Pamantasan ng Cabuyao

College of Business Administration and Accountancy

ETH101

Group 3

Lehman Brothers: The Collapsed

Submitted by:
Bangsal, Jewett Charles S.
Cabaluna, Mikhaela B.
Castor, Danica C.
Matira, Noverlyn F.
Merano, Hannah Mae B.
Nangca, Marjeth V.
Obias, Prances Dianne R.
Pioquid, Hannah Nicole B.
Saulo, Marc C.

2BSA-2 / Tuesdays / 3pm – 6pm

Submitted to:
Prof. Norvin L. Tamisin, MBA

TOPIC
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Lehman Brothers: The Collapsed

KEY TERMS AND CONCEPTS

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.
The case establishes an overview of the risks included in Lehman Brothers’ business, how they
were neglected and finally led to the downfall.
The main business areas of Lehman before the collapse were 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.
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.
Before the bankruptcy, Lehman Brothers’ risk management department had identified five
specific risks inherent in their business namely:
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.
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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.

Exposed also on the case were the following terms relating the Lehman Brothers Bankruptcy
including:

Liquidity crisis is the inability to meet short term obligation.

Derivative instruments enable firms to derive the value of investment from the changes in the
price and value of other underlying assets such as stocks or commodities.
Collateralized Debt Obligations (CDOs) also accounted for the losses in the securities market
during the global financial crisis of 2007. CDOs are derivative instruments which involves the
conglomeration of both prime and subprime securities intended to be sold to a special purpose
vehicle in a low-tax jurisdiction.
Leverage is the firm’s capability to finance a portion of its assets with securities bearing fixed
rate of interest with the hope of increasing the ultimate returns to the equity shareholders.

BACKGROUND OF THE CASE

The failure of Lehman Brothers in 2008 was the largest case of bankruptcy in US history.
But the failure was the beginning of a series of events that were yet to be unfolded.
The news and negative effects of the bankruptcy rippled through the market. The Dow Jones
Industrial Average declined by more than 500 points by the end of the trading session of the day
(Mamun & Johnson, 2012). Tremendous research has been done on the failure of Lehman

Brothers including the causes of failures and whether it could have been prevented. A
devastating report in March 2010 “recounted in minute detail the practices carried out by
Lehman Brothers, an institution founded in 1850 that declared bankruptcy on September 15,
2008. Notably, the executives were accused of “gross negligence” in their duty of disclosure”
(Morin & Muax, 2011, p. 38). This also sheds light on unethical practices that were either
directly exercised by top managers or were supervised under their watch. Also, many blame
accounting standards and techniques and how they are used to portray financial statements as not
what they are, but how management wants them to portray. These practices leave open windows
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of opportunities for those whose intentions are to misuse their position, whether it is for personal
reasons or short-term gains of the organization. In case of the Lehman it seems that it was more
of the latter. Lehman failed to disclose various transactions in the notes to their financial
statements. This may be due to negligence of accountants and auditors that leads many to argue
for the reexamination of Generally Accepted Accounting Standards (Jeffers, 2010).
Many also blame the techniques that are currently used to predict firms’ financial distress.
The numerous bankruptcies and financial difficulties that US banks went through in 2008,
including the events that analysts failed to predict, indicated shortcomings in financial analysis
techniques (Morin & Maux, 2011).
There is no single cause that led to the failure of Lehman Brothers. There were numerous
causes and agents that led to the disaster, including greedy Wall Street traders, the debt load of
American households, the Fed’s action, rating agencies, and last but not least, the deregulation
(Morin and Maux, 2011). These factors were responsible for the crisis of credit and not solely the
failure of Lehman Brothers. Still, the market of Credit Default Swaps was one of the biggest
factors dedicating to the catastrophe, if not the biggest one as Lehman was heavily involved in
that market. In explaining the sub-prime market, Morin and Maux (2011) explain that sub-prime
loans “refer to inferior quality (sub) real estate loans whose higher risk of payment default is
countered by the bank with a higher interest rate. These mortgage loans, granted at variable rates
were extended to American households with modest incomes” (p. 41). Morin and Maux (2011)
also discuss Lehman’s involvement in that particular market as well as how Lehman
caused erosion in that market at the same time:

“The bank is accused of having sold Collateralized Debt Obligations (CDOs) to its clients and
taking short positions that effectively eroded the value of these securities. In doing so, Goldman
Sachs also helped other clients to short the mortgage bond market and triggered the plunge of the
subprime market. Rumors of collusion between banks
soon followed”

“Investments in the sub-prime mortgages and mortgage backed securities are at risk of being
written off amid a crisis in the US sub-prime mortgage market. Much of that subprime debt was
repackaged as collateralized debt obligations (CDO’s) and mortgage backed securities and was
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sold in the wholesale market. Many of the hedge funds and investment vehicles invested heavily
in these securities and are finding them illiquid due
to the defaults in the mortgage market.”

The schemes Lehman allegedly carried out using REPO 105 therefore had a significant
impact on its balance sheet by undervaluing its liabilities. The income statement was also
affected, but to a lesser extent: financing costs were undervalued given that Lehman did not
recognize these REPO transactions as loans. However, with respect to the cash flows involved in
these transactions, inflows and outflows of funds are the same regardless of the accounting
method used.
Repo as repurchase agreement (repo) that has historically been used by companies to
manage their short term cash. But in the Lehman case, these transactions took an unusual spin
that were intended to make Lehman’s balance sheet look healthier that what they really appeared
to be. The traditional agreements normally involve an investment banking firm giving a
counterparty highly liquid securities in exchange for cash. These are accounted for as loans with
collateral. In case the investment banking firm is not capable of paying, the lender will sell the
collateral for his money to be reimbursed.
Sarbanes-Oxley Act was enacted into law in 2002 and in response to the collapse of Enron
and WorldCom, following the discovery of many accounting scandals. The Act is designed to
restore investors’ confidence, to enhance the reliability and accuracy of the financial reporting, to
improve the corporate governance system, to improve the content and timeliness of the disclosue
requirements, to strengthen the role of the independent directors, and to improve the internal
control practices and procedures.

STATEMENT OF THE PROBLEM

The issues being discussed in the case are:
a. Credit Default Swaps;
b. Unethical behavior of top managers;
c. Misinterpretation of financial statements; and
d. Low standard and complex structure of the company;
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ANALYSIS OF THE PROBLEM
The failure of Lehman Brothers was contributed to numerous factors that went in parallel to
contribute to the biggest bankruptcy in the US history. They went hand in hands because no
single factor could have brought this disaster by itself. Dubious and doubtful accounting
practices could not be possibly practiced in the long run if not for low ethical standards held by
top managers as well as the auditors. It seems as if auditors mainly tried to shield themselves
from legal action just by executing the minimum requirements expected from them. The Repo
105 procedure is nothing but an ordinary and legal practice for short-term financing that was
taken out of its context by unethical accounting practices in order to please investors and lenders.
The complex structure of Lehman also provided a window of opportunity for the same unethical
managers to abuse the trust that was placed in them, the organization, and management by
investors and shareholders. It can also be concluded that the Sarbanes-Oxley Act was violated
because top managers deliberately tainted the financial statements to falsely show the health of
the company to be better than what it really was at the time. Once these managers were incapable
of reaching their growth and expansion rate they had to inflate their financial statements to keep
the appearance of a company with high rate of growth.
At the end, Lehman’s failure had an impact beyond expectations. The consequences did not
just leave its negative print on the economy but also on the society with the lost confidence in
institutions and corporate culture. As Greenfield (2010) mentions, “one must wonder when
businesses and their executives will realize that their activities can significantly impact the very
fabric of human society”. In any event, holding higher standards and ethical culture by auditors,
managers, and rating agencies are essential in avoiding this sort of disaster.

ACTION PLAN

Caplan et al., (2010) mention

that in 2006, Lehman made a
deliberate decision in
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pursuing a higher-growth
business strategy. To achieve
their goal they switched from a
low-risk
brokerage model to capital-
intensive banking model that
required them to buy assets and
store
them as opposed to acquiring
assets to primarily moving them
to a third party. Having to keep
the assets internalized the risk
and returns of the investments.
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The mismatch between short-

term debt and long-term,
illiquid investments required
Lehman to continuously roll
over its debt, creating
significant business risk.
Lehman
Caplan et al., (2010) mention
that in 2006, Lehman made a
deliberate decision in
pursuing a higher-growth
business strategy. To achieve
their goal they switched from a
low-risk
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brokerage model to capital-

intensive banking model that
required them to buy assets and
store
them as opposed to acquiring
assets to primarily moving them
to a third party. Having to keep
the assets internalized the risk
and returns of the investments.
The mismatch between short-
term debt and long-term,
illiquid investments required
Lehman to continuously roll
over its debt, creating
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significant business risk.

Lehman
Caplan et al., (2010) mention that in 2006, Lehman made a deliberate decision in pursuing a
higher-growth business strategy. To achieve their goal they switched from a low-risk brokerage
model to capital-intensive banking model that required them to buy assets and store them as
opposed to acquiring assets to primarily moving them to a third party. Having to keep the assets
internalized the risk and returns of the investments. The mismatch between short-term debt and
long-term, illiquid investments required Lehman to continuously roll over its debt, creating
significant business risk. Lehman borrowed hundreds of billions of dollars on a daily basis. Since
market confidence in a company’s viability and debt-servicing ability is critical for it to access
funds of this magnitude, it was imperative for Lehman to maintain good credit ratings (p. 24). In
order to pursue this high growth trend they had no other option but to aggressively target a high
growth rate in revenues. But they also had to target an even faster growth in its balance sheet and
total capital base. This unreachable target led them to hold $700 billion in assets in 2007 on
equity of $25 billion with $675 billion in liabilities (Caplan et al., 2010). This unfeasible strategy
at the time also brought along higher risk because most of assets were long term and highly
illiquid. Commercial real estate, private equity, and leveraged loans were just to name a few. As
the subprime crisis unfolded Lehman had to act quickly, and that meant liquidating a vast
amount of its illiquid assets in housing mortgages. Negative perception of the market caused the
assets to be bought as even a lower price. Looking back at the events unfolding and the strategy
that Lehman chose, one may conclude that pursuing the company strategy at any cost was
absolutely wrong. There is a cost to any strategy and Lehman must have forgone its high-growth
strategy if its cost outweighed the benefits and was deemed as unfeasible at the time.

RECOMMENDATIONS
The demise of Lehman clearly shows the linkage between regulations and actions management
set-ups. The failures exposed the deficiency in the regulatory system thereby requiring urgent
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need for strict supervision of specific performance indicators such as a firm’s liquidity position,
solvency and profitability. Policy makers such as the International Financial Reporting
Standards, SEC, the Basel Accord et al, must initiate stringent policies to address Lehman failure
to avert any future occurrence. Firms must also be compelled to adhere to good corporate
governance practice to restore investors’ confidence. Sound ethical practices and standards must
adhere to and replicated in every organization. Also if they had done better stress testing and
simulations they would have not changed their focus from brokerage and financial services. The
high leverage ratio affected the other risks adversely making downfall fast and unstoppable.

CONCLUSIONS
The recent competition in the banking industry has led to most banks engaging in risky
exposures. 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 (Morin & Maus, 2011). External auditors also played a major part in this failure by not
detecting these financial statement malpractices by the Lehman managers. According to
Greenfield (2010), the main indicators of fraud could be detected in the financial statement
apparently; the external auditors could not discover this activity. It must however be noted
that the demise of Lehman had not impacted on the US economy alone but the world as a whole
hence; firms ought to eschew unnecessary business strategies, stringent supervision of existing
regulations, amended of the reporting standards to prevent dubious accounting practices,
formulation of 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.
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REFERENCES
Lehman_Brother.pdf
Lehman_Brothers_.docx
lehmanfinal.pdf
SSRN-id2016892.pdf
https://www.researchgate.net/publication/230687440_The_Bankruptcy_of_Lehman_Brothers
_Causes_of_Failure_Recommendations_Going_Forward
https://www.researchgate.net/publication/324808648_lehman_Brothers_Financial_Case