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How did Lehman Brothers fall?
On Monday, 15 September 2008, financial markets around the world convulsed in sheer panic.
In New York, the Dow Jones Industrial Index suffered one of its biggest-ever falls, falling 504 points (down 4.4%) in a single session. On this side of the Atlantic, the FTSE 100 index tumbled almost a tenth (9.9%) in the four days to 18 September. While stock markets plunged, the cost of credit soared, with credit spreads blowing out to record levels. This was no ordinary financial crisis.
WHAT CAUSED THIS MARKET MAYHEM?
The answer is the bankruptcy of a company, but this was no ordinary bankruptcy and no ordinary company. On Sunday, 14 September, leading US investment bank Lehman Brothers — having failed to be rescued by a buyer or a government bailout — went under.
The bankruptcy of Lehman rocked the financial system to its core, not least because it was the biggest corporate bankruptcy in US history. With over $600 billion in assets to administer, Lehman’s bankruptcy was many times more complex thanin 2001. Also, as a leading investment bank, Lehman was deeply plumbed into the global financial system, thanks to a spider web of companies, contacts and contracts around the world.
WHY DID LEHMAN FAIL?
Some blame chief executive Dick ‘the Gorilla’ Fuld for his overconfidence and failure to recognise that Lehman faced a momentous crisis. Arguably, Fuld’s battle to salvage something for Lehman’s suffering shareholders eventually cost them every cent.
Some commentators blame Bank of America for ending takeover talks with Lehman in favour of buying its larger rival Merrill Lynch for $50 billion the following day. Other pundits blame Barclays for refusing to buy Lehman without US government backing, in the form of emergency funding. However, one needs to look at the financial history of the firm just before it went under.
Lehman Brothers Holdings from 2000–2008
Under the direction of Dick Fuld, Lehman expanded its portfolio of services to include the more risky and complex financial products that were being developed during the 2000′s in the wake of deregulation of the financial industry, including, in particular, the 1999 repeal of the Glass-Steagall Act that had prohibited affiliations between commercial banks and investment banks and their activities.
The following is the market capitalization value of Lehman Brothers Holdings Inc 1994–2008 (in $bn)
Lehman aggressively pursued opportunities in proprietary trading (trading with its own money to make a profit for itself rather than for its clients), derivatives, securitization, asset management, and real estate. In 2000, proprietary trading comprised 14% of the firm’s total revenues. By 2006, that figure had increased to 21%. The change in business composition was accompanied by significant growth in revenues and an increase in market capitalization (see Figure 1). From 2000 to 2006, the firm’s revenue growth of 130% outpaced that of its rivals, Goldman Sachs and Morgan Stanley. During Fuld’s tenure, the firm’s revenues grew 600%, from $2.7 billion in 1994 to $19.2 billion in 2006. Equity markets recognized this performance by bidding up the firm’s stock price such that its market capitalization appreciated by some 340% over the same period. Again, this significantly outpaced its rivals’ growth.
In March 2006, despite rumblings that the housing market had peaked, Lehman Brothers adopted a new business strategy aimed at capitalizing on its significant experience with real estate. (Another reason may have been that the firm had previously been successful in pursuing a counter-cyclical strategy in the 1980s.) Prior to 2006, Lehman would acquire assets primarily to “move” them to third parties through securitization, but with its new strategy, as it sought greater market share and prof its, it acquired assets to “store” them as its own investments, retaining the risk and returns of those investments on its books in hopes of greater profits. The targeted growth areas were its proprietary businesses—commercial real estate, leveraged loans (loans to highly leveraged, or speculative-grade, firms that usually offered higher returns in exchange for increased credit and liquidity risk) and private equity—businesses that put more capital at risk, especially if an investment turned sour, and which were more ill liquid than Lehman’s traditional lines of business.The firm aggressively bought real-estate-related assets throughout 2006, and by mid-2007, Lehman held significant positions in commercial real estate. This made it difficult for it to raise cash, hedge risks,and sell assets to reduce leverage in its balance sheet, all critical to its health in a difficult financial environment.Even though the U.S. housing prices began to decline in mid-2006, Lehman continued to originate subprime mortgages and increase its real estate holdings as other parties exited the market. In August 2007, Lehman announced that it would close BNC Mortgage, its main subprime origination platform and its Korean mortgage business. It also suspended its wholesale and correspondent lending activities at its Aurora Loan Services subsidiary. Yet, in October 2007, it acquired the Archstone Real Estate Investment Trust, the largest residential REIT in the U.S., amid concerns from rating agencies and investors that it was overpaying for the deal. At the end of its 2007 fiscal year, Lehman Brothers held $111 billion in commercial or residential real estate-related assets and securities, more than double the $52 billion that it held at the end of 2006, and more than four times its equity. Increasingly, rating agencies and investors expressed concerns regarding these types of assets due to the ill liquidity of the market for them and to the substantial losses that other firms experienced in these categories. The constant revaluation by Lehman Brothers of these types of assets would contribute to significant write-offs throughout 2008.
The Reasons for Lehman Brothers’ Collapse:
During the good times, the best way to enhance your returns is to ‘gear up’ by borrowing money to invest in assets which are rising in value. This enables you to ‘leverage’ (magnify) your returns, which is particularly useful when interest rates are low. However, leverage cuts both ways, as it also magnifies your losses when asset prices fall. (Witness the recent return of negative equity to the UK property market.)
A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every £1 of cash and other readily available capital, it would lend £12. In 2004, Lehman’s leverage was running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in 2007.
Thus, Lehman was leveraged 44 to 1 when asset prices began heading south. Think of it this way: it’s a bit like someone on a wage of £10,000 buying a house using a £440,000 mortgage. If property prices started to slide, or interest rates moved up, then this borrower would be doomed. Thanks to its sky-high leverage, Lehman was in a similar pickle.
Beginning in mid-2007, real estate markets began to show signs of weakening. Lehman and other investment banks came under greater scrutiny regarding the value of their real-estate-related-assets and their liquidity. Rating agencies and analysts began demanding that the investment banks reduce their leverage. To reduce leverage, firms have two choices—to increase equity or to sell assets. While Lehman did raise $6 billion in additional capital in early 2008, it preferred to sell assets.But this strategy proved challenging for Lehman. In January 2008, Fuld instituted a deleveraging strategy to reduce Lehman’s real estate positions, but Lehman was unsuccessful at selling such assets at acceptable prices, given the slowing of the market. Also, Lehman was reluctant to sell such assets at discounted prices. Not only would it risk taking losses on the sold assets, but to do so would call into question the value of its remaining assets of similar type and compel it to mark them to market value, potentially recognizing losses.
Most businesses fail not because of lack of profits but because of cash-flow problems. Like all banks, Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a massive asset base (and equally impressive liabilities), Lehman didn’t have enough in the way of liquidity. In other words, it lacked ready cash and other easily sold assets.
Lehman’s long-term assets were being funded by short-term debt (e.g., repo agreements and commercial paper) and Lehman borrowed billions of dollars each day in the overnight wholesale funding markets in order to operate. By early 2008, other institutions were less likely to accept Lehman securities as collateral(or, alternatively, demanded more collateral for a given level of financing, thereby eroding Lehman’s ability to continue to carry out its short-term obligations). Following the near collapse of Bear Stearns in March 2008, precipitated by a liquidity crisis, rumors circulated that Lehman would be the next bank to go under. As Lehman’s perceived financial position worsened, it faced a higher cost of credit. Some lenders withdrew from the firm, refusing to roll over its repos, others demanded bigger haircuts (discounts), and still others refused to accept all but a narrow type of collateral, refusing Lehman’s real-estate-related assets and rendering them even more ineffective.For example, between June and August 2008, Lehman delivered an additional $9.7 billion to J.P.Morgan Chase to support its securities clearing and tri-party services (wherein it acted as agent for Lehman’s repo transactions). Also, uncomfortable with the collateralized debt obligations (CDOs) that Lehman delivered, J.P. Morgan requested additional collateral, but would only accept cash.Other lenders made similar demands, severely restricting Lehman’s access to funding. Before its failure,$200 billion of Lehman’s assets were funded with secured overnight loans, largely repos, 80% of which came from 10 institutions. Hesitation or stricter standards by a small number of lenders could (and did)cause significant funding problems for the firm.
After the terrorist attacks of 11 September 2001, US interest rates plummeted, causing a five-year boom in domestic and commercial property prices. This boom ended in 2006 and US housing prices have since fallen for three years in a row.
Lehman was heavily exposed to the US real-estate market, having been the largest underwriter of property loans in 2007. By the end of that year, Lehman had over $60 billion invested in commercial real estate (CRE) and was very big in subprime mortgages (loans to risky homebuyers). Also, it had huge exposure to innovative yet arcane investments such as collateralised debt obligations (CDO) and credit default swaps (CDS).
As property prices crashed and repossessions and arrears sky-rocketed, Lehman was caught in a perfect storm. In its third-quarter results, Lehman announced a $2.5 billion write-down due to its exposure to commercial real estate. Lehman’s total announced losses in 2008 came to $6.5 billion, but there was far more ‘toxic waste’ waiting to be unearthed.
Lehman’s operations were subject to supervision by a number of governmental and industry organizations, including its primary regulator, the SEC, the Chicago Mercantile Exchange (CME), which regulated certain derivatives, the Office of Thrift Supervision, which supervised Lehman’s thrift subsidiary, and the New York Federal Reserve Bank (NYFED). After it filed for bankruptcy, many questions were raised about the efficacy of these agencies’ oversight. Despite reviewing daily reports regarding Lehman’s leverage and liquidity, neither agency took any preventive or corrective action pursuant to its authority. In the aftermath of Lehman’s bankruptcy filing, Anton Valukas, the bankruptcy examiner, criticized the agencies for not taking a more active role in preventing the firm’s failure: “So the agencies were concerned. They gathered information. They monitored. But no agency regulated.” (Valukas Statement, 6). He was particularly critical of the SEC, Lehman’s primary regulator: The SEC knew that Lehman was reporting sums in its reported liquidity pool that the SEC did not believe were in fact liquid; the SEC knew that Lehman was exceeding its risk control limits;and the SEC should have known that Lehman was manipulating its balance sheet to make its leverage appear better than it was. Yet even in the face of actual knowledge of critical shortcomings, and after Bear Stearns’ near collapse in March 2008 following a liquidity crisis, the SEC did not take decisive action.”
Lehman once employed 28,000 people across the world, including 5,000 in London. At their peak, its shares traded at $85, but then they were roughly at 10¢. Lehman’s remains were shared out between Barclays, which bought its US broking arm, and Japanese giant Nomura, which bought its European and Asian assets. These firms, plus number-one investment bank Goldman Sachs, have profited most from picking over the bones of Lehman’s businesses.
In short, Lehman Brothers — a company with a 158-year history, including 14 years as an NYSE-listed giant — failed simply because it took on too much risk in a booming market. In the end, its move from the safety of corporate finance and M&A (mergers and acquisitions) income into the risky world of proprietary trading proved to be its downfall.
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