The Bank that Failed the World

Arghya Sarkar, 10012311

Introduction

On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and

$619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far

surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the

fourth-largest U.S. investment bank at the time of its collapse. Lehman's demise also made it

the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through

global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified

the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization

from global equity markets in October 2008, the biggest monthly decline on record at the time.

Building an Empire

In 1850, Henry, Emanuel and Mayer Lehman, Bavarian immigrants to Alabama, began

bartering for cotton as payment from customers at their store, and within a few years these

original Lehman Brothers were full-blown commodities traders. Subsequent generations of

Lehman would take the firm into investment banking, backing America's great retail

enterprises, from Woolworth's to Macy's, and then funding the first television manufacturers

and broadcasters in the Thirties.

It operated at a wholesale level, dealing with governments, companies and other financial

institutions, employing 25,000 people worldwide, including 5,000 in the UK. Its core business

included buying and selling shares and fixed income assets, trading and research, investment

banking, investment management and private equity.

Capitalising on Market Trend

The Prime Culprit

In 2003 and 2004, with the U.S. housing bubble well under way, Lehman acquired five

mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which

specialized in Alt-A loans (made to borrowers without full documentation). Lehman's

acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses

enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of

growth than other businesses in investment banking or asset management. The firm securitized

$146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits

every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion

on revenue of $19.3 billion.

Lehman's Colossal Miscalculation

In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization

of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing

market were already becoming apparent as defaults on subprime mortgages rose 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. In the post-earnings conference call, Lehman's

chief financial officer (CFO) said that the risks posed by rising home delinquencies were well

contained and would have little impact on the firm's earnings. He also said that he did not

foresee problems in the subprime market spreading to the rest of the housing market or

hurting the U.S. economy.

Sub-Prime Mortgage Crisis Explained

Following the tech bubble and the events of September 11, the Federal Reserve stimulated a

struggling economy by cutting interest rates to historically low levels. As a result, a housing

bull market was created. People with poor credit got in on the action when mortgage lenders

created non-traditional mortgages: interest-only loans, payment-option ARMs and mortgages

with extended amortization periods. Eventually, interest rates climbed back up and many

subprime borrowers defaulted when their mortgages were reset at much higher monthly

payments. This left mortgage lenders with property that was worth less than the loan value due

to a weakening housing market. Defaults increased; the problem snowballed, and several

lenders went bankrupt.

Investors and hedge funds also suffered because lenders sold mortgages they originated into

the secondary market. Here the mortgages were bundled together and sold to investors as

collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). When

the higher risk underlying mortgages started to default, investors were left with properties that

were quickly losing value. In the wake of the meltdown, central banks released liquidity into

the market place, which allowed struggling lenders and hedge funds to continue operations and

make the necessary payments on their obligations.

Exposure to the mortgage market

Lehman borrowed significant amounts to fund its investing in the years leading to its

bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this

investing was in housing-related assets, making it vulnerable to a downturn in that market. One

measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners’

equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating

tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in

the value of its assets would entirely eliminate its book value of equity. Investment banks such

as Lehman were not subject to the same regulations applied to depository banks to restrict their

risk-taking.

The Beginning of the End

As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds,

Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-

related jobs and shut down its BNC unit. In addition, 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 its shareholders' 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

temporary rebound. 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.

Lehman's final months

In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200

positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction

in goodwill. The firm said that poor market conditions in the mortgage space “necessitated a

substantial reduction in its resources and capacity in the subprime space”.

In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis.

Lehman's loss was apparently a result of having held on to large positions in subprime and

other lower-rated mortgage tranches when securitizing the underlying mortgages. Whether

Lehman did this because it was simply unable to sell the lower-rated bonds, or made a

conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated

mortgage-backed securities throughout 2008. In the second fiscal quarter, Lehman reported

losses of $2.8 billion and decided to raise $6 billion in additional capital. In the first half of

2008 alone, Lehman stock lost 73% of its value as the credit market continued to tighten. In

August 2008, Lehman reported that it intended to release 6% of its work force, 1,500 people,

just ahead of its third-quarter-reporting deadline in September.

On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the

state-controlled Korea Development Bank was considering buying Lehman. Most of those

gains were quickly eroded as news emerged that Korea Development Bank was “facing

difficulties pleasing regulators and attracting partners for the deal.” It culminated on September

9, 2008, when Lehman's shares plunged 45% to $7.79, after it was reported that the state-run

South Korean firm had put talks on hold.

Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed

the S&P 500 down 3.4% on September 9, 2008. The Dow Jones lost nearly 300 points the same

day on investors' concerns about the security of the bank. The U.S. government did not

announce any plans to assist with any possible financial crisis that emerged at Lehman.

On September 10, 2008, Lehman announced a loss of $3.9 billion and their intent to sell off a

majority stake in their investment-management business, which included Neuberger Berman.

The stock slid 7% that day.

On September 13, 2008, Timothy F. Geithner, then president of the Federal Reserve Bank of

New York called a meeting on the future of Lehman, which included the possibility of an

emergency liquidation of its assets. Lehman reported that it had been in talks with Bank of

America and Barclays for the company's possible sale. The New York Times reported on

September 14, 2008, that Barclays had ended its bid to purchase all or part of Lehman and a

deal to rescue the bank from liquidation collapsed. It emerged subsequently that a deal had

been vetoed by the Bank of England and the UK's Financial Services Authority. Leaders of

major Wall Street banks continued to meet late that day to prevent the bank's rapid failure.

Bank of America's rumoured involvement also appeared to end as federal regulators resisted

its request for government involvement in Lehman's sale.

Allowing Lehman Fail

Lehman Brothers was the fourth-largest investment bank in the United States. It was considered

one of Wall Street's biggest dealers in fixed-interest trading and was heavily invested in

securities linked to the US sub-prime mortgage market. With these investments now shunned

as high risk, analysts say it was inevitable that confidence in Lehman Brothers would likely be

hit - particularly after the collapse of Bear Stearns earlier this year.

In its June to August period in 2007, the bank said it would make write downs of $700m as it

adjusted the value of its investments in residential mortgages and commercial property. One

year on this figure soared to $7.8bn, which in the last week before crash resulted in Lehman

reporting the largest net loss in its history. The bank also admitted that it still had $54bn of

exposure to hard-to-value mortgage-backed securities. As a result, Lehman saw its share price

plummet more than 95%. Despite having access to cash reserves, worried investors pummelled

the firm's shares in the eventful last week after talks to raise billions of dollars from outside

investors ran into a brick wall.

This significant improvement sealed the bank’s fate. But still, nobody expected it to spin so

much wayward. People expected the US Federal reserve to intervene, chairman Hank Paulson

to devise some strategic plan to get Lehman out of this misery. When none of this panned out,

people went into shock.

"It's unconscionable what they did – or more accurately what they didn't do," says Joseph Stiglitz,

Nobel prize-winning economist and professor at Columbia University. "They didn't do their homework. People were talking about the failure of Lehman Brothers from the moment of the

failure of Bear Stearns in March, or before, and they didn't do a thing. If they knew there was systemic risk, why didn't they do anything about it?"

Paulson had been pushing Lehman to find a solution to its problems, to sell itself or to raise

cash. He had not been preparing a government-sponsored contingency plan. There was none.

That weekend, everyone was flying blind.

When Bear Stearns ran into trouble, the US Treasury made the terms favourable for JP Morgan

Chase to buy it. And just in the previous week, the US government effectively nationalised

Fannie Mae and Freddie Mac, which between them own or guarantee about half of the $12

trillion US mortgage market. So already the US tax payer has been put at risk of shouldering

the burden of billions of dollars of losses, and it is becoming politically less acceptable for the

government to keep bailing out private companies. Plus also the moral hazard problem comes

into the fore. If govt. keeps bailing out failing companies, what prevents others from taking

extra risks to maximize revenue? The govt. had to draw a line somewhere, send a message to

the financial institutions and they chose Lehman Brothers.

By not giving UK bank Barclays a guarantee for Lehman's trading obligations as part of a deal

to buy the business, analysts say the US Treasury had put a line under its willingness to use

public money to rescue banks which have made wrong decisions. Instead, government officials

have focused on supporting the financial system in other ways, announcing measures to ease

access to emergency credit for struggling financial companies.

Dire Consequences Globally

Nobody had a Lehman Brothers cheque book or current account. The company was an

investment bank that specialises in big and complex deals and investments. Despite this,

Lehman's collapse and the troubles of other financial institutions was felt by millions of people

around the world - at least indirectly.

Most of our banks and pension funds had dealings with Lehman, or with firms like hedge funds

that traded extensively with Lehman. Unwinding Lehman's complex deals took months if not

years. During that time the global financial system was snarled up. Many banks dint even know

for sure how much they are exposed to Lehman, and went through extreme difficulty freeing

up the money in those deals.

This in turn intensified the credit crunch, with dire consequences for businesses and consumers.

And the dramatic collapse of Lehman Brothers had also shaken the financial markets, with

share prices slumping around the world.

--- Other Financial Institutions

Merrill Lynch was “THE” topic of discussion when it emerged that Lehman would go

bankrupt. US authorities and many bankers feared that after Lehman's demise the attention of

investors and speculators would have moved to Merrill. They were also in a similar position

like Lehman and in the time of disaster, moved fast to secure their own future. Taking

advantage of the fact that US treasury did not issue any guarantee for Lehman’s assets, Merrill

CEO John Thain thrashed out a deal with the anticipated buyer of Lehman, namely Bank of

America. The bank hopes to find safety under the roof of this banking giant. Bank of America

also wanted to spread their domain to investment banking and was more than happy to

capitalize on the deal.

The biggest worry, though, was insurance giant AIG. The company was running out of cash to

cover its losses and had asked the government for an emergency bridging loan, reportedly to

the tune of $40bn. AIG’s trouble would directly affect millions of consumers and companies

around the world. It would also hurt the whole financial system, because AIG is in the centre

of a web of complex financial deals. And compared with AIG, the crisis surrounding Lehman

is small beer. Keeping this bitter truths in mind, and in retrospect of Lehman Brothers’ fall,

Federal Reserve ultimately rolled out $85bn to save AIG.

What Now? – Principal Lessons Learned

1 – Bank executives lie…they also got paid huge amounts, weren’t as smart as they thought they were

and those that ended up at the top tended to be deeply flawed individuals…

On Sept 10 in a conference call with investors, days before Lehman collapsed, Dick Fuld

clearly stated to his shareholders that “no new capital was needed” and that “real estate and

investments were properly valued”. Yet only five days later, Lehman filed for bankruptcy.

At a congressional Committee just a few weeks later, he was defiant. He stood by his “no new

capital was needed” statement: “no sir, we did not mislead investors”. And he added that “we

(made) disclosures that we believed were accurate”. If no new capital was needed why did

Lehman go bust five days later? And if he didn’t know the financial position of Lehman what

was he doing as CEO?

As part of the Congressional Committee hearings, Dick Fuld was allowed to make a

presentation before he was questioned. These are his exact words as to the cause of Lehman’s

demise:

“Naked short sellers targeted financial institutions and spread rumours and false information. The impact

of this market manipulation became self-fulfilling as short sellers drove down the stock prices of financial

firms. The ratings agencies lowered their ratings because lower stock prices made it harder to raise capital

and (it) reduced financial flexibility. The downgrades in turn caused lenders and counter parties to reduce

credit lines and then demand more collateral which increased liquidity pressures. At Lehman Bros the

crisis in confidence that permeated the markets lead to an extraordinary run on the bank. In the end

despite all of our efforts we were overwhelmed.”

There are two facts about this statement that should be intensely scrutinised. Firstly the

downfall of Lehman, according to him, is due to the naked short sellers spreading false rumour

and misinformation. It is not that it was too highly leveraged, too risky and that he had missed

the speculative property bubble completely. And secondly Lehman was “hoisted with its own

petard” – it was injured by the device (short selling) that it had used frequently and very

profitably to injure others. Investment banks have made fortunes from shorting financial

instruments – bonds of indebted governments, shares of troubled companies etc. But then short

selling was used against the very financial firms that had so championed and defended its use.

A delicious irony.

Despite Fuld’s best attempts to obscure his compensation, the Congressional Committee

calculated he was paid at least $480mn in the period from 2000 to when Lehman went bust in

2008. Even for the credit boom times, he was getting massive sums. Such high levels of

compensation reinforced his sense of his own financial genius and infallibility. And that

explains why he found the demise of Lehman so difficult – it challenged his view of his own

brilliance. It’s also why he blames others and not his own shortcomings. Some of his statements

defy belief and confirm he was living in a different reality. He stated that “(past) decisions were

both prudent and appropriate”. That is an extraordinary level of arrogance and conceit for a

man presiding over the largest bankruptcy in America’s corporate history.

2 – Regulatory capture is not a theoretical concept…

The Nobel Prize winning economist George Stigler first came up with the term. It describes a

regulator that is supposed to act in the public’s interest but ends up acting in ways that benefit

the industry that it is supposed to be controlling. Or in laymen’s terms, these regulators are

“captured” by their industries – the gamekeeper turns to poaching if you want to say.

In retrospect just the lack of limits to leverage and the low capital requirements created a

disaster waiting to happen. And that is without all the slicing and dicing allowed, credit rating

agency failures etc. Financial firms had so much money and power, they persuaded politicians

and regulators to leave them alone. Such regulatory capture is not unusual but in the financial

industry it caused global devastation.

Weak regulation was highly beneficial to the banks short term but it has come at great economic

cost to the countries those banks are supposed to serve. Also the failure of weak regulation of

the past now ensures much stricter regulation in the future. Short term view, the banks and

executives benefitted but in the long term the operating environment will be a lot tougher.

3 – Allowing Lehman fail was the wrong decision…

Was Hank Paulson’s decision to let Lehman go bust justified? It’s difficult to comment upon,

but the devastation in the credit markets was truly terrible and Mr Paulson had no idea it would

be that bad. However he acted firmly against creating moral hazard – if bank executives know

the government will always bail them out, then they will take massive risks. Tails I win, heads

you lose, is not a great way for the banking and financial industries to be run.

However what needs to be done now is to create a way for banks to fail without destroying the

system. And the new concept of a bank’s “living will” attempts to do so. Regulators are trying

to make banks safer for the future, restricting “too big to fail” and splitting investment and

traditional banking apart.

However any criticism of Paulson has to be tempered by the remembrance of the environment

– September 2008 was a crazy time. Just one week before the collapse of Lehman, Freddie

Mac and Fannie Mae were effectively nationalised and bailed out by the state. On 16th

September, the day after Lehman’s bankruptcy, the Federal Reserve had to lend $85bn to AIG.

To try and understand what was happening and the implications of it was extremely difficult

at the time. But overall, the decision has not yielded good results and intensified the credit

crunch and subsequent global recession.

4 – We never learn the lessons of the past…

In 1931, the Austrian bank Creditanstalt – the oldest and largest in the country – went bust

because it used short term borrowings to fund long term loans. It faced a liquidity crisis when

foreigners stopped lending to it. At the same time Lazards was the first British bank to fall after

a “rogue trader” made a large and unauthorised bet which went wrong. The failure of banks in

the current crisis is remarkably similar. The funding and liquidity crisis at RBS and JPMorgan’s

$6bn whale like loss mirror the situations above. And these are not the only parallels. History

gives us hundreds of examples of the same behaviour repeated time and time again in the

financial industry. It is a deeply depressing thought that the human race (or at least the part of

it that works in banking) cannot learn any lessons from history.

Asset price bubbles, credit booms, banking collapses. It’s all been seen so many times before.

And so why were we not better prepared? And despite all the current regulatory reform to

ensure this never happens again, I’ve got to bet that it will.

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