From Hero to Dust

Introduction
Lehman Brothers had humble origins, tracing its roots back to a small general store that
was founded by Henry Lehman in Montgomery, Alabama, in 1844. In 1850, Henry Lehman
and his brothers, Emanuel and Mayer, founded Lehman Brothers. It was headquartered in
New York, London, and Tokyo, operating a network of offices around the world. It had major
presence in equity and fixed income sales, trading, research, investment banking, private
equity and private client services. It served the financial needs of corporations, governments,
municipalities, institutional clients and high-net-worth individuals worldwide.
While the firm prospered over the following decades as the U.S. economy grew into an
international powerhouse, Lehman had to contend with plenty of challenges over the years.
Lehman survived them all the railroad bankruptcies of the 1800s, the Great Depression of
the 1930s, two world wars, a capital shortage when it was spun off by American Express in
1994, and the Long Term Capital Management collapse and Russian debt default of 1998.
However, despite its ability to survive past disasters, the collapse of the U.S. housing market
ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime
mortgage market proved to be a disastrous step.
The 2008 global financial meltdown saw most of the top global financial institutions crumble
into liquidation and bankruptcy. The bankruptcy of Lehman Brothers, a financial institution
that collapsed with assets worth $600 billion in 2008 global financial crisis, was the largest
catastrophe to hit the financial industry in the United States.

Causes for the failure of Lehman Brothers

Economic Reasons:
The Macro and Micro-economic environment in which Lehman Brothers operated
played a vital role in its demise. Indeed, what basically happened to Lehman was typically a
simple economic case of supply outstripping demand.
Market Demand:
After the terrorist attacks of September 11, 2001, the Fed greatly lowered interest
rates in order to stimulate economic growth and prevent deep recession. Expectedly, the
largest Wall Street firms began reacting to this Federal Reserve policy of extremely low rates
at which money was borrowed by purchasing billions of dollars of subprime mortgage
loans. These were most likely bought from nonbank mortgage companies, which borrowed
money from companies like Lehman in order to make loans and quickly resell them to Wall
Street.
Bear Stearns and Lehman Brothers almost monopolised this market as other players
like Merrill Lynch were late arrivals to the highly leveraged/risky subprime lending and
securitizing business. Lehman offered bulk loans to nonbank lenders, also purchasing
mortgage products and then turning them into Asset Backed Securities (ABS), and then
selling these bonds to end investors basically made up of the insurance companies, Hedge
Funds, Pension Funds, Local Governments and foreign banks.
The Securities and Exchange Commission escalated the already worsening economic
situation in 2004 by encouraging these investment banks through the relaxation of the preexisting limits on leverage. Expectedly, the leverage ratios of the five largest independent
investments banks hit the rooftop. Lehman's greedy internal financial policy did not help
matters at all, as it offered potentially dangerous leverage ratios as much as 30:1, asset-toequity ratio. Given this scenario, any 3% drop in value of assets completely blows out the
entire value of equity thus rendering the company bankrupt. Nevertheless, Lehman grew

rapidly, playing a dominant role in the securitisation market and the leveraged lending
businesses posting record earnings quarterly from 2004 to 2007.
Even after the economy had recovered, the U.S Fed notoriously kept interest rates
low which made mortgage payments even cheaper and affordable thus greatly reducing the
likelihood of defaults to barest minimum. Therefore, demand for homes began to escalate,
sending prices up. In addition, millions of homeowners seized the opportunity of rate drops
to refinance their existing mortgages. As the industry became saturated (as virtually
everybody now owned a home), coupled with the never-ending competitive rivalry among
lenders, the quality of the mortgages went down resulting in the erosion of underwriting
standards.
Market Volatility:
For the fear of inflation due to excess liquidity in the markets, Fed started
increasing interest rates which eventually made mortgages already owned, worth less than
the amount for which they were initially purchased due to higher payments. This sent
widespread panic across all stakeholders making them lose confidence and trust in financial
markets leading to mortgage defaults and subsequent foreclosures. With this ugly scenario
playing out, coupled with the Lehman's increasing inability of meeting its debt
obligations, investors lost confidence in its stocks resulting to bankruptcy with about
$613 billion in debt.
Technological:
Advancement in technology played a very "double-edged sword" role at Lehman
Brothers. It brought about drastic reduction in the cost of creating mortgages. The growth of
the internet coupled with easier availability of information made it simpler to find easy and
less costly borrowers, mortgage offerings, thus encouraging it to rely more heavily on
convenient sources of information rather than on the more labour intensive time tested
methods. On the other hand, these innovations created what economists call an "agency
problem". Since the mortgage originator was no longer going to hold the mortgage to
maturity, but rather was going to immediately sell it to a securities firm and collect its fees
upfront, it did not have a strong inclination to conduct a thorough appraisal of the loan,
making it difficult to recover loans.
Liquidity crisis:

Central to the failure of Lehman was their inability to meet short term obligation.
Despite its high asset base, Lehman was experiencing intermittent liquidity problems. As a
result, Lehman was losing its market confidence; apparently, most banks withdrew their
services and credit lines to Lehman Brothers. At this point, the confidence level of lenders and
customers weaned; rendering Lehman unattractive in the eyes of investors and prospective
investors. To address this challenge, Lehman reduced their gross asset base $147 billion to
boost their liquidity position. Their liquidity redemption strategy further saw the reduction
in their commercial mortgage exposure by 20% and leverage from a factor of 32 to
approximately 25. However, Lehmans liquidity crisis was not rescued by their proposed
strategy and bailout.
Collateralized Debt obligation and Derivative crisis:
In their quest to take advantage of opportunities in the real estate market, Lehman
Brothers prior to collapse were reported to have ventured into several risky and
unnecessary investments like, entering into the derivative market. Most of its derivatives
were credit default swaps; evidently, the property prices crashed in the financial market
during the global economic crisis leading to repossession of assets. Collateralized Debt
Obligations (CDOs) also accounted for the losses in the securities market during the global
financial crisis of 2007. Financial analyst argued that the decline in the values of CDOs
significantly contributed to the collapse of Lehman Brothers.
Leveraging:
The high borrowing attitude of Lehman to finance their assets culminated into high
leverage position. As at 2007, Lehmans high leverage ratio has increased from 20 to 1 in
2004 to 44 to 1 shareholders equity. By implication, for every $1 of cash and other available
financial resources, Lehman would lend $44 which was too high a leverage ratio to
maintain. The consequence of the global financial crisis that saw prices sliding coupled with
increased interest rates, Lehmans financial position was adversely impacted leading to their
bankruptcy.

Socio-cultural Reasons:
The health of an organization mostly depends on its employees, stake-holders and
clients. Few reasons contributing to Lehmans failure include:Employees:

Lehman Brothers' corporate culture was one that instilled fear in its employees

as top management hired and fired at the slightest provocations. Never were there any internal
collaboration between the senior management and other members of staff towards the
enhancement of the firm's business through brainstorming and use of feedback reports. While
senior management often rewarded themselves with mind blowing cash bonuses, other
employees were mostly rewarded in "stock" options which are now worthless. This led to lack
of motivation and dissatisfaction among its employees, resulting in the inefficiency in their
operations.
Investors:

The compensation practice at Lehman was clearly not in investors' interest as

evidenced in the way CEO Mr Fuld acted. At a time when his firm was at the brink of
bankruptcy, he kept rewarding himself with bonuses and even approved the disbursement of
$20 million in "special bonuses" to three departing executives. He shielded the true liquidity
situation as well as risk exposure at Lehman from the investing public which depicts lack of
financial accountability and gross social irresponsibility which eventually eroded investor
confidence and trust.
Customers:

With the continuous availability of low interest funds, change in

consumer taste became the norm. An individual who otherwise wouldn't have been able to
afford a house now had access to owning more than one house. This made the public adopt
the culture tending towards investment rather than consumerism which affected other real
sectors of the economy. This change in consumer taste favoured Lehman initially because of

increase in mortgage demands. Soon Lehman had no borrowers for its mortgage products
because everybody now had a house; and with the increase in interest rates, foreclosures
became apparent because the real weak financial status of its borrowers became obvious.

Political/Legal Reasons:
Repeal of the Glass-Steagall Act:
The repeal of the Glass-Steagall Act of 1933 saw many commercial banks merging
with investment banks. Financial analysts blamed this change on the failure of Lehman. In
their quest to compete with commercial banks which has high leverage positions, Lehman
merged and acquired many commercial and investment banks. The unethical merging
activities by Lehman exposed them to several risks leading to their bankruptcy.
Unethical Management practices:
In their quest to achieve their expansion strategy and other specific objectives,
managers of Lehman decided to use a number of dubious mechanisms, unacceptable
accounting practices coupled with their blatant disregard for prudent corporate governance
practices. Lehman employed window dressing presentation facilitating the manipulation
of their financial statement aimed at attracting investments and showing a different picture of
the firm. This was corroborated by the application of charges against their auditors Ernst
&Young by the Attorney General for assisting Lehman Brothers in perpetrating a number of
financial statement fraud. Lehman further used Repos 105 transactions to enhance the firms
financial health at the year end. Lehmans managers blatantly violated the Sarbanes-Oxley
Act which was enacted to strengthen the roles and actions of directors, enhance sound
securities practices. Lehman also violated most of these provisions when they used Repos 105
to misled financial statements. This action was further corroborated by the subpoena of
Lehmans CFO and CEO and other executives for a possible financial penalties and

imprisonment by the US House of Representatives Committee on Oversight and Government

Reforms.
The role of government in Lehmans demise:
Lehman did not have the adequate collateral that Fed requires to provide a guarantee.
It became apparent that Fed wouldnt use the taxpayer money to prevent a Lehman
collapse. As Alvarez, one of the central banks board of governors put Fed could not make
loans that it believed would never be paid, while Baxter, General Counsel of New York Fed
said A Fed loan would have been a bridge to nowhere. Lehman was meant to go bankrupt
considering its excessive leverage, huge losses, liquidity drain, low level of market
confidence, speculative investments, and the accounting gimmicks under Repo 105.

Possible Recommendations
Although it's already too late to rescue Lehman Brothers the following are few
recommendations as regards the global credit crisis:

Clearly, the fall of Lehman Brothers was a preventable man-made disaster. Lehman's
CEO, Mr Richard Fuld enshrined a very poor risk management culture in the
organization by offering highly leveraged Mortgage Backed Securities(MBS). He
should have at least sold the company early enough the way Merrill Lynch's CEO

smartly did.
The collapse would have been prevented supposing management had taken more
proactive risk management actions rather than their reactive measures at a time when

the company was almost down.

Regulatory bodies must tighten financial policies making sure they are monitored for
compliance to prevent unscrupulous banks from issuing highly leveraged mortgage

securities and adopting risky ventures to protect investor's interests.

The Treasury should inject more money into the economy to bail out the ailing banks

and insurance companies in order to avoid total collapse of the system.

I believe the U.S congress can device a framework on how bonuses should be
calculated and disbursed to these chief executives. Bonuses must be earned strictly
based on performance and should tally with sound social responsibility. This way,

credibility could be restored in the capital markets.

Investment firms must adopt and adapt an effective liquidity management/risk
management strategy which often entails a trade-off/balancing act between

profitability and the risk of insolvency. Striking the right balance depends on
management's ability to estimate and manage cash flows. However, written policies
and procedures as well as the establishment of minimum acceptable levels of liquidity

must be in place.
Lehmans inability to cope with operations of its 3000 legal entities worldwide and its
strategy of business expansion and growth resulted in issues with complex capital

structure. This could have been avoided with better capital budgeting decisions.
Transparency and accountability must be embraced by all stakeholders in order to

restore overall confidence.

Organizations must see CSR as a strategic tool for doing business. They must follow
global guidelines in CSR activity and reporting. This goes a long way in building trust.

Conclusion
The timeless creed in management has been that of "doing the right things is better
than doing things right. But the most successful companies excel in both. Lehman was
efficient (doing things right) because it applied the least amount of inputs (leveraged MBSs)
to make the large outputs-profits. The recent competition in the banking industry has led to
most banks engaging in risky exposures. However, this was a very risky venture, hence their
ineffectiveness (not doing the right things). The collapse of Lehman is a clear indication of
this phenomenon.
The failure could be attributed to a multiplicity of factors ranging from dubious
accounting practices, unethical management practices, over investment in risky unsecured
investments, laxity on the part of regulators. External auditors also played a major part in this
failure by not detecting these financial statement malpractices by the Lehman managers. The
main indicators of fraud could be detected in the financial statement apparently and the
external auditors could not discover this activity. It must however be noted that the demise of
Lehman had not impacted the US economy alone but the world as a whole. Hence, firms must
eschew unnecessary business strategies; have stringent supervision of existing regulations,
amending reporting standards to prevent dubious accounting practices, formulate alternative
and practical financial failure prediction models and regulations of the derivative market. The
international business community must ensure that businesses hold high standards and ethical
culture which to a large extent essential in avoiding collapse of firms in the global business
world.

References:
https://en.wikipedia.org/wiki/Lehman_Brothers
https://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers
http://www.investopedia.com/articles/economics/09/lehman-brotherscollapse.asp
http://www.nytimes.com/2008/09/15/business/15lehman.html?
_r=3&hp&oref=slogin&
http://www.cnbc.com//id/39869844
http://dailybail.com/home/inside-the-collapse-of-lehman-brothers-the-realstory-behind.html