Case Study: The Collapse of Lehman Brothers

On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time. (For more information on the subprime meltdown, read Who Is To Blame For The Subprime Crisis?) The History of Lehman Brothers Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded by German immigrant Henry Lehman inMontgomery, Alabama, in 1844. In 1850, Henry Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers. 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 theU.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. (To learn more about previous financial disasters, be sure to check out our Crashes Special Feature.) The Prime Culprit In 2003 and 2004, with the U.S. housing boom (read, bubble) well under way, Lehmanacquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. (Check out the answer to our frequently asked question What is a subprime mortgage? to learn more about these loans.) Lehman's Colossal Miscalculation In February 2007, the stock reached a record $86.18, giving Lehman a market capitalizationof close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. In the postearnings conference call, Lehman's chief financial officer (CFO) said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy. The Beginning of the End

Lehman was quickly running out of time. housing market gained momentum. Lehman declared bankruptcy. Lastditch efforts over the weekend of September 13 between Lehman. In 2007. amid plummeting equity markets worldwide. these measures were perceived as being too little. The firm also said that it had boosted its liquidity pool to an estimated $45 billion. Too Late However. Moody's Investor Service announced that it was reviewing Lehman's credit ratings. including a write-down of $5. The firm reported a loss of $3.) Hurtling Toward Failure Lehman's high degree of leverage . or four times its shareholders' equity. and reported that it had raised another $6 billion from investors. while its short-term creditors cut credit lines. as the state-owned South Korean bank put talks on hold. Even as the correction in the U. On September 10.500 mortgage-related jobs and shut down its BNC unit. The stock plunged 77% in the first week of September 2008. However. the stock resumed its decline as hedge fund managers began questioning the valuation of Lehman's mortgage portfolio. Lehman pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position. Over the summer. The same day. 2008. and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions. after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time. it also closed offices of Alt-A lender Aurora in three states. decreased gross assets by $147 billion. reduced its exposure to residential and commercial mortgages by 20%. which in retrospect. the company eliminated 2. Lehman's stock rebounded. In addition.As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds. In the fourth quarter of 2007. Lehman's stock fell sharply. With only $1 billion left in cash by the end of that week.the ratio of total assets to shareholders equity . Lehman continued to be a major player in the mortgage market. its first loss since being spun off by American Express.8 billion.6 billion. aimed at facilitating a takeover of Lehman. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9. the firm did not take the opportunity to trim its massive mortgage portfolio. and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. too late. and also announced a sweeping strategic restructuring of its businesses. leading to a 45% plunge in the stock and a 66% spike in creditdefault swaps on the company's debt.9 billion. (Read more in Dissecting The Bear Stearns Hedge Fund Collapse.S. Lehman underwrote more mortgage-backed securities than any other firm. resulting in the stock plunging 93% from its previous close on September 12. On Monday September 15. Barclays PLC and Bank of America.the second-largest underwriter of mortgage-backed securities . would turn out to be its last chance.) Too Little. following the near-collapse of Bear Stearns . During that month. The company's hedge fund clients began pulling out. These developments led to a 42% plunge in the stock on September 11. The news was a deathblow to Lehman. Confidence in the company returned to some extent in April. as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. On June 9. and cut down leverage from a factor of 32 to about 25. as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. On March 17. Lehman's management made unsuccessful overtures to a number of potential partners.was 31 in 2007.Lehman shares fell as much as 48% on concern it would be the next Wall Street firm to fail. Lehman announced a second-quarter loss of $2. . accumulating an $85-billion portfolio. However. (Read Hedge Fund Failures Illuminate Leverage Pitfalls to learn more about the double-edged sword of leverage. were unsuccessful.

and fall even more. government's decision to let Lehman fail. In June 2003.creating a flood of liquidity in the economy. always looks to be taken for a ride. as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008.the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments. The Fed continued slashing interest rates. Unfortunately.S.) When the Wall Street evangelists started preaching "no bailout for you" before the collapse of British bank Northern Rock. August 2007 turned out to be just the starting point for big financial landslides. by continued low inflation despite lower interest rates. they hardly knew that history would ultimately have the last laugh. holding the hands of a willing banker was a new ray of hope. no job and no assets. the seeds of the subprime meltdown were sown during unusual times. emboldened. and accounting scandals. (For more reading on the subprime mortgage market. In this article. and internationally. the Fed lowered interest rates to 1%.S. fall. the fear of recession really preoccupied everybody's minds. For them. This environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold. once out of the bottle. see Who Is To Blame For The Subprime Crisis?. more home buyers. (For further reading. With the onset of the global credit crunch and the fall of Northern Rock. see ourSubprime . Although the economy nicely withstood terrorist attacks. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out. the U.5% in May 2000 to 1.S. given the size of the company and its status as a major player in the U. These subprime borrowers wanted to realize their life's dream of acquiring a home. we'll recap how the financial crisis of 2007-08 unfolded. Many questioned the U. more appreciation in home prices. short-livedrecession.from 6. the lowest rate in 45 years.Conclusion Lehman's collapse roiled global financial markets for weeks. In 2001. perhaps. The Bright Side Of The Credit Crisis and How Will The Subprime Mess Impact You?) The 2007-08 Financial Crisis In Review Before the Beginning Like all previous cycles of booms and busts.economy experienced a mild. no one was there to warn about the tummy aches that would follow. The whole financial market started resembling a candy shop where everything was selling at a huge discount and without any down payment. It wasn't long before things started to move just as the cheap money wanted them to. Since then. Cheap money. It found easy prey in restless bankers . we have seen many big names rise. read The 2007-08 Financial Crisis In Review. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal that was also announced on September 15. More home loans. "Lick your candy now and pay for it later" . (To learn more about the financial crisis. the bust of thedotcom bubble.and even more restless borrowers who had no income.75% in December 2001 . (Keep learning about bubbles in Why Housing Market Bubbles Pop and Economic Meltdowns: Let Them Burn Or Stamp Them Out?) To keep recession away. the Federal Reservelowered the Federal funds rate 11 times .

By that time. This caused 2007 to start with bad news from multiple sources. Investments and the Public Problems in the subprime market began hitting the news.S. homeownership had peaked at 70%.which freed them to leverage up to 30-times or even 40-times their initial investment. But even this large move was only a small affair in comparison to what was to happen in the months ahead. Northern Rock.Mortgages special feature. Declines Begin There were early signs of distress: by 2004. largely due to prevailing fear of the unknown amidst banks. Bear Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages . The Beginning of the End But. had to approach the Bank of England for emergency funding due to a liquidity problem.Goldman Sachs (NYSE:GS). Lehman Brothers. From June 30. which led to a 40% decline in the U. well-known New Century Financial also filed for bankruptcy. Home Construction Index during 2006. U. Every month. central banks and governments around the world had started coming together to prevent further financial catastrophe. To make things merrier. In April. The trouble started when the interest rates started rising and home ownership reached a saturation point.S. Horror stories started to leak out. They decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. a British bank. onward. The interbank market froze completely. home prices started to fall. which . the Fed started raising rates so much that by June 2006. raising more people's curiosity. During February and March 2007. Merrill Lynch (NYSE:MER). every good item has a bad side. more than 25 subprime lenders filed for bankruptcy. August 2007: The Landslide Begins It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United State's borders. no one was interested in buying or eating more candy. feeling as if the cavities were never going to come. but many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans.) But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. Multidimensional Problems The subprime crisis's unique issues called for both conventional and unconventional methods. Then. 2004. Everybody was on a sugar high. Bear Stearns and Morgan Stanley (NYSE:MS) . Not only were new homes being affected. one subprime lender or another was filing for bankruptcy. theSecurities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks . which was enough to start the tide. According to 2007 news reports.enough to start a global financial tsunami if more subprime borrowers started defaulting. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed.25% (which remained unchanged until August 2007). in October 2004. By June. during the last quarter of 2005. and several of these factors started to emerge alongside one another. the Federal funds rate had reached 5.

By October 2008. especially mortgage-backed securities. government then came out with National Economic Stabilization Act of 2008. China. a seeming liquidity crisis can very quickly turn into a solvency crisis for financial institutions. Merrill Lynch was sold to Bank of America. But the silver lining is that. Crisis of Confidence After All The financial crisis of 2007-08 has taught us that the confidence of the financial market.75%. after every crisis in the past.were employed by governments worldwide. Bear Stearns was acquired by JP Morgan Chase (NYSE:JPM). central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. Central banks in England. The idea was to put the interbank market back on its feet. respectively. The U. once shattered. markets have come out strong to forge new beginnings. government guarantees and outright nationalization. and Fannie Mae and Freddie Mac were put under the control of the U. but bad news continued to pour in from all sides. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown. can't be quickly restored. Canada. federal government. The Fed started slashing the discount rate as well as the funds rate. In a unanimous move. Indymac bank collapsed. In an interconnected world. the Federal funds rate and the discount rate were reduced to 1% and 1. Lehman Brothers filed for bankruptcy. Switzerland and theEuropean Central Bank (ECB) also resorted to rate cuts to aid the world economy.S. Different governments came out with their own versions of bailout packages. a balance of payment crisis for sovereign countries and a fullblown crisis of confidence for the entire world. which created a corpus of $700 billion to purchase distressed assets.S. . Sweden.

» Study the role of leadership at Lehman Brothers behind the company's rise and subsequent collapse. Contents: Page No.Victim or Culprit? What Went Wrong? The Fed's Decision? 1 2 5 10 11 13 . Issues: » Understand the reasons that led to the subprime crisis in the US and its impact on financial institutions.The case discusses the rise and fall of Lehman Brothers Inc (Lehman Brothers) from a small dry goods store to one of the leading investment banks in the US. » Examine the innovations in financial instruments primarily derivatives. » Analyze the consequences of lack of supervision on OTC derivatives and mortgage lending mechanism in the US. Introduction The Subprime Crisis The Fall of Lehman Fuld . The case highlights the role of several stake holders in the mortgage business that contributed to the crisis. It also explains the role of certain OTC derivative instruments that led to the collapse of the company. It examines the various factors that contributed to the fall of Lehman Brothers including leadership issues. » Debate on the role played by the US policy makers for adopting liberal credit driven economic growth policy that eventually led to the subprime crisis. excessive leverage. It examines in detail the reasons that led to the subprime crisis since the year 2007 in the US and how it led to the collapse of 158 year old Lehman Brothers. » Analyze the aggressive strategies that Lehman Brothers followed in the mortgage business. » Appreciate the significance of risk management and the drawbacks of excessive leverage. failure of risk measures employed like 'Value at Risk' and poor regulation of the investment banking industry.

However. The bank reported a loss of US$ 2.Henry M.Exhibits "The collapse of Lehman Brothers has sent a major jolt through global financial markets as it is by far the biggest victim of the credit crisis that started in August 2007 and had been considered too big to fail. its first loss since it went public in the year 1994. The Korea Development Bank (KDB)5 which had earlier evinced an interest in purchasing a 25% equity stake in Lehman announced that it had withdrawn this offer.. As per the details filed by Lehman in its bankruptcy filings." 2 .9 billion (after provisioning for US$ 5. Global Insight. in 2008.8 billion in the second quarter of 2008 ending May 2008.15 to US$ 7. 2008.Howard Archer. Paulson Jr. With this. "Lehman announced bad earnings around the middle of June.6Lehman could not manage to restore confidence in the markets and raise capital . US-based Lehman Brothers (Lehman). 2008. in September 2008. the bank announced a restructuring plan that intended to sell a majority stake in its investment management business (Refer to Exhibit II for the business segments of Lehman Brothers). filed for Chapter 11 bankruptcy3 sending shock waves through the financial sector the world over. The plan also included spinning off a majority of its remaining commercial real estate holdings that had gone bad. it held assets worth US$ 639 billion4 whereas its total liabilities stood at US$ 613 billion." 1 . and we told Fuld that if he didn't have a solution by the time he announced his third-quarter earnings. Lehman's shares plunged by almost 45% from US$ 14.79 after KDB's announcement. Economist. United States Treasury Secretary. We pressed him to get a buyer. KDB backed off stating that the price Lehman quoted was too high and hence it was not interested in purchasing the stake because of bad market conditions. Lehman again reported a net loss of US$ 3. Introduction On September 15. there would be a serious problem. into a new public limited company. one of the top five investment banks in the US.6 billion in write-downs) for the third quarter ending August 2008 (Refer to Exhibit I for the financial highlights of Lehman Brothers between 2003 and 2007). Lehman earned the dubious distinction of having filed the biggest bankruptcy ever in the world. on September 10. To turn around its operations.

They claimed that the bankruptcy could have been avoided if JP Morgan had not frozen Lehman's assets. most of them agreed that the then ongoing subprime crisis was a root cause. joined him and the store was renamed as H.Victim or Culprit? Fuld. joined the firm in 1850 the name of the firm was changed to Lehman Brothers. Henry's brother. selling a part of its equity stake and eventually had to file for Chapter 11 bankruptcy. Alabama. . in Montgomery. Lehman. another brother. Henry died in 1855 due to yellow fever. Analysts felt that Fuld was riding high on his success and was aggressively conducting business to attain the top slot in the investment banking business.. Excerpts The Fall of Lehman Lehman Brothers was founded in 1844 when 23year-old Henry Lehman (Henry) emigrated from Germany to the US and opened a dry goods store. While many analysts attributed different reasons for the collapse of Lehman. the US government adopted a policy of credit driven consumption led growth for its economy. which had led to a liquidity crisis. Analysts claimed that the move by JP Morgan Chase (JP Morgan)7 to freeze Lehman's assets days before the bank filed for bankruptcy was one of the factors responsible for Lehman's collapse. In 1847.. Fuld .. Lehman & Brothers. who was Wall Street's longest serving CEO till Lehman collapsed. Emanuel Lehman (Emanuel). American policy makers started slashing interest rates to ease the liquidity in the system from late 2001.. was known to be very loyal to the company and brought the firm out of difficult situations several times during his tenure. The Subprime Crisis In order to overcome the crisis caused by the dot com burst8 and 9/11 attacks9. After Mayer Lehman (Mayer). To stimulate consumption.

.6 per cent to 2..96 points Dow Jones Industrial Average was down 4...91 points Impacts Main article: Financial crisis of 2007±2010 . Paulson's (Paulson) decision for not bailing out Lehman whereas another Wall Street investment bank Bear Stearns had been bailed out in March 2008.179.51 points Nasdaq Composite index fell 3. Experts opined that with the huge fiscal deficit and balance of payment deficit the US had.192. Exhibits Exhibit I: Financial Highlights of Lehman Brothers Exhibit II: Business Segments of Lehman Brothers    The wider index closed down 4. The US economy had a savings rate close to zero in 2007.7 per cent at 1. Many analysts criticized US Treasury Secretary Henry M. The Fed's Decision? The Fed's decision to let Lehman file for bankruptcy rather than providing a bailout solution attracted mixed reactions from several analysts. the US dollar (dollar) would have depreciated unless it was a global currency.What Went Wrong? Industry experts blamed the subprime crisis and the resultant collapse of Lehman Brothers on the global macroeconomic imbalance that the US had created.4 per cent lower at 10.917.

the S&P 500.2 trillion and pension assets lost $1. Total retirement assets.3 trillion.S. a broad U. Taken together. stock index. Total home equity in the United States. During the same period. savings and investment assets (apart from retirement savings) lost $1.8 trillion by mid-2008 and was still falling in late 2008. Housing prices had dropped 20% from their 2006 peak. Impacts from the Crisis on Key Wealth Measures Between June 2007 and November 2008.[182][183][184] [edit]Financial market impacts. had dropped to $8. 2007 Further information: List of writedowns due to subprime crisis FDIC Graph . dropped by 22 percent. these losses total a staggering $8.S.3 trillion.[edit]Impact in the U. from $10.U.3 trillion in 2006 to $8 trillion in mid2008. [181] Members of USA minority groups received a disproportionate number of subprime mortgages. Americans lost more than a quarter of their net worth. with futures markets signaling a 30-35% potential drop. Bank & Thrift Profitability By Quarter . Americans' second-largest household asset.S. which was valued at $13 trillion at its peak in 2006. and so have experienced a disproportionate level of the resultingforeclosures. By early November 2008. was down 45 percent from its 2007 high.

the first major subprime related loss to be reported.2 billion in 2006 Q4 to $646 million in the same quarter a year later. [188] As the crisis deepened. [189] Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle. or announced that they were negotiating seeking merger partners. when HSBC. About $750 billion in such . down 31% from a record profit of $145 billion in 2006. 2008 The TED spread ± an indicator of credit risk ± increased dramatically during September 2008. a decline of 98%. Top management has not escaped unscathed. Further information: Indirect economic effects of the subprime mortgage crisis As of August 2008. wrote down its holdings of subprime-related MBS by $10. insured depository institutions earned approximately $100 billion.[193][194] [edit]Financial market impacts. some of which has been invested into food and raw materials. the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it intocommodities as "stores of value".5 billion. [185] During 2007.The crisis began to affect the financial sector in February 2007.5 trillion of their holdings of subprime MBSs. In all of 2007. at least 100 mortgage companies either shut down. Profits declined from $35.6 billion in 2007 Q1 to $19.[192] Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository institutions insured by the FDIC to decline from $35. financial firms around the globe have written down their holdings of subprime related securities by US$501 billion. 2007 Q4 saw the worst bank and thrift quarterly performance since 1990."[190][191] Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds.3 billion in 2008 Q1. more and more financial firms either merged.[195] The IMF estimates that financial institutions around the globe will eventually have to write off $1. a decline of 46%. as the CEOs of Merrill [187] Lynch and Citigroup resigned within a week of each other in late 2007. suspended [186] operations or were sold. During 2007. the world's largest (2008) bank.

by purchasing newly issued preferred stock in their major banks. These losses are expected to top $2. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. This was the largest liquidity injection into the credit market. some economists state that Third-World economies. a measure of the risk of interbank lending. $150 billion were withdrawn from USA money funds. and other central banks was immediate and dramatic. these central banks purchased US$2.8 trillion from 2007-10. Thus the massive reduction in bank capital just described has reduced the credit available to businesses and households. The IMF estimated that U. This credit freeze brought the global financial system to the brink of collapse.5 trillion.[198] The International Monetary Fund estimated that large U. and the largest monetary policy action. These losses have wiped out much of the capital of the world banking system. banks losses were forecast to hit $1 trillion and European bank losses will reach $1. banks were about 60 percent through their losses. [196] However.S.5 trillion of government debt and troubled private assets from banks. In effect. The TED spread (see graph above).S. the money market was subject to a bank run. The response of the USA Federal Reserve. quadrupled shortly after the Lehman failure. The governments of European nations and the USA also raised the capital of their national banking systems by $1. theEuropean Central Bank. the crisis hit a key point. such as the Brazilian and Chinese ones.S. will not suffer as much as those from more developed countries. Banks headquartered in nations that have signed the Basel Accords must have so many cents of capital for every dollar of credit extended to consumers and businesses. [197] During a two day period in September 2008. [196] When Lehman Brothers and other important financial institutions failed in September 2008.6 trillion. During the last quarter of 2008. U.[199] . but British and eurozone banks only 40 percent. The average two day outflow had been $5 billion. The money market had been a key source of credit for banks (CDs) and nonfinancial firms (commercial paper). in world history.losses had been recognized as of November 2008.

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