Why did Lehman Brothers collapse and how significant the impact was?

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Introduction

The world had witnessed two of the most important events in 2008; one was the fierce

presidential competition to the White House, and the other was the collapse of one of the most admired

firms – Lehman Brothers. The aftermath of this fallout was extremely significant to the financial world

that it has become a debated topic for many years after. Ben Bernanke – the chair of the Federal Reserve

(Fed) – once called it “the worst financial crisis in the history” (Chu, 2018). This report aims to explain

the full picture behind the collapse of Lehman Brothers. Also, it demonstrates some facts about its impact

on global scale and provides lessons for financial institutions to learn from one of the biggest corporate

failures in the history.

Overview of Lehman Brothers

Lehman Brothers (NYSE: LEH) was establish in 1850 by three brothers Henry, Emanuel and

Mayer Brother who were all immigrants from Germany. Lehman was originally a general stored evolving

to a commodities brokerage and later becoming the fourth largest investment bank at that time behind

Morgan Stanley, Goldman Sachs and Merrill Lynch. The firm was considered a persistent stronghold for

surviving numerous crises spanning global history such as two world wars, the Great Depression and

Long Term Capital Management collapse (HBS Baker Library).

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After being spun off from American Express in 1994 as an independent firm, Lehman Brothers

had constantly expanded its presence in advanced economies such as Europe, Asia and Australia, and

increasingly invested in investment banking, stock and bond trading, market research, investment

management and private banking (HBS Baker Library). Lehman also focused heavily in subprime

mortgages and derivatives in early the early 2000s.

The cause of collapse of Lehman Brothers bank

The temblor so-called Lehman Brothers went into history of financial world because this titan is

their own victim to blame for. High risk in real-estate sector in the context of a fierce credit crisis is the

main cause leading to the collapse of the 158-year-old financial empire Lehman Brothers. This historic

downfall can be explained by several following reasons:

1. Risky real-estate market:

In the 2000s, Adriene and Jacob (2015) documents that investors in the US and abroad, who were

looking for a low risk and high return, started throwing their money into the US housing market;

believing to earn greater returns from the interest rates homeowners paid on mortgages. Instead of

investing in an individual’s mortgage, global investors bought investments called mortgage-backed

securities (MBS), which bundles thousands of single mortgages (Adriene and Jacob, 2015). MBSs along

with other kind of securities are bundled into Collateralized Debt Obligation (CDO), and together they are

sold to financial institutions like pension funds, mutual funds and investment banks. Lehman, like other

investment banks, had used the mortgage securitization to turn real estate loans into risky mortgage-

backed securities packages for the market. At the same time, rating agencies like Standard and Poor’s and

Moody’s gave these investments AAA ratings to attract more influx of money from investors. In order to

increase leverage on its capital, Lehman made a bold decision on its aggressive strategy by taking on

greater risks. As a subprime residential mortgage business, Lehman was doubling down in MBS with

their counter-cyclical strategy by loosening their standards and granting loans to low-incomed people

with poor ratings so as to gain greater profit; as a result, they significantly exceeded their own internal

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risk limits and controls (Valukas, 2010). With the lax lending requirements and low interest rates, it

brought a number of investors to join the ride; pushing the US price of homes to increase significantly

and out of control (Andriene and Jacob, 2015).

The real estate bubble began to burst when people defaulted the mortgages because they could

not afford the incredibly expensive homes; resulting in a large number of houses were put back on the

market for sale. Unfortunately, the supplied units outnumbered the demand on the market, and this caused

home prices to fell. Andriene and Jacob (2015) said the fall in price exacerbated the situation when some

borrowers had mortgages bigger than the house’s real value, so they stopped paying; pushing the prices

down further. As the market for MBSs were collapsing, it left Lehman with worthless assets. Excessive

investments in subprime mortgages and leveraged loans had put Lehman in a mountain of debt and led it

faced the likelihood of bankruptcy.

Source: HBS Baker Library

2. Internal issues

2.1 Disagreement on opinions

One of the main reasons began from the internal conflict of the executive team. Although being

warned by Mike Gelband, the head of fixed income at Lehman who foresaw the upcoming danger of the

credit crunch, the CEO and other executive committees completely disregarded his recommendations and

insisted with the aggressive strategy as they wanted more risks and earned big profit for their fortune.

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They even threatened to dismiss Mike from his position. Possessing many brilliant talents but being led

by a couple of blindly greedy leaders, Lehman once was described as “lions led by donkeys” (McDonald

& Robinson, 2009, p.121). This act had led to a regretful departure of one of the greatest minds at

Lehman and later led to the demise of the firm as Mike predicted at the beginning.

2.2 The misrepresentation in accounting

Acknowledging the rating agencies particularly focused on net leverage, Lehman had to report

favorable numbers to preserve their ratings and investor confidence. Valukas (2010, p.4) revealed that

Lehman used accounting gimmick to create a misleading picture for their current financial condition; in

fact, they leveraged the Repo 105 transactions to temporarily remove $50 billions of its assets from

financial position before each fiscal reporting period. The purpose of Repo 105 is to treat asset selling as

sales rather than financings so as to decrease net leverage ratio. By doing that, they succeeded in

maintaining attractive ratings and bringing more investors for the firm. Despite being aware of this illegal

practice, Lehman’s auditor - Ernst & Young (EY) - took no investigation to review their balance sheet.

Consequently, EY was accused of facilitating accounting fraud and helping Lehman deceive the public

(Valukas, 2010).

2.3 The lack of determination and delays in making critical decisions

It is the way of resolving the unwise and assertive crisis of the Lehman’s boards that had pushed

Lehman into a corner. Lehman's problem was not new and had been warned for a long time. As

mentioned in his autobiography “ What It Takes”, Schwarzman (2019) – the CEO of Blackstone and

former employee at Lehman - and his real estate team identified a large block of bad mortgages that

Lehman was holding and unable to sell before the crisis. He offered $10 billion to take a small part of the

outstanding assets and sell them over time. However, contrary to his expectation, Lehman’s CEO turned

down the offer as “he preferred to stagger on than to take the hit to his equity” (Schwarzman, 2019,

p.250). After the fall of Bear Stearns, all eyes were on Lehman Brothers; questioning it would be the next

victim. Only until this time did Dick Fuld start to seek buyers as Lehman was deepened in mortgage

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crisis. Having been involved with Lehman for nearly four decades and been a driver of the firm through a

financial crisis in 1998, he had a strong and sentimental attachment to the firm, and it was difficult for

him to accept how little Lehman was worth. Negotiations with the Korea Development Bank, Barclays

and Bank of America could have ended but Lehman was unable to do so due to price disagreement; as a

result, Lehman’s stock had plummeted over 90 percent since 2007, and they declared bankruptcy on

September 15, 2008 (HBS Baker Library).

3. External issues

Besides the above reasons, there are other external factors leading to the demise of Lehman

3.1 US Government

Federal Reserve (Fed) at that time could have poured billions of dollars to save Lehman as they

did with Bear Stearns by providing $29 billions of assistance to JP Morgan to acquire them, but they did

not do the same for Lehman Brothers. Decision makers from Fed and Treasury determined that rescuing

Lehman was illegal, and “…they were unwilling to break the law” (Ball, 2018). The Treasury secretary -

Henry Paulson - and his colleagues pointed out that unlike Bear Stearns and AIG, Lehman did not have

sufficient collateral to cover the bail out, so they refused to extend additional credit for the investment

bank. According to Ball (2018), however, there were some observers believed that Lehman’s fate was

decided by the insiders’ opinions of political and economic consequences of the rescue. One deciding

factor coming from the intense criticism that Paulson would have to endured from helping Lehman, and

he feared to face backlash from politicians and the media as Fed once experienced in saving Bear Stearns.

Additionally, the event happened near the US presidential campaign which made it even more sensitive.

The use of taxpayer money to rescue financial corporations was in a heat debate, and the government was

put in a tough decision-making position among alternative options. At the peak of the crisis, AIG was

chosen to receive assistance as it had the market cap four times as big as Lehman’s, and Antoncic - the

former CRO of Lehman Brothers (as cited in The Wharton School’s note, 2018) - stressed that “…it is the

interconnectedness” that matters for the government’s decision. She further analyzed that the collapse of

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AIG would trigger a greater domino effect globally as opposed to Lehman’s since it possessed billions of

dollars worth of protections across the US and Europe. Therefore, the best choice of the government was

to force the private sector to save Lehman; otherwise, Lehman had to sacrifice.

3.2 The fierceness of the market

In addition to the following reasons, Lehman’s death was partly due to the market’s panic.

Lehman was a victim of the aggressive short selling from hedge funds who effectively bet the stock

would go down sharply in value (Bower, 2015). Bower (2015) also comments that the Collateralized Debt

Obligations which Lehman had built made it highly vulnerable, and that complex product was believed to

be a crucial contributor to the debt bubble. Although short selling is a legal practice, it was the cause of

false rumors to lower the value of Lehman’s stocks. This caused the market to lose confidence in Lehman

and put the firm in disadvantage.

The aftermath of Lehman’s collapse

The fallout of Lehman Brothers triggered a ripple effect that leaded to a recession not only in the

US but on a global scale. This event had made a number of big names fell into a crisis spiral, not just

Lehman. Morgan Stanley, Merrill Lynch, UBS to name a few all suffered heavy losses with total of

hundreds of billions of dollars, and the number of employees laid off at these firms reached thousands;

causing unemployment rate soared globally. Stock markets also faced the free fall due to the crash.

Figure 1. Source: Federal Reserve Bank of San Francisco

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A research conducted by Federal Reserve Bank of San Francisco, as in figure 1, illustrates the

difference between the actual and the hypothetical estimates of EBP and GDP during 2007-2008 financial

crisis; showing that the behavior of EBP and DPD would be materially different without the financial

shocks. The authors of the research also note that the crisis lowered output by approximately 7% points;

representing (in dollar terms) a lifetime income loss of about $70,000 per Americans.

In his article, Chu (2018) assesses that the consequences caused international trade to fall at a

faster rate than it did during the Great Depression; making the global economic recovery in several

Western nations extremely week over the following decades by historical standards. According to an

estimate of the chief economist at Bank of England - Andy Haldane (as cited in Chu, 2018), the total cost

of the crisis in forgone economic growth was astronomical; piling up between $60 trillion to $80 trillion.

Moreover, oil and gas sector were also heavily affected from this financial crash. In fact, oil prices dived

from its peak at $147 in 2008 to the low of $33 in 2009; liquid natural gas prices dropped from $14 to $4

due to diminishing demand (Investopia, 2020). Amid the financial chaos, government stepped in to ease

the lenders from panicking and enacted a $700-billion program so-called Troubled Assets Relief Program

(TARP) to shore up the banks. Specifically, Fed lent roughly $250 billion to support AIG, auto makers

and homeowners with the effort to stabilize the financial system (Swagel, 2009, p.5-6). Such a massive

bail out along with billions of dollars government spending to rescue real-estate firms and banks imposed

a huge burden on the budget of the government in the future.

It is not surprising that the public found themselves skeptical of the economy after Lehman’s

catastrophe as they placed so much trust into the investment banks. Although not the scope of this report,

the crash is believed to be the main motivator for the creation of a decentralized digital money, which

later is well-known as Bitcoin. This new form of money is said to function as an alternative to state

money and is built upon the idea of trust among peers.

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The meaning of “too big to fail”

The term “too big to fail” means certain businesses, such as banks who own trillions worth of

assets, are extremely important for a nation that failing is not an option for them (Onaran, 2017). The term

was introduced in the daily lexicon after the financial incident in 2008. In his article “Too big to fail”,

Onaran (2017) states that failure of the powerhouse like these financial institutions could lead to a

financial turmoil on global scale since they are so interconnected, and only massive bailouts from

government could save the titans from failing.

Lessons learned for financial institutions and the rest of the world

This is the biggest bankruptcy in American history, and its aftermath is truly remarkable. It had

panicked the banking sector, threatened the world financial order; followed by major efforts from the

governments of countries around the world to suppress the crisis. There are some key lessons that the

world can learn from:

- When a financial crisis arrives, an intervention by the government is paramount as they can keep

the financial crisis from spreading into an economic disaster like the Great Depression. Without

credit aid, the economy will suffocate despite any responses from the policy; therefore, Fed must

ensure to have considerable liquidity to solve the problem in an orderly way (Blinder & Zandi,

2015). Blinder and Zandi (2015) also believe that the ability to provide emergency loans from

Fed should not be limited under Federal Reserve Act. Although bailing out billions of dollars to

cure the recession is expensive and chaotic, it is believed to be an effective way to maintain

balance of the market.

- Creditors should reduce their expectations to receive bailout from the governments in unfavorable

circumstances; if not to say, they should be heavily penalized for their cause of actions to

minimize moral hazard (Blinder & Zandi, 2015). The term “moral hazard” is used to refer to

financial institutions when they are too dependent on the bail out to take incentive to make risky

bets. Such strict rules must be imposed to restrict banks from crossing the lines in the future.

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Additionally, transparency in communication with the public should be considered a crucial part

of the bailout operation, and policymakers are encouraged to expend efforts to make it less

politically biased (Blindly & Zandi, 2015).

- After the financial recession, regulators repeatedly emphasized the importance of internal

communication whose effectiveness lies on a two-way contact between senior management and

subordinates. The voice of the top managers and boards will be ineffective if there is no

engagement of staffs in pockets of organizations (Karp, 2018). Moreover, opinions should be

equally weighted before making final decisions, and the interests must be towards the common

goal, not the individual’s. It is recommended that boards should consider establishing dedicated

ethics and culture committees to guide them in forming, following and conserving the firm’s core

values (Karp, 2018).

Conclusion

It has been over ten years since the demise of Lehman Brothers, but the consequences still echo in

financial world and government system. This report captures both inside and outside factors that caused

the crash in the 2007-2008 recession, as well as depicts the chain reactions from the real estate bubble;

resulting in thousands of job losses and a deficit of billion dollars worth of national outputs. This

recession revealed several loopholes in financial system; thereby it helped policymakers and management

teams to reflect their mistakes. Through lessons provided above in this report, they can help both

government and financial firms to avoid the problem of too big to fail and cope with future crises.

References

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