Introduction
Too big to fail, is a prime case of Lehman Brothers Bankruptcy. In February of 2007, the fourth largest investment bank in the U.S, Lehman Brother, was selling at $86 per share with a total market capitalization of nearly $60 billion. With more than $4 billion in net income, it was soaring to higher highs. However, in March of the same year, its share price fell by almost 50%. And in June, reported a quarterly loss of $2.8 billion. Then on 15th September, 2008, Lehman Brothers, the fourth-largest investment bank in the United States filed for Chapter-11 bankruptcy. Within no time, the incorporation vanished from the investment banking landscape.
During the time of collapse, the company had more than 25,000 employees working for it together with $639 billion in total assets and $613 billion in obligations as liabilities. Still today and the years to come, The Fall of Lehman Brothers would remain as an exemplary case reminding us that nothing lasts forever however, the impact of too big to fail is severe and long lasting.
History of Lehman Brothers
The foundation of the company dates back to a long time ago in the 1840s when Henry Lehman and his brother Mayer established the firm. Initially, the company started to sell local groceries, mainly in exchange for cotton that farmers produced. This led the company and the brothers into the cotton trade business. The favorable market condition then led the company towards many avenues in the journey of finally making it the largest investment bank in the history of the U.S. After the demise of Henry, the other brothers ventured out the scope of their businesses into commodities trading and brokerage services based on their expertise of trade.
The company then entered into the New York Exchange market and started underwriting most significant initial public offerings (IPOs) in the early 1900s as an investment bank. In this journey, it partnered with Goldman and Sachs in the 1900s, started selling bonds on behalf of the US government, entered the financial markets to raise funds for business and started taking lead in underwriting business paving its way to become the largest investment bank.
The company prospered over the following decades as the economy of the country grew simultaneously. However, it faced abundant challenges before it collapsed in 2008. The company’s strong foundation survived the railroad bankruptcy of the 1800s, the Great Depression, the two world wars, capital shortage when it was stripped away by the American Express and several other challenges. However, the company went on its knees when the U.S. housing bubble collapsed in the series of events that led to the 2008 financial crisis.
Causes of Lehman’s Failure
There are several reasons for the failure of the company and its subsequent bankruptcy in 2008. These reasons range from the financials to non-financials. Some of the reasons include the unsurmountable risk that the company had taken against the assets it held, the culture of the organization, the inactive regulation and the interrelated system of the U.S.
Fannie Mae and Freddie Mac
The excessive involvement in mortgage back securities associated with the housing bubble burst was the main reason for company’s failure. The housing prices were relatively stable during the 1990s which however began to rise towards the end of the decade. The increase and decrease in the houses prices were consequences of the regulations that lowered the mortgage lending standards.
In the 1990s, the federal government set up two government sponsored enterprises known as Fannie Mae and Freddie Mac. The function of these two enterprises was to operate in the secondary market and purchase the mortgages originated by the banks and other lenders. As a government backed enterprise, they could borrow funds at 50 to 70 basis points cheaper than the other lenders. In addition, the regulation imposed by the Department of Housing and Urban Development in the mid-1990s forced these two enterprises to extend more loans to low- and moderate-income households.
In addition, the Housing and Urban Development also mandated the two enterprises to extend 40% of their new loans to borrowers with income below the median in 1996. This mandate was further increased to 50% in 2000 and 56% in 2008. Because of such government regulation the two-enterprise had to accept more unsecured subprime loans. And since Freddie and Fannie were government backed entities, mortgage originators such as Lehman Brothers and several others were willing to make subprime and other risk loans as they could be passed on to the government and recover in cases of discrepancy. This resulted in the deterioration of lending standards. Lehman had underwritten more such mortgage-backed securities than any other firm which amounted to a total of $85 billion. The equivalent amount was four times more than its shareholder’s equity and thus impacted the company when the bubble burst.
Debt and illiquid Investment proportion
Similarly, evaluating a few of the other causes minutely, we can see that the bank was engulfed with too much risk. Given such risk, the ability of it to pay them as they became due was deteriorating on a timely basis. It had $613 million in debt against $639 million in assets. Surfacially, the equivalent amount of assets is more than the amount of debt, right? However, the quality of its assets was highly illiquid. Illiquid here means that the company could not sell off its assets readily in the market whenever it wanted.
In addition, the increasing amount of debt in any company increases its risk of financial distress as the claim of debt holders increases against the claim of the shareholders and the company itself. When the company is unable to meet the interest installment payment, the debt holders can file for bankruptcy. And when the company was unable to meet the financial obligation alongside not being able to raise funds after selling assets, it led to its downfall through bankruptcy.
Accounting Manipulation and Window Dressing
Alongside, involvement in several accounting manipulation and corporate governance issues was another reason. Several studies claim that the company was involved in window dressing the financial statements. The window dressing was done to manipulate to show a positive view to the shareholders and potential investors a lucrative financial position. It manipulated about $50 billion in its financial statements in 2008 which was not acceptable by the laws.
One of the examples of its manipulation includes the transactions of repos. It is legal for banks and financial institutions (BFIs) to engage in Repos and Reverse Repos to maintain the liquidity in the market. However, it should be done only after considering its benefits to the organization and its stakeholders in a transparent manner. But Lehman tried to play around with the legal framework. It acquired government bonds from other banks involving its specialized units established in the U.S. But the settlement of the bond was, however , then transferred to the company’s affiliate company in London known as Lehman Brothers International. Since this was not acceptable, it therefore signifies the actions of the company in committing fraud.
High Leverage
Another important factor was its leverage position. Leverage means the amount of debt you have for every amount of equity in your company. Lehman adopted a strategy to borrow debt unnecessarily with an attempt to leverage its assets. In 2007, its degree of leverage was 31. Although this may not seem significant, its largest mortgage portfolio made it highly prone to the market condition prevailing then. A year later on March 17, 2008, due to the same concern of high leverage, it was predicted to see a similar fate as that of Bear Stearns collapse.
This speculation and investor pessimism led its shares to fall by nearly 48%. Investor confidence declined even more as hedge fund managers started questioning the valuation of Lehman’s mortgage portfolio with increasing inflation and interest rate on the other hand. The company adopted a series of strategies such as boosting liquidity to $45 billion, decreasing its unwanted assets by $147 billion, and reducing its exposure to highly risky mortgage-backed securities by 20%. This helped the company reduce its leverage to 25 from 32.
The Aftermath
The adopted measures did not serve well as it was already too late for them to work. Due to continuous downfall in performance, its stock fell 77% in the first week of September in 2008. The hope of relief for Lehman Brothers was a South Korean bank who was trying to invest in Lehman’s stock. However, the bank ladder stepped back which led Lehman’s stock to fall by an additional 45%. Now, the debt holders started filing suit against the company for their payment. The company was already facing a loss of $3.9 billion by now. It then announced a corporate restructuring strategy. However this did not work out because the company rating firm, Moody’s, was reviewing its credit rating given its increasing default chances. This news further depleted the stock price with a plunge of 42%.
Now the company was not in the state of resurrection. It only had $1 billion in cash. Finally on 12th September, 2008, it declared bankruptcy. Upon its declaration, the company’s stock price plunged by 93% against its previous day closing price. Even the Fed could not rescue the company by extending further loans because the company did not have adequate collateral to support the loan extended under the Fed’s emergency lending power. And Lehman’s default was the key moment that aggravated the crisis in 2008. Its collapse triggered all of the financial ripple down both in the U.S. as well as around the world.
Impact of Lehman’s Collapse
The collapse of Lehman brought a significant ripple effect in the financial sector of the U.S. as well as around the world. Its collapse on stock market returns had a devastating impact on major stock indexes. In addition, it has a huge number of employees who are working for it around the world. After its failure, more than 25,000 employees lost their jobs. In addition, their investment into the company as employee stock options was a major loss for them. The fall of company’ stock price also shattered their bright future.
Lehman’s downfall also had a substantial impact on its creditors or investors who had trusted the bank with their resources and were left empty handed upon its failure. Its integration in the financial system was so interrelated that more than 75 bankruptcy proceedings were recorded following the bankruptcy of the company. Its collapse was significant in bringing more robust risk management practices and regulations in the financial markets. Although the impact of government regulation, mainly the Housing and Urban Development department with mandatory service of loans at lower rate and the impact of Freddie and Fannie, was a major contributor. The bankruptcy of the company gave introduction to BASEL III which focuses on making financial institutions more resilient to financial distress.
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