A Case Study of the Lehman Brothers Bankruptcy

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Financial Risk MVE220

Work distribution:
2010-11-24
Both the members of the project team have contributed
equally to the case. Even though several parts have Examinator: Holger Rootzén
been written individually, the analyzing and key
concepts have been developed mutually together. Robin Feng 910911-1675
Niklas Fredriksson 900310-1855
 Abstract
Lehman Brothers was the fourth biggest investment bank in
America until it filed for the bankruptcy in September 2008, less
than a year after the bank presented its biggest profit ever. This
report is a part of a reading project about the bankruptcy and aims
to establish an overview of the risks included in Lehman Brothers’
business, how they were neglected and finally led to the downfall.
The authors have examined five different types of risks that
constituted the inherent risk in Lehman Brothers; market risk,
credit risk, liquidity risk, operational risk and reputational risk.
After analysis, the authors can conclude that all of the above
mentioned risks were exceptional high and played a significant role
in what would become the largest bankruptcy in history. Finally,
the authors present a summary of recommendations for more
sustainable risk management in investment banking.

Key words: Lehman Brothers, Investment bank, market risk, credit risk, liquidity risk,
operational risk, reputational risk, Bankruptcy
Table of Content

Introduction ........................................................................................................... 4
Background ........................................................................................................... 4
Risks in Investment Banking................................................................................. 4
From Boom Years to Crisis ................................................................................... 5
The Strategical Failures ......................................................................................... 6
Exceeding the Risk Limits .................................................................................... 7
Summary of Recommendations ............................................................................ 8
References ........................................................................................................... 10
Further reading .................................................................................................... 11
Introduction
When the investment bank Lehman Brothers fell on 15 September, 2008, it was the largest
bankruptcy ever, and it still is. The bank had assets of $639 billion, which is about as much as
the five subsequently largest bankruptcies combined. The size of the bankruptcy could also be
described as more than one and a half time the gross domestic product of Sweden in 2009.
(Investopedia Staff, 2010)
This report aims to establish an overview of the financial risks included in Lehman Brothers’
business, how they were neglected and finally led to their bankruptcy. Furthermore, to analyze
the risks and give a recommendation of a more sustainable risk approach.

Background
The foundation for Lehman Brothers was laid by the German immigrant Henry Lehman and
his brothers in the 1850s. For the first decades the company traded cotton, but in the
beginning of the 20th century it started with banking and securities trading, eventually
becoming an investment bank. Investing and doing business in growing sectors of the 20th
century as well as going global and acquiring other firms, Lehman Brothers expanded and
became one of the world’s largest investment banks. (Historical Resources, 2010)
Modern investment banks like Lehman are complex institutions with advanced and opaque
structures, with daily transactions of several billion of dollars. The main business areas of
Lehman before the collapse was typical investment banking as well as equities, fixed income,
capital markets and investment management. Their investment banking business provided
financial services such as mergers and acquisitions, underwritings and issuing securities. In
the other business lines, the equity part of Lehman invested in equity around the world while
the fixed income, capital markets and investment management parts concerned various
services and wealth management. Their main revenues came from fees derived from the size
of the transactions or services provided. (Lehman Brothers 2007 Annual Report, 2008).

Risks in Investment Banking

Due to the nature of investment banking there will always be a trade of between risk and
potential profit. How prone one is towards risk is essentially a complex strategical decision,
where risk contra profit must be carefully balanced to satisfy all the company’s stakeholders,
both in short and long term. In the beginning of the 21th century the economy was blooming
and as always, the growth seemed to last forever. The stability in the economy motivated a
higher risk taking in order to make bigger profits. Likewise, several investment banks
exposed themselves to extremely high risks and generated record profits annually. Lehman
Brothers, for instance, had a net income of $4.2 billion during 2007, which was an all-time-
high for the bank. However, only one year later Lehman Brothers was forced into bankruptcy
due to failure in managing risks.
Before the bankruptcy, Lehman Brothers’ risk management department had identified five
specific risks inherent in their business. (Lehman Brothers 2007 Annual Report, 2008).
 Market risk represents the potential unfavorable change in the value of a portfolio of
financial instruments due to changes in market rates, prices and volatilities.
Credit risk represents the possibility that a counterparty or obligor will be unable or
unwilling to honor its contractual obligations to Lehman Brothers.
Liquidity risk is the risk that Lehman brothers are unable to meet their payment
obligations, borrow funds in the market at a good price on a regular basis, to fund
actual or proposed commitments or to liquidate assets.
Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people and systems, or from external events.
Reputational risk concerns the risk of losing confidence from the customers, public
and the government due to unfortunate decisions about client selection and the
conduct of their business.
In summary, the market, credit, liquidity, operational and reputational risks constituted the
total risk in Lehman Brothers business (Lehman Brothers Annual Report, 2007). In order for
successful and sustainable investment banking they must be carefully managed and balanced.
On the other hand, if treated with disrespect they could have disastrous consequences and
destroying whole companies.

From Boom Years to Crisis

Investment banking is extremely competitive. Lehman Brothers was the fourth largest
American investment bank and aimed to become the biggest. In order to overtake its rivals,
Lehman Brothers pursuit an annual growth in revenues of 15 %. In support of the revenue
growth they targeted an even faster growth in total capital base, which was projected at 15 %
per year. In order to achieve these expansion goals Lehman’s management made major
changes in its business strategy. They altered from a lower risk brokerage model to a higher
risk, more capital intensive investment banking model. Instead of making money from
transactions, they shifted towards making money on long-term investments. Lehman’s
management primarily focused on expanding three specific areas of principal investment:
commercial real estate (real estate used for generating profit, like offices), leveraged loans
(loans for leverage buyouts) and private equity. (Bankruptcy Report No.08‐13555, 2008)
Lehman Brothers were also heavily involved in different kinds of subprime loans and
mortgages. Subprime loans were loans to people which were considered financially risky, and
were issued without or with little security. Because of the risk in these loans, they had higher
interest rates. Subprime loans had become popular and widespread because of a long period of
low interest rates in the wake of the September 11 attacks and the big housing bubble
followed. There were also government initiatives that encouraged banks to issue loans so that
even financially weak people could buy houses. (Norberg, 2009)
Lehman Brothers, as well as the other leading investment banks, made big profits from
subprime loans as long as credit defaults were at normal rates. The model was to originate
loans and turn them into securities, which means splitting many loans into tiny pieces and
mixing them to even out the credit risk. The securities, called Residential Mortgage Backed
Securities, were sold to investors to make money for the bank. Although the loans were
considered risky, the securities were considered and rated to be almost as safe as state
obligations. This was primarily because the loan takers were considered independent and due
to ever rising real estate prices. (Norberg, 2009, Bankruptcy Report No.08‐13555, 2008)
However, the bubble of cheap loans and skyrocketing real estate prices burst in 2006. When
the interest rate started to climb an increasing number obligors started to default which meant
a significant loss in revenues and a severe increase in liquidity risk. The investors realized that
the securities had more risk than assumed and started to avoid them, while the rating institutes
started to downgrade them. This meant that Lehman Brothers was stuck with unsellable assets
with constantly falling values. Another consequence of climbing interest rates was that the
demand for commercial real estate fell along with the prices. This meant further problems for
Lehman Brothers, as they had to write-down their quite recently acquired commercial real
estate assets. (Bankruptcy Report No.08‐13555, 2008)
As many of the investment banks were facing trouble, the credit market uncertainty grew
which meant increased loan costs on the whole market, a so called credit crunch. This made
their leveraged loans assets difficult to sell. As all of this sums up, Lehman had three business
areas, subprime loans, commercial real estate and leveraged loans, with assets they couldn't
sell, assets with steadily decreasing market-values. (Bankruptcy Report No.08‐13555, 2008)
In the beginning of 2008 Lehman Brothers made a quarterly loss of over $2.5 billion, mostly
concentrated in the mentioned areas (Lehman Brothers First Quarterly Report, Lehman
Brothers Second Quarterly Report 2008). The fact that Lehman Brothers were losing money
combined with their high debts and a balance sheet filled with weak, illiquid assets had
disastrous consequences for the banks reputation. Lenders and other interdependent parties
successively lost confidence in the bank which lead to increasing capital costs and difficulties
in getting short-term funding to maintain liquidity.
Lehman Brothers announced a quarterly loss of $3.9 billion in September 2008 (Lehman
Brothers Second Quarterly Report, 2008). Even though Lehman Brothers had managed to sell
some of their assets during the year in order to decrease risk and get liquidity, the market
didn't believe in Lehman Brothers and the firm became unable to borrow enough money for
their daily operations (Bankruptcy Report No.08‐13555, 2008). It became clear that few
other options than bankruptcy were possible. Lehman negotiated with other banks about a sale
during the weekend of 12-14 September, but no settlements were reached. Due to their
reckless behavior and disregard of risk awareness, the US government had lost confidence in
the bank and chose not to intervene in the inevitable end of Lehman Brothers. When Monday
came, September 15 2008, Lehman Brothers had to file for bankruptcy. An era of 158 years
had ended; the largest bankruptcy in history was a fact, and what in the beginning was a credit
crunch turned into a full blown financial chaos.

The Strategical Failures

There were several strategical mistakes that eventually led the bank into bankruptcy. When
Lehman started to focus more on long-term investments instead of brokerage, it consumed
significantly more capital than before. Considering Lehman Brother’s small equity base this
meant a drastically increase in liquidity risk. (Bankruptcy Report No.08‐13555, 2008) This
created a vicious cycle that in return made it much more difficult for the bank to borrow
capital and to hedge risks. By not carefully investigating and acknowledging the capital
demands of the new business line, Lehman Brothers exposed themselves to liquidity risks
which could have been avoided. An alternative, more risk aware approach would have been to
advance slowly in the new lines. And as the company learns the fundamentals of the business
and thereby the inherent risk as well, successively expand in size.
Lehman Brothers continued to pursuit their aggressive growth strategy despite the financial
crisis. They believed that the subprime crisis would not spread onto other market and to
global economy. Consequently, they believed that instead of reducing risk as their rivals did,
there was an opportunity to take market shares and improve profits. These actions lead to
severe increase in credit risk and operational risk due to an enlarged market risk. In the end a
relatively manageable risk and loss became significantly larger and struck Lehman twice as
hard. A more rational, risk minimizing approach would have been to execute a more thorough
market analysis before making such an important strategically decision. The analysis would
probably have led to some alarming conclusions that would have intimidated the management
to go in another direction. (Bankruptcy Report No.08‐13555, 2008)
The liquidity risks and losses of income were amplified by Lehman Brothers capital structure
and leverage ratio. (Bankruptcy Report No.08‐13555, 2008) The leverage ratio is defined as
total assets divided by shareholders equity. Using leveraged finance is like walking on stilts
when picking apples. As long as you keep your balance, you will be able to get more apples,
but it will hurt more if you fall. In finance, as long as return on total assets is greater than the
capital costs the leverage ratio generates a positive leverage effect, which speaks for a high
leverage ratio. However, if the return on total assets is smaller than the capital cost, the
leverage will make losses substantially larger. So, a high leverage ratio involves a high risk.
The previous leverage regulation made it possible for investment banks to have a ratio of 12
to 1. However, due to a rule change in 2004 they were enabled to enlarge their leverage ratios
up to 40 to 1.( Niall Ferguson, 2008,) Lehman Brothers took advantage of this and in only two
years of time they increased their leverage ratio from 24.4 to 30.7 (Lehman Brothers Annual
Report, 2007).
In real figures, of Lehman Brothers’ total assets of $ 691 billion only $ 22.5 billion was
shareholder’s equity, which meant that $ 668.5 billion were liabilities. With such a high
leverage ratio, a negative return on total assets of 4 % would be greater than the whole
shareholders’ equity. The target leverage ratio is a tradeoff between risk and feasible earnings.
However, one must conclude that Lehman Brothers leverage ratio was way too high and in the
future one must undermine the shareholders growth demand in order to find a more risk aware
ratio. One way to better control the leverage ratio could be to adapt it more flexible after the
conjuncture cycles. In practice this would mean that during stable economic times one should
use a higher leverage ratio. When the conditions start to shifts the management should
successively lower the ratio to effectively hedge the leverage risk. Another, more regulatory
approach, would be to restore the old leverage restrictions. The successes or impact of such
credit regulations is of course hard to determine. However, one cannot deny the force behind a
leverage ratio of 30 to 1. From delivering new record profits each year, Lehman Brothers
found themselves losing $5 billion dollars in only 6 months, quickly destroying the
shareholders equity.

Exceeding the Risk Limits

When analyzing Lehman Brothers risk management one can conclude that Lehman’s
management countless times exceeded their own risk limits, ultimately exceededing their risk
polices by margins of 70% as to commercial real estate and by 100% as to leverage loans.
(Bankruptcy Report No.08‐13555, 2008) One explanation of this rather dangerous behavior
is the compensation system. In order to attract and keep the sharpest minds in the industry,
investment banks normally rewarded their most revenue generating employees with big
monetary bonuses.
However, the bonus incentives are asymmetric. If the firm’s results are negative, it loses its
accumulated capital, whilst the staff only loses its future payments and gets to keep old
bonuses. This situation creates the risk of moral hazard. Traditionally, investments are a
tradeoff between risk and potential profit. However, since bankers at most can lose their job,
they may take excessive risk in order to get bigger bonuses. This creates at situation where the
bankers acts without any feeling of risk. In the case of Lehman Brothers, the staff and
management made a fortune during the good years when the firm made record profits, profits
that were possible due to high risk taking with high leverage and exposure to then profitable
loaning and real estate affairs. For example, Richard Fuld, the CEO of Lehman Brothers who
had ruled the bank for 16 years when it collapsed, made approximately $350 million during
the 00's, even after the stock had crashed. Astronomic salaries bred the greed and short
sighted thinking in management that made them blind to what the result would be if the worst
case scenarios really happened. A big part of the bonuses are paid as stocks in the company, so
the incentives are only partly asymmetric. Of course, running the bank into bankruptcy is
unbeneficial and tragic for everyone in the company, but it seems short-term thinking
overpowered long-term thinking.
Besides exceeding their own risk limits they choose actively not to include their new
business, real estate and leverage loans in their stress test simulations. (Bankruptcy Report
No.08‐13555, 2008) Consequently, Lehman’s management did not have a regular and
systematic way of estimating the potential losses of thess large and illiquid. They motivated
this conduct by a false believe that these new business areas were small in comparison with
their old ones and that the potential profits far exceeded the possible risks. This clearly
demonstrates unnecessary high operational risk taking and could effectively been reduce by a
more humble and professional mindset.

Summary of Recommendations
In essence, a risk describes the probability and consequence of a negative event. The risks
identified and defined by Lehman Brothers in their own business represented different
scenarios in which the bank would suffer losses due to negative events related to market,
credit, liquidity, operations and reputation respectively. In retrospective, it is clear that all of
these scenarios became reality and were reasons to why the giant bank failed. To answer the
question of what could have been done differently is to see how the risks affected the
company and how they interacted.
It’s likely that the bonus system encouraged the management to take big risks. The operational
errors made when excluding assets in stress tests, exceeding established risk limits and over-
leveraging the balance sheet, may have been fueled by bonus prospects. A banking system
without bonuses is unthinkable for many, but another way to decrease the future bonus-related
risk taking could be to build in a risk-aversion parameter in the bonus criteria. For instance,
no bonuses are rewarded if stress test shows large risks, even if profits are big, although this
requires stress testing to be executed by independent instances.
A lot of market risk could have been avoided if Lehman hadn't invested heavily in correlated
assets. The credit crunch hit largely because of the subprime crisis and it affected both
commercial real estate and leveraged loan assets. Because of the ties between the assets,
Lehman was struck quickly by losses on many fronts. The consequences of a hit in this chain
could have been less fatal if the bank had been operating more diverse and not concentrated
its portfolio. Also, if the firm had focused on damage control early and started to sell troubled
assets earlier, they would have suffered less loss. Instead, they doubled down and hoped for a
quick recovery that never came.
When the firm shifted its strategy towards long-term investments, it made itself vulnerable to
liquidity risks. They became dependent on short-term funding for long-term investments,
which turned out to be a fatal mistake as the credit market dried up and they were stuck with
illiquid assets. The shift also made them much more exposed to credit risk through subprime
loans. They clearly underestimated the probability of massive defaults and the consequences
they would have. To avoid this, they shouldn’t have lent as much and irresponsible and not
owned the whole process from origination to securitization. Also, if they had done better
stress testing and simulations, it is probable that they wouldn’t have changed focus from its
brokerage and financial service business, which are more liquid and less risk-inherent.
The effect of the high leverage ratio was that it made the consequences of the other risks
much deeper. As all the other risk scenarios came true, the leverage made the downfall fast
and unstoppable. It's a reason to why a 158-year old bank could collapse less than a year after
its most profitable year ever. As noted, a more flexible leverage ratio could be a way of
decreasing the risks, although it can be difficult to achieve. The easy solution then is to use a
low and sustainable leverage ratio from the beginning. Also, the government regulation which
changed the maximum leverage ratio can be seen as a big error because it made sky-high
leverage possible.
The firm’s excessive risk taking in the other areas eventually damaged the banks reputation.
Lehman failed when it made the probability and consequences of lost confidence disastrous.
Since reputational and liquidity risks are linked together, a downward spiral was created. The
actors on the financial market didn't trust Lehman with funding for its daily operation when
credit markets dried and this became the lethal blow. At this point, Lehman Brothers couldn’t
have acted much differently than what it did. The wheels had already spun out of control and
the end was inevitable.
References
Lehman Brothers (2008), Lehman Brothers 2007 Annual Report

Lehman Brothers First Quarter Report, 2008

Lehman Brothers Second Quarter Report, 2008

Norberg, J. (2009) En perfekt storm - Hur staten, kapitalet och du och jag sänkte
världsekonomin

Valukas, A. R., Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s Report
Chapter 11 Case No.08‐13555, REPORT OF ANTON R. VALUKAS, EXAMINER, Volume I
and III, Jenner & Block LLP . Called “Bankruptcy Report No.08‐13555” in the text.

Niall Ferguson,“Wall Street Lays Another Egg”, Vanity Fair, December 2008, p. 4

Historical Recources (2010), History of Lehman Brothers,

http://www.library.hbs.edu/hc/lehman/history.html

Investopedia Staff (2010), Case Study: The Collapse of Lehman Brothers

http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp

MarketWatch (2008), Lehman posts deep loss, to sell assets

http://www.marketwatch.com/story/lehman-plans-to-jettison-assets-quarterly-loss-hits-39-
billion
Further reading
For those who want to learn more about the subject, there are many sources to chose from.
The book "En perfekt storm: Hur staten, kapitalet och du och jag sänkte världsekonomin"
(availible in English titled "Financial Fiasco: How America's Infatuations with
Homeownership and Easy Money Created the Economic Crisis", (2009)) by Swedish author
and liberal debater Johan Noberg is a good introduction to the financial crisis. It recounts the
crisis, it's buildup and aftermath in a fairly simple way, although it doesn't focus explicitly on
Lehman Brothers.
"A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman
Brothers" (2009), written by Lawrence G. McDonald and Patrick Robinson, narrates the
collapse from McDonald's point of view. McDonald served as vice-president of Lehman
Brothers before and during its demise.
Another book, "Too Big to Fail: The Inside Story of How Wall Street and Washington
Fought to Save the Financial System - and Themselves" (2009) by New York Times
reporter Andrew Ross Sorkin tells the story about the financial crisis in 2008, based on
numerous interviews with people from Wall Street. It deals about Lehman Brothers as well as
the other banks.
A BBC Two documentary called "The Bank That Bust The World" is a part of a series about
the financial crisis is and focuses on the Lehman Brother crash. It describes what led to the
bankrupt, as well as the last days and the consequences.
The bankruptcy report by Anton Valukas, ”Lehman Brothers Holdings Inc. Chapter 11
Proceedings Examiner’s Report” also provides much information, although it’s over 2 200
pages. The report is divided into volumes so it is still possible to read on specific topics.