed out by the government if they got into trouble. This belief created a moral hazard, encouraging firms like Lehman Brothers to take on excessive leverage and invest in high-risk assets. The government's decision to let Lehman fail was a direct, albeit chaotic, attempt to counter this very moral hazard.
