The collapse of Lehman Brothers in 2008 sent ripples across the financial world. From the small shop in Montgomery Alabama started by Henry Lehman in 1844, that became the Lehman Corporation in 1920, its stocks began trading on the floor of the New York stock exchange in 1994 and posted record revenues in 2007 at which time Richard Fuld was CEO (reuters). On 15th of September 2008, Lehman Brothers the 4th largest investment bank in the United States of America filed for bankruptcy protection (BBC). This precipitated the loss of thousands of jobs on both sides of the Atlantic. According to Mollenkamp, Whitehouse, Hilsenrath and Dugan (2009) some critics look back at the systemic crisis that ensued since the Lehman collapse and conclude that it could have been avoided if the government had stepped in, having already committed billions of taxpayers’ dollars to keep troubled institutions such as Fannie Mae and Freddie Mac in business. However, they are also quick to lay the bulk of the blame squarely at the feet of investment banking giant: “To be sure, Lehman’s downfall was largely of its own making.
The firm bet heavily on investments in overheated real-estate markets, used large amounts of borrowed money to supercharge its returns, then was slower than others’ to recognize its losses and raise capital when its bets went wrong. The depth of the firm’s woes made finding a willing buyer a difficult task, leaving officials with few viable options”. (Mollenkamp et al 2009) Managers must take decisions, that is why they are hired, to make difficult calls over and over again because they have the skills and the audacity required. In the world of high finance it is not uncommon to take bold far reaching decisions. Careers in finance are built on the decisions made at crossroads. Five months later on 19th January 2009 Anton Valukas, chairman of law Chicago Law firm Jenner & Block and a former federal prosecutor was named to lead an independent investigation of the events leading to the Lehman Brothers’ bankruptcy (Scinta 2009). The report, released in March 2010, would cast long shadows over the management actions, individual and institutional involvement and meandering paths that leading to the downfall of the firm. This paper will draw from the bankruptcy report and other important publications to determine how the investment bank failed. In the course of performing its examination, the paper will identify the notable milestones and analyse the events that led to them.
The failure of Lehman Brothers cannot be examined in isolation, the context is the global financial crises, the fertile ground in which the seeds for Lehman’s demise were sown (Zingales 2009). A number of causes have been advanced for the financial crises such as issues with monetary policy ( Ely 2009, Schwartz 2008) lack of transparency (Zingales 2009) a complacent market obsessed with high returns (Zingales 2009) Flawed financial innovations (Schwartz 2008) over promotion of home ownership (Ely 2009). The Lehman collapse however also triggered a shocking meltdown of global finance such was its impact (Hillman 2009) By approximation, the lowest point for the Lehman brothers’ debacle was the announcement by the one and a half century old bank that it would file for bankruptcy protection following its inability to secure government assistance (Shields, Ackerman, Devitt & Sigo 2008). How had it come to this? The starting point could very well have been the firm’s decision to take on a more risky growth strategy. The Lehman Bankruptcy Report notes the sudden growth in the firm’s balance sheet as show in the table 1.
Reported Net Assets 268.936 300.767 337.667 357.102 372.959 396.673 327.774TABLE 1 SOURCE: REPORT OF ANTON VALUKAS EXAMINER VOL I P. 57 The bankruptcy report describes the phenomenal growth in the firm’s balance sheet as follows: “Lehman’s net assets increased by almost 128 billion or 48% in a little over a year from the 4th quarter of 2006 through the first quarter of 2008” (Valukas 2010 p 57 ) The firm had taken on a monumental amount of risk setting itself up for either breakaway success or mega failure .Some questions arise here, such as why did they adopt the riskier investment strategy? Did Lehman executives fully understand the risks accompanying such a strategy? In addition, from corporate governance perspective was everyone at home with the idea. The examiner bankruptcy report shed some light regarding the risk appetite of similar institutions to Lehman Brothers : “Lehman’s business model was not unique; all of the major investment banks that existed at the time followed some variation of a high-risk, high-leverage model that require the confidence of counterparties to sustain” (Valukas 2010 p. 3).
In the sophisticated world of investment banking, the faint of heart rarely find a place to roost. Perception is everything in fact it is reality, once perception shifts reality changes, moreover such financial institutions are known to attract that best people and the most daring from the best business schools. The examiner’s report lends ample support in, mentioning the fact that the investment banking business model puts people under a lot of pressure to take the kinds of risks that led to Lehman’s fall, while government agencies on their part are cited are as having fallen short of their full oversight responsibilities (Valukas 2010) This milestone is the culmination of a series of events or more precisely, the investment decisions taken by Lehman managers to pursue a countercyclical business strategy.
The promise of substantial opportunities in the subprime housing market led to the relaxing Risk controls most notably the single transaction limit, moreover opposition was crowded out and despite obvious warning signs and candid advice from some managers about the leveraged loans and commercial real estate businesses, the firm’s power brokers were figuratively hands over ears. The Lehman brothers’ journey into the abyss can be chronicled thus; the firm makes a strategic decision to pursue aggressive growth by taking on very high risk in addition it would also increase its leverage greatly (Valukas 2010). Shortly afterwards the subprime residential mortgage crises became full blown, decimating the real estate business, at which point the firm failed to demonstrate the agility critical to its survival. Its lethargy was exemplified in its sit still attitude with the hope that things would eventually turn around and their hefty wager would pay off. The bank actively walked the fine line by transcending the boundaries of its own risk control mechanisms thus defeating their purpose. The growth strategy turned out to be a disastrous malignancy causing the firm to lose direction. The collapse of Bear Sterns appeared to many to be a prelude and the collapse of Lehman brothers would most certainly follow. Its managers would thereafter be preoccupied with how to keep the bank from going under.
One of the keys to the gravitation toward this strategy was to the ability of Lehman executives to sell it to its internal audience at the highest level; a case of expert internal salesmanship. The foray into commercial real estate investments, leveraged loans and private equity, the triple foci of the new strategy, was partly the result of meticulously selling the strategy to high-level executives (Valukas 2010 p61). Apparently, most if not all of the top executives at Lehman including CEO Richard Fuld fully understood this strategy; Fuld demonstrated sufficient comprehension or at least had enough information to also give his own presentation (Valukas 2010 p 62). From the corporate governance view, the board apparently gave their blessing to the malignant growth strategy (Valukas 2010, P 76). Furthermore, some directors did not appear overly concerned about omissions from the bank’s stress tests, these omissions being the very same investments in the new aggressive growth strategy. (Valukas 2010, p. 77). Inadequate liquidity can cause very serious problems for investment banks involved in huge transactions such as Lehman. The bankruptcy report the liquidity position of the firm is described as precarious, occasioned by the its astronomical leverage when weighed against its aggressive growth strategy there was inadequate liquidity; moreover the assets in its balance sheet had become noxious, its capital had been depleted and the firm had become more vulnerable. This according Valukas (2010) further highlights the riskiness of Lehman’s growth strategy (p. 62- 63). The noxious assets posed an even bigger problem; it trapped the firm from almost every angle. Considering the issue of raising cash especially in a difficult period; firstly the illiquid assets were poised take beating on sale and secondly they were unsuitable as collateral for borrowing neither was it possible to hedges to protect such mammoth investment (Valukas 2010)
The managers of Lehman failed to monitor its risks in their traditional way, as they explored uncharted investment waters they became more exposed. However the managers were willing to back the new strategy to the fullest extent even if it meant slackening their risk controls. In doing this they fuelled the investment strategy. The report sheds more light to these actions: “Historically, its stress testing had not been designed to encompass the risks posed to the firm by principal investments in real estate and private equity, because those positions previously made up a small portion of Lehman’s portfolio. Lehman did not revise its stress testing to address its evolving business strategy. Because of SEC requirement to conduct regular stress testing on its portfolio to quantify the catastrophic loss it could suffer over a defined period of time. Lehman ran a series of stress tests based on 13 or14 different scenarios. Some of the scenarios were historical events” (Valukas 2010, p. 66) To compound matters, Lehman’s Managers needed its publics to feel confident about the quality of its stress testing, to that effect the report points out that the firm may have actively deceived the public, it remarks: “Lehman’s Managers represented to its external constituents that regular and comprehensive stress tests were performed to evaluate the potential P&L impact on the firm’s portfolio of abnormal yet plausible market conditions” (Valukas ” 2010) The paper earlier pointed out Lehman’s eventual disregard for its own risk management and control infrastructure, these limits or risk measures had kept Lehman centred in its approach to risk . This sophisticated mechanism had to be very intricate and well tuned as result of which so called “risk appetite usage “could be computed for product/ business lines, divisions and for the whole firm, in addition such values could be obtained on a daily basis (Valukas 2010) This paper had earlier pointed out the absence in Lehman’s stress tests of aggressive growth investment in commercial real estate and private equity. In its original form of the stress test only stocks, bonds and other free trading securities were tested. The report explains why the investments in the aggressive growth strategy were excluded: “Because these assets did not trade freely, they were not considered susceptible to stress testing over a short-term scenario. And since Lehman did not then have significant investments in these areas, excluding them from the stress testing did not undermine the usefulness of the results” (Valukas 2010, p. 67)
Lehman Brothers decided to shut down its subprime mortgage unit BNC mortgage in August 2007 exiting a hitherto unprofitable business, it would however continue to focus on Alt- A which were closer to prime mortgages through its Aurora loan services platform standards ( White &Kim 2007). The anticipated turn was yet to arrive and in January 2008, its Aurora’s programme was suspended (Valukas 2010, p.137) According to the Lehman bankruptcy report, the examiner came to the conclusion that under Delaware law, Lehman managers were entitled to pursue their malignant growth strategy as this was in conformity with the business judgement rule. Despite disregarding their risk limits, the examiner concluded that they did not act recklessly. Though these business decisions led to failure did not constitute an outright breach of the duty of care (Valukas 2010, p.178). These investment decisions ultimately failed but they were just that, business decisions, taken in a traditionally risky industry. In taking these actions, the managers wagered and expected to win. Were they unwise? Were they greedy? Did they go into investment overdrive? Or did they make the best decisions they felt possible given the information and time available, neither of which can ever be totally appropriated by anyone. Could timing have played an important role in the outcome of the decisions? The managers made this decisions again with the conviction that they got the timing right. Plainly, they made bad decisions which led to down fall of the firm.
Banks want to show a good net leverage position that is favourable when compared to industry peers. Large Financial institutions use similar instruments to raise funds for short-term financing. Like its competitors Lehman’s rating was of utmost importance to its managers this was also necessary to keep stakeholders’ confidence high be they investors or other parties. The examiner’s report notes that at this point Lehman was at panic stations, nothing would work, and it would then have to announce a $2.8 Billion loss in the 2nd quarter of 2008. The result of high stakes investments gone badly (Valukas 2010). Bad news gets around very quickly and Lehman proceeded to sell the idea it had achieved a significant reduction in its net leverage ratio to less than 12.5. It also claimed to be highly liquid about which it boasted a highly formidable position, while also claiming a reduction in net assets on its balance sheet by $60 billion (Valukas 2010 ). The firm did however mention the extreme difficulties it faced in that quarter even as they persuaded the market of its liquidity (daily telegraph 10 june 2008)
Leman deployed a massive growth strategy which brought the firms risk exposure levels to unprecedented proportions. The housing market went down, leaving Lehman with billions in noxious assets sitting on its balance sheet. It needed to deleverage very quickly. The examiners bankruptcy report offers details as to how the firm hid its true debt levels through the “Repo 105” device, repo is known to mean repurchasing. Lehman Brothers were able to temporality take $50b from its balance sheets at key quarterly reporting dates to improve its finanacial leverage ratio. in doing this, lehman misled investors (what repo 105 really mean) . according to ….. lehman exploited wealnessses in US Statement Of Financail Standards (SFAS 140) accounting for transfers and servicing of finanacial assets and extinguishing of liabilitiesallowing it to book repo 105 and 108 transactions as sal;es rather than finanacing transactions according consequently Lehmans rep 105 transactions remobed securities inventory from oitss balance sheet fro the duration of the repo (a week to ten days) lehman receives cash at the mon ment of the transaction . by using borrowed fund from 105 transactions to reduce shoert tern laibilites lehman reduced oits total assets and by that reduced its leverage ratios. Valukas (2010) finds that the motivae behind conduction big ticket repo 105 transactions very close quarter end in late 2007 and 2008 was to momentarily re move inventories form its balance sheet in order to rep[port lower leverage figures (publiocly dieclosed leverage). According to Valukas (2010 p 762-763) despite konowig that peers were not using devices similar to repo 150 lehman mangers actually oversaw a n escalation in the use of repo 150. The report also notes that bthey were caught betwen a weakedned position unable to risk alerting the narket by raising equirt funds and a potential huge losses should they sell invemntory . (Valukas 2010 763) The examiner determined that the Repo programme had another crucial dimension, one that necessitated lawyers in the UK to affirm the transactions as sales as this was not possible in the US. In doing this it is the conclusion of the xeaminser that civil suits could be brought against lejhman . as theri “sole purpose was balance sheet manaipulation” The way Repo 105 transactions were applied suggest that Lehman were playing fast and loose with theiur balance sheet
Lehaman annomved its filing for bankruptcy protection on the morning of 15th seotember 2008 . how far did the officers go to save the firm and its managers should not allow their company to sink the ought to do every thing in theri power to save it In the light of the above Lehman managers needed to mount the strongest defensive strategies they could to save their dearly beloved investment bank. Helping the institution to survive is a sacred duty. According to Philips (2008 )New york city mayor Michael Bloomberg lamented the cloure of an instoitution that that provided a piece of the American deram. In 20/20 hindsight opinions have varied as to whether Lehman could have indeed been rescued. Macdonald (2009) is quite certain that had cooler heads and some self control prevaiuled the firm might have been rescued but a combination of a CEO who didn’t liasten departure of key brilliant lehman readers and sheer obstinacy cost the firm its last chane to be saved. Despite the intensity of the meetings held that fateful weekend with intention of finding a solution and avoiding the fall it became abundantly clear as the hours slipped by that a deal was not goiung top be reached .Akll attemptes to rescue the bank had failed . Lehman sid in court documents that itsn bankruptcy was brought about by problem sin the global financial markets and worldwide economic conditions (Rozens & Terzo 2008). (Rozens & Terzo( 2008) also point out that judgikng formits its over 100000 creditors $639Bn in assets and $613bn innliabilitires its bankruptcy has enomours implications.
How did an investment bank the size of Lehman brother fail?. it had made several reaching business deciusions thsere is every indication that not every body was on board with thses decisions though through the use of clever presentations and acute selling skills the strategy was sold to the board and otherhigh ranking executives. A radical plunge inro a new statregy menat demphsizing traditionalbusiness line which had kept lehman profitable for fpoutreem stratght yeras.
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